As we reach the midpoint of 2004, we find the S&P 500 up about 3% for the year despite outstanding fundamental progress by most companies. Earnings comparisons versus last year are up more than 25%, driven by recent cost cutting, low interest rates and long-awaited revenue growth. In addition, corporate "liquidity" is much improved - companies have, on average, repaired their balance sheets and now have excess cash that can be used for reinvestment or to return to shareholders. For the economy as a whole, this profits recovery has translated into the best GDP growth in two decades, as well as rising productivity and employment. Yet the market has made little headway in the past six months and, interestingly, the S&P 500 sits near its level of six years ago (remember the sudden and scary collapse of Long-Term Capital Management that summer?).

The market's listlessness is particularly ironic when one considers the fertile current news environment. As if the approaching U.S. presidential election was itself not enough to cause sharp market moves, the recent handover in Iraq, skittish oil prices and the Fed's unmistakable new interest rate policy should have provided ample opportunity for speculators on both ends of the spectrum to engage in a real battle over the market's future direction. But there is little evidence of a struggle: in the first six months of the year, the S&P 500 has fluctuated within a 7% trading range, far short of the more typical 25% figure and well below last year's 39%. As an example, just nine months ago Fed watchers speculated about "printing press" solutions to deal with the threat of deflation. Now, after a well-telegraphed interest rate increase (and a severe case of whiplash for bond investors who currently worry about inflation), are we supposed to quietly accept a lethargic stock market without question?

One possible explanation relates to market efficiency. Six months ago, we urged our clients to "curb their enthusiasm" after strong performance in 2003. Despite a great deal of general optimism, we labeled the overall market as "fairly valued": many of our stocks traded near the middle of their buy and sell targets. Prospectively, such a level implies average stock market returns and risk levels. As we all know, the stock market tends to look ahead, and the strength of the market's recovery over the previous 14 months properly reflected, in hindsight, the market's optimism that the economy and corporate profits would recover. Well, now earnings are "catching up" with slower-moving stock prices, and valuations are beginning to look a bit more favorable on the whole. Looking ahead to 2005, most market yardsticks are near their long-term averages and interest rates remain relatively low. Our own analysts are finding a few more opportunities these days, although the average stock on our list still trades near the middle of our target range. We remain optimistic over the next several years (particularly that stocks are likely to beat bonds), but we recognize the near-term might deliver just average returns amidst some greater volatility. So in this context, the market's pause this year is a logical result of 2003's prescient rally.

Another basis for the market's stall could be attributed to investor complacency - perhaps the tidal wave of macro issues has "frozen" investors, each of us waiting for a break in the news one way or the other to drive the next set of investment decisions. Indeed, the unresolved "Big Issues" of the day (most prominent: the election and Iraq) seem to get as much coverage on CNBC and other market-related media as they do in the traditional press, implying that investors believe resolution of these issues will have significant market impact. But as history tells us, rarely are the outcomes as extreme as feared, and certainly with presidential elections, past market data show remarkable consistency under both Republican and Democratic administrations. We offer no prognostication on the resolution of these Big Issues, but we would make this point: the more that investors brood over such matters to the point of ignoring individual company fundamentals, attractive investment opportunities are bound to arise for our clients.

The fact is, however, there is actually a lot of speculative activity under the market's surface today: just look at trading volumes, which have exploded over the past decade. The meteoric rise of hedge funds is a new feature of the markets in recent years, and it has surely affected traditional market structures and trading patterns. According to the Hennessee Group, there are over 5,000 hedge funds in the U.S. today managing about $500 billion in assets (assets have grown 50-fold since the early 1990s!). These investment pools, often leveraged but also designed to engage in a variety of strategies (including short sales), now account for as much as 30-40% of all commission dollars on Wall Street (they tend to be very active traders), and they are an important reason why the average holding period for stocks has declined from two years in 1990 to just 11 months recently. Hedge funds are "sexy": they disguise their portfolio holdings, charge high performance-related fees and offer their managers lottery-type compensation opportunities. There are many hedge funds with outstanding long-term track records, but the rapid proliferation and asset gathering of these investment funds in recent years has raised some eyebrows. We are not in the business of analyzing or recommending specific funds or strategies, but we are interested in how these funds can affect the investment opportunities we seek for our clients.

One real impact has been on Wall Street and traditional "sell-side" analysts. It has been a rough few years for Wall Street: the major firms settled and paid big fines because of alleged conflicts of interest (i.e. favorable stock recommendations in order to win investment banking clients). The banks reacted by reducing staff, eliminating obvious conflicts and changing their focus in order to cater more and more to the active hedge funds that increasingly dominate. We remember the days when "sell" recommendations were quite rare; today, however, "sells" and "holds" now account for more than half of all recommendations. In one sense, this is an improvement because research output is less overtly optimistic. But one suspects another bias has crept in: the hedge funds may be fueling a growing need for "short" ideas, and so Wall Street has evidently responded with appropriate recommendations. Furthermore, Street research reports increasingly emphasize the near-term, as more trading volume is aimed to exploit quick price moves. Shorter trading horizons is an industry development we have commented upon over the years, and it's pretty clear the hedge funds have amplified this trend given the structure of their compensation arrangements. In the end, this probably means more rapid "churn" among individual stocks, although the overall effect on the market can be less dramatic. We are nearing the day when "buy-and-hold" generates the same glazed look as buggy whips and haberdasheries!

It's probably too early to say whether hedge funds or Street research bear any direct responsibility for today's uneasy market equilibrium. Our hunch is that this may be one factor among many that explains how increasing short-term trading activity can coexist with a docile overall market. Nonetheless, we at Harris Associates continue to rely on our own group of experienced analysts in order to avoid the potential conflicts and biases of sell-side research. As always, we do our own fundamental work, and our investment horizon extends into years, not days or weeks. We rarely use Street research, but when we do pick up a report to read during the daily commute, the ideal piece sets up as follows: total report of eight pages (six devoted to regulatory disclaimers and footnotes). "Strong business and balance sheet, but industry conditions likely to be weak for a few months. Stock is likely to fall in the near-term. Sell." That's a stock a short-term trader will sell and one we can get excited about!

Hedge funds offer some unique investment strategies, yet we wonder if investors have a complete picture of their impact. In any case, we take note of the evolving trading environment and biases, and we expect long-term investors such as ourselves to retain a decided advantage. One other note: we eat our own cooking, just like the hedge funds. As we reported late last year, our employees have a collective $145 million investment in our own family of mutual funds. We think that's a strong statement about our own commitment to our investment operation and our clients.

Turning back to our market outlook, the fundamental liquidity story for most businesses is very strong. Companies are now reaping the benefits of recent cost-cutting and debt reduction (Bear Stearns estimates 90% of cash flow over the past two years has gone toward balance sheet repair). This dramatic improvement in the financial position of U.S. companies bodes well for further value-enhancing activities, including increased capital spending, merger/acquisition activity and hikes in dividends/share repurchases. And in turn, this should lead to value growth - and presumably rising share prices - for a lot of companies. As we have argued recently, we believe stocks offer a better bargain than bonds for the foreseeable future.

Given this fundamental backdrop, plus the Big Issues of the day, the market's stillness is counterintuitive. From our perspective, however, the current pattern fits with a market that is still digesting the strong results from last year. In addition, changes on Wall Street and evolving trading patterns, for at least the time being, may be reinforcing the current broad equilibrium despite lots of activity at the individual stock level. Finally, investors are probably a bit frozen, too, as they ponder a whole set of macro issues; as we've stated before, the tendency of investors is to often overthink such matters. Our own objective of identifying strong businesses trading at significant discounts to value can benefit from these distractions, and this fact encourages us to remain diligent, opportunistic and patient even during today's unremarkable market.



Edward S. Loeb