We live in a world with too few real surprises, so it's refreshing to experience amazement every now and then. First, the Cubs are still in the thick of the pennant race, and it's already July! In the Mideast, even amidst more bloodshed, both the Israelis and Palestinians appear to be making actual good faith efforts to negotiate toward a more peaceful coexistence. And the stock market last quarter staged one of its strongest advances in five years, confounding most of the supposed experts. To continue with the Cubs analogy, the team's progress to-date provides few definitive answers and instead invites more questions: Will the pitching hold up? Can the team remain injury-free? How important was Sammy's corked bat? And so for investors, the questions accumulate as well: Will the economy stage a recovery later this year? Can we really trust CEOs? Will the tax cut help? From our perspective, the mounting questions on these and other issues point to a general condition of disbelief and distrust. Belief, it seems, is a rare commodity these days.

In this environment, our clients enjoyed strong equity performance during the past quarter. While our stock picking proved to be rewarding over the period, in retrospect the key decision for all investors was, simply, to stay invested. As we discussed in our last commentary, too many investors raced for the sidelines with the approach of war in Iraq and the prospect of a fourth consecutive year of lousy equity returns. Despite the uncertainty, three months ago we argued that attractive valuations and decent fundamentals offered meaningful opportunities to those with a long-term investment horizon. In truth, we did not predict such a strong, quick market advance, but neither were we surprised -- history tells us the market often acts to baffle us all. In any case, we remain consistently upbeat regarding the next several years, although we admit the market's advance is unlikely to follow a straight path. More on that later.

As we observe the economy and markets, however, the level of disbelief and distrust is palpable. We may all be more rapidly informed these days, but that does not mean we are better informed or more knowledgeable:

The Economy
Despite the recent market rally, most investors distrust the economic recovery. In fact, for at least the past year, the tone of newspaper headlines has been downright gloomy, implying recession, deflation and financial stress. But below the headlines lurk the facts: the U.S. economy likely just recorded its seventh consecutive quarter of GDP growth (averaging 2.6% annually). Real after-tax personal income has shown similar growth, and corporate profits are up as well. Productivity growth over the past 18 months is at record levels. However, unemployment is up, and many wonder whether today's housing boom could become tomorrow's bust and impetus for significant economic weakness.

We are rarely comfortable volunteering economic prognostications. As noted above, however, we are struck by the wide gulf between the headlines and the facts. Notably, there has been no economic downturn since the end of 2001! Furthermore, the level of economic stimulus behind the economy right now is substantial: strong government spending, a double-barreled tax cut (squeezed into the next two years), low inflation and interest rates, a weakened U.S. dollar and decent corporate profits (to name just a few). It seems to us that a weaker economy over the next few quarters is a low probability wager.

Corporate Governance & Animal Spirits
In a remarkable turnaround, most CEOs today would probably rather go hide in a cave than be quoted in the press. Investor suspicion, to be fair, is predictable: Enron, WorldCom, Adelphia and Tyco are strong memories that will linger for quite a while. But there are thousands of public companies, and although the scandals seem numerous, only a small percentage of companies have been affected. The repair process will take time; unfortunately, however, investor distrust translates into timid behavior on the part of CEOs: capital spending is down, merger and acquisition activity is at a fraction of its level from 1999-2000 and venture capital funding is difficult to find. A real fear is that CEOs feel the pressure to act too conservatively and within a narrow time frame; it may be more difficult for them to generate long-term value growth for their companies and shareholders. If this is correct, Greenspan's interest rate cuts simply "push on a string" and will yield no benefit. It's ironic that just at the moment we need CEOs to act confidently and commit capital to long-term, value-enhancing projects, scrutiny about their behavior is at its highest.

But the distrust and disbelief are unlikely to linger for too long. First, the war is now over and the corporate governance scandals appear to be on the wane. Second, the recent tax cut reduces the cost of capital for investment by a meaningful amount (particularly through the dividend and capital gain tax changes), thereby lowering the hurdle CEOs face in order to justify investment decisions. This should help ignite the crucial but unpredictable "Animal Spirits" economist John Maynard Keynes wrote about seventy years ago. According to Keynes, this risk-taking is a key component of the growth in our living standards ("it is our innate urge to activity that makes the wheel go around"). Finally, Greenspan's rate cuts have essentially lowered the after-tax, real return on cash to zero: if CEOs want to prove their worth, surely they can find better alternatives than keeping the money under the mattress.

Bonds vs. Stocks
With the after-tax, after inflation yield on cash near zero, after-tax dividend yields on stocks better than 5-year Treasuries, and even with the lowest tax rates on capital gains and dividends since the 1940s, investors do not really believe in the stock market. The rush to bonds by so many investors speaks to Japan-like fears for the U.S. economy (we continue to view the odds of such an outcome as very low), and bond funds continue to swell with new money. We were amused -- and even embarrassed -- to read that a recent poll commissioned by ProFund Advisors found that 65% of investors do not understand that rising interest rates generally have a negative impact on the value of bonds. Oops!

Investors are unfortunately "anchored" by their experience of the past three years: stocks are viewed with disdain and bonds embraced as can't miss. In fact, the situation was eerily similar back in 1999 when stocks appeared a sure thing, particularly those in the tech sector. But today, the embedded math of bond returns plus the tax law changes favor equities versus fixed income by a wide margin over the next several years. To be sure, short duration bonds can play an important role for capital preservation, and yes, the recent market rally dampens our enthusiasm a bit. But the opportunities in the equity market remain substantial for long-term investors. Valuations are by no means rock bottom cheap today, but even a stock market closer to fair value offers substantially higher returns than the prospects we see in fixed income.

Truthfully, we are not too displeased with the current state of affairs. The public's bout of disbelief and distrust offer at least two important benefits to equity investors (in general) and to our clients (in particular). First, the market tends to climb the proverbial "wall of worry": without skepticism and doubt, there would be no new investors or cash to coax the market higher over time. Second, our long-term focus at Harris Associates recognizes that investor mood swings -- such as today's disbelief -- typically fade with time as the facts speak for themselves. We are willing to be patient today and stay the course because the long-term opportunities appear to be substantial.

Edward S. Loeb
Partner, Portfolio Manager, Director of Institutional Portfolios