So it has come to this: users of Amazon.com can now make charitable donations to cash-starved web sites with a simple point-and-click. The Amazon Honor System (we're not making this up) helps revenue-challenged businesses (i.e. those that can't make money) solicit cash from generous and guilt-ridden consumers in a fast, New Economy manner. Some would equate this program to the regular "pledge" drives on public television; others would call it panhandling. We were going to congratulate Amazon.com on its altruism and civic-mindedness, but then we discovered the company takes a 15% commission on every donation (again, we're not making this up).

As this anecdote underscores, the world has changed a great deal in the past twelve months. From the pinnacle of last year's NASDAQ market -- and all its apparent enthusiasm, rosy outlook and embrace of unproven business models -- the New Economy stocks have come crashing down. In fact, NASDAQ's 65% decline since last March may actually underestimate the carnage. Layoffs, liquidations and bankruptcies are rippling through last year's hottest sectors, and the impact is now being felt in the more traditional areas of the U.S. and foreign economies. The latest statistics point to a significant economic slowdown, and broader market averages such as the S&P 500 are down more than 20% over the past year. Despite the apparent gloom, however, our clients have enjoyed strong positive investment returns over the past twelve months, emphasizing once again the benefits of the stock selection and investment discipline we've highlighted for some time. We think there are a number of good reasons for our clients to remain optimistic -- more on that in a moment -- but it's fairly clear the economic winds won't be as favorable as they've been in recent years.

While the magnitude of the current slowdown is still unknown, the speed of the decline -- in both economic and market terms -- is without question. So far, this slowdown feels like a recession (even if we haven't met the technical definition yet) because of what a mathematician would call the "second derivative" effect: going from a +6% rate of growth to +1% is a bigger rate of change than if we went from +2% to -2% (the pattern for the typical postwar recession). We may get into negative territory yet, as inventories of PCs, cell phones and other high tech equipment pile up, product prices fall, profit margins evaporate and layoffs increase. And the weakness is spreading to other sectors as well. But whether we are in a technical recession or not, the point is that high stock prices and optimistic forecasts created, in hindsight, too much capacity and too much inventory. The stock market decline hasn't helped, either, since more individuals have more of their assets invested in equities than at any time in history. A recent study showed U.S. household net worth declined in 2000 for the first time in at least 55 years, and shrinking portfolios lead to declining consumer confidence and less spending (just as the opposite occurred on the way up).

While our economy has faltered before, this is the first time in nearly thirty years that U.S. economic malaise has coincided with similar weakness in both Europe and Asia. Europe, on one hand, appears to have a few wild cards up its sleeve: the switch to a single currency and the increasing willingness of governments and business leaders to embrace concepts such as deregulation, privatization and maximization of shareholder wealth. But Asia's ultimate recovery rests squarely on Japan, the second largest economy in the world and one mired in such a political and economic morass that its stock market today stands no higher than it did in 1986, two-thirds below its peak. With the Internet Bubble now being compared to Japan's own stock market bubble of the 1980s, it's fair to question whether our economy and markets face a similar fate.

The Japanese economic success of the 1980s was driven by an activist central government and a cost/quality-focused corporate sector. For its part, Japan's government targeted and supported important industries (such as automobiles and electronics), directing investment spending and managing competition. At the same time, Japanese corporations succeeded in making their products as low-cost and high-quality as any in the world through unique manufacturing techniques. The result was an export-driven economy that produced outstanding, competitive products for consumers throughout the world. But even at their peak, Japanese companies were far less profitable than their Western counterparts, and Japanese consumers suffered from high local prices and stifling regulation.

But the web of interlocking shareholdings among corporations and the major banks (keiretsu) -- plus an overinflated real estate market -- placed the boom in a much more precarious spot than most realized. As the Nikkei dropped from its 1989 peak near 39,000 (like NASDAQ, it simply fell of its own weight from an unsupportable level), the domino effect placed the entire economy at risk. The stock market crisis quickly became a banking disaster, but unlike our own S&L crisis of a decade ago, the bad loans have essentially remained on the books of the banks. Without aggressive writeoffs and restructuring, these loans have proved to act like a noose around the neck of the economy. Japan's activist government sought to counteract the slowdown through massive public works projects -- $1.1 trillion spent since 1993 on bullet trains, bridges and tunnels -- but this has brought deflation and low investment returns rather than recovery. Years after the slowdown began, Japan's fate seems dire indeed: massive government debt, true deflation in product prices (the only industrialized country to experience true deflation since the 1930s) and $250 billion in bad loans still on the books of the struggling banks. And if that weren't enough of a nightmare, bank interest rates are now at zero and still are not low enough to jump-start the economy!

We won't attempt to offer any new prescriptions for Japan. But as we see it, the differences between the U.S. and Japan are meaningful enough to predict that our post-bubble fate won't follow the Japanese model. Most important, Japan's economy remains insular, unreformed and rooted more in politics rather than in the free market. There have been few real reforms in Japan in the past decade -- a revolving door of political leaders lacks the will to force the painful restructuring that any successful solution requires. Recently Matsushita, the consumer electronics giant (e.g. Panasonic) made a major cost-cutting announcement to address its profit woes. Instead of layoffs, the company is simply shifting to other divisions 5,000 workers out of its total of 290,000. Until companies and the banks bite the bullet and focus on profitability rather than politics, investment returns will stay low and Japan -- and the rest of Asia -- will languish.

The U.S. economy is by no means perfect, but there are several features of the U.S. system that should help to prevent a decade-long malaise. The first is a strong belief in the market itself. While Japanese politicians consider how to use the nation's savings to artificially prop-up the stock market, Washington has learned over the years that self-corrective market mechanisms can play an important role. The rise and subsequent failure of so many dot-coms is unnerving but it allows scarce investment capital to seek the highest returns possible, just as the rapid recovery from the S&L crisis proved a decade earlier. Second, an independent Federal Reserve helps ensure that short-term political fixes don't dominate required long-term medicine. While it's easy to criticize the Fed for the recent stock market decline, the last ten years have been pretty darn good. Greenspan was early, but he was on the right track with "irrational exuberance" warnings in 1996. The Fed's most recent interest rate cuts are the largest and swiftest ever, and there is no reason to believe they won't work as intended. Finally, the Japanese bubble encompassed the entire economy while our problems appear to be contained to just a few economic sectors; the repair and recovery should be more assured.

In bull markets, investors have a great deal of faith -- in politicians, Federal Reserve presidents, earnings estimates and new business ideas; in bear markets, that faith is usually replaced by doubt. Today, it's easy to wonder how the market and U.S. economy can recover. Greenspan, once hailed as a visionary, now receives the scorn of millions of investors for not acting more aggressively to bail them out of a declining stock market. From our perspective, the events of the past year were not surprising and have run close to script. An uncertain atmosphere is the hallmark of any rapid stock market decline, and this is precisely when thoughtful fundamental analysis can provide attractive long-term investment returns. As always, we remain focused on our core value philosophy, open-minded to new ideas and opportunistic in a volatile and uncertain environment.