"I want to know why there's zero growth in this family's receipts....This thing of ours is supposed to be recession-proof!"
- Tony Soprano (HBO series The Sopranos; Episode 40, 9/15/02)

The perversity (and attraction) of HBO's The Sopranos is that viewers find more in common with Tony and his New Jersey mob family than one would expect -- family squabbles, sending a kid to college, dealing with troublesome relatives. Well, that shared experience now extends to the economy and the stock market. In another scene, Tony's wife Carmela wonders whether they should be making some legitimate investments in the stock market to diversify their estate. But Tony reacts negatively because he feels the deck is stacked against even the most powerful mob bosses:

"We don't have those Enron-type connections......."

Investors seem to be running away from the market not only because they can't trust Corporate America, fear war with Iraq or are troubled by the economy's lack of strength, but also because of the emotional anguish of three consecutive years of stock market losses. Or maybe the problem is Greenspan -- perhaps Tony should have a sit-down with the Fed Chairman to "suggest" a change in interest rate policy! While life often imitates art, there are few cinematic (or even historical) references to such prolonged market weakness. The S&P 500 has now declined as far as the painful 1973-74 bear market (about 50%). The NASDAQ (-77%) is now approaching the Dow's decline from the Crash of 1929 (-89%).

Even our portfolios finally reacted to the market's sharp decline. The S&P 500 fell 17% since our last letter, and while our portfolios performed admirably over the past 30 months (as all the major averages fell sharply from their peaks), we could defy gravity no longer. For the quarter, our portfolios declined in sympathy with the broad market; this was the first time we had failed to outperform the market by a meaningful margin in ten consecutive quarters. We are very disappointed in this result, but we accept the inevitable: our gravity-defying performance was unlikely to last indefinitely under such broad market duress. Over the years, we have done our best to forecast reasonable long-term investment returns as well as manage our clients' expectations about our own abilities. As our clients know, our investment record over the past several years -- and the past quarter century -- remains strong, and as we will explain, we do not expect the most recent quarter to be part of an extended trend.

It is now clear that we are currently being affected by many of the same market forces which have impacted investors since early 2000. The most recent quarter indicates investors are fleeing from equities: the outflow of cash from equity mutual funds hit an all-time high (in dollars) in July, while in percentage terms the withdrawals since June are only exceeded by the three month period surrounding the Crash of 1987. As we pointed out in our last letter, the Mountain of Worry seems to grow higher each day. Emotion rules over Reason. There have been few places to hide in the equity market, and so many investors have sought refuge in cash or bonds.

Which brings us to the questions of the moment: Will the stock market recover? Why? When?

At this point, the case for market recovery rests equally on fundamental and psychological factors. We remain fundamental investors first and foremost: our analysts seek to identify strong businesses run by shareholder-oriented management teams where the stock trades at a significant discount to the fundamental, intrinsic value of the enterprise. Today, we find abundant opportunities to invest in such businesses because so many stocks of fine companies have suffered major price declines over recent months. In addition, we believe our clients now own higher quality businesses because the typical "premium" for owning the strongest company in an industry has declined substantially. Business conditions are challenging -- the economy is providing only mild, uneven growth -- but these market-dominant businesses should benefit from the economic cycle (we would contend that the Strong tend to become Stronger over the course of a recession as their competitive edge widens). We have therefore taken advantage of these opportunities. Our portfolios are nearly as undervalued today as they were in early 2000 (just prior to The Turn), with average forward Price/Earnings and Price/Cash Flow multiples of about 13x and 7x. Given the low level of interest rates, these are unusually low multiples in both relative and absolute terms, particularly for such a fundamentally strong group of companies.

The psychological case for market recovery is equally strong, and it is derived from our well-known skepticism of the Crowd's prevailing wisdom. Today's atmosphere is an incubator for emotion-ridden, irrational thought. As we view the scene, most investors today seem to believe the following: bonds will outperform stocks, the economy could suffer a prolonged Japan-style recession, corporate management can't be trusted, and the Iraq situation poses too great of a risk to be invested in stocks. This negative investor mood is likely the result of three painful years of market decline more than predictive certainty. As an example, let's take the bonds vs. stocks argument. While it is true bonds have outperformed stocks for the past five years, the odds are stacked against bonds for the next five. First, interest rates are already so low that even if rates stay constant over the period, the return will only match today's current bond yield (2.7% for 5-year Treasuries). In fact, those rates would need to fall nearly another full percentage point to 1.8% for bond investors to match the historical rate of return for stocks (10%). In addition, stock dividend yields are now close to 2%, implying that equities would need to rise less than 1% over the next five years to equal today's expected return from bonds. That should be a fairly easy task, although few investors can conceive of any such recovery given the past few years' pain. In summary, we believe the bonds vs. stocks argument now favors stocks.

Are we worried about the state of the economy? Corporate misdeeds? The prospects for war? Certainly. A prolonged, deep recession would render our fundamental cash flow estimates overly optimistic. But the U.S. is not Japan circa-1992: the Fed is adding liquidity to the economy at a rapid pace, we believe the current deficit spending will act as a further stimulant, and debt-ridden companies are entering bankruptcy (not lingering), thus freeing up investment capital for better uses. In our view, our economy is more transparent and fundamentally more sound than Japan a decade ago. In the meantime, the economy continues to grow modestly, bolstered by an unprecedented mortgage refinancing boom, good inventory control and improving worker productivity. As for the corporate misdeeds, Dennis Kozlowski is likely to head to jail, and this will do more to reform future corporate behavior than any law Congress could ever dream up. With regard to Iraq, consider this: the last time the stock market declined three consecutive years was 1939-1941: the invasion of Poland, Pearl Harbor, the Battle of Britain, etc. Saddam Hussein and Osama bin Laden are certainly troublesome, but do they represent a significantly greater threat to our personal and economic freedom than Adolf Hitler and Emperor Hirohito did? We believe a fourth consecutive year of decline in 2003 would appear to be a low probability outcome.

Only in retrospect does a stock market bottom appear crystal clear. Most investors have felt enormous pain for the past several years. This pain has created a sense of fear that has permeated the economy and our markets. Investors have responded by selling their stocks and mutual funds and burying their cash under the floorboards (just like Tony!). But the argument for stocks today rests on several firm foundations. Business conditions are challenging, but corporate profits are still up versus a year ago. The fiscal and monetary policy responses have been sensible. Osama bin Laden is either dead or at least severely weakened while Afghanistan is free from the Taliban. Corporate misdeeds have been identified and serve as a powerful lesson. Looking out over the next several years, we believe stocks are much more attractive than bonds. And finally, investor sentiment is extremely negative, setting up the conditions needed for market recovery. Stay tuned.