In a year when political events - rather than financial - dominated the headlines, the frustrating stock market as of October staged a notable late burst to make it a rewarding year after all. Equities surged in the final two months of 2004 to produce annual returns near or above historical long-term trends, all the more respectable given the strong results of 2003. A year ago in this space, we remarked: "Even if stocks are close to 'fair value'...returns are likely to outpace most other asset classes." Well, so far so good, and given current conditions, we would make a similar argument for the year to come.

For many investors, however, the two-year rally has yet to fully reverse the decline of 2000-2002, and the naysayers continue to linger. The skeptics' current focus is the relative value of the dollar - caused by our trade and budget deficits - and the likelihood of increases in future inflation and interest rates that would undermine the health of our economy. It is, admittedly, a powerful argument, one that seems to be showcased daily in the papers and on TV. The numbers and implications are big: foreigners own more than 40% of U.S. government debt, the dollar has fallen more than 20% versus major currencies over the past two years, and our economy will show its fragility if there is a run on the dollar. But we would caution our clients to pause and take a deep breath before scrambling for bars of gold bullion to stash in the attic. The doomsday scenario seems to us to be another example of an overblown macro fear that we have witnessed countless times before. Do you remember the Population Bomb? That was Paul Ehrlich's well-respected 1968 prediction that famine would engulf our planet, which proved to be wildly incorrect. The imminent exhaustion of the world's oil reserves? The Y2K disaster? Well, doomsday has been put off quite a few times, and regrettably, too many elements of our society seem to thrive on such broad-based fears. Any investment program built on such a predictive strategy would undoubtedly be awful! As one of our partners here at Harris Associates once remarked, it's very difficult to be a successful long-term investor if one is constantly worried about low-probability macro outcomes. At this point, we believe the current bout of anxiety fits the historical pattern.

An interesting paradigm of this phenomenon is presented in Michael Crichton's wonderful new bestseller, State of Fear. It's a potent combination of fiction and scientific fact that explores global warming and catastrophic climate change, a belief now so conventional in the public mind it hardly seems to require supporting evidence. Crichton (Jurassic Park, television series ER) weaves a provocative thriller where environmental hysterics resort to extreme measures to support their cause. Crichton sprinkles the novel with plenty of real-world scientific data meant to raise serious questions in the reader's mind, and the end result is a more balanced, skeptical point of view on the topic.

But whatever one's personal opinion on climate change, State of Fear carries a broader message: "Fear", in an almost pathological way, seems to pervade our society. Despite all the progress, knowledge, and wealth humankind has achieved, we spend a great deal of time fearful of our food, our medicines, our homes, our environment, and so on. Long before 9/11, public panics were common (McCarthyism, cancer from power lines, Killer Bees, to name just a few), and in retrospect, they were typically shaped more by cultural assumptions about our vulnerabilities rather than robust evidence. Crichton warns us it's dangerous to rely on conventional wisdom in a credulous, media-driven society. Despite the current focus on global warming, newspaper headlines thirty years ago warned of global cooling and a coming ice age! The point is that there is always a great deal of fear and uncertainty in this world, and as a society we are extremely susceptible to those who may have their own agendas. We should be more curious and more skeptical.

There is also a rich history of financial-related angst, and we've discussed many in these pages. In the current installment, the conventional wisdom on the dollar goes like this: foreigners, sooner rather than later, will stop buying our Treasury bonds because the U.S. is borrowing more and becoming a bigger credit risk (because of the budget deficit), and because the dollar assets they currently own are generating losses (i.e. the trend is negative); the required interest rate increase by the Fed to stop this trend will choke off the recovery of the U.S. economy. In the short run, we have no particular insight on the merits of this argument, but it seems that those who have become apoplectic on the long-term financial consequences are being swayed by a campaign long on fears and momentum, and short on facts.

First, the U.S. budget deficit situation is improving, not deteriorating. The absolute dollars are certainly big - over $400 billion for fiscal 2004, but at just 3.6% of GDP (and headed lower as the economy grows), we are a long way from the deficits of the 1980s when the figure was well above 5%. We remember David Stockman's shrill deficit warnings in 1985, and a similar panic in 1993 ironically preceded the budget surpluses of the late 1990s! The current improvement is coming from better-than-expected tax receipts (e.g. soaring corporate profits) and lower growth in discretionary spending (less than 1% growth expected for fiscal 2005). State and local budgets, in fact, have returned to surplus within the past year, and the consumer savings rate is not nearly as bad as advertised. In fact, the low national savings rate statistic ignores any of the improvement in consumer balance sheets from rising home values or investment gains. So, we believe overall borrowing requirements are likely to become less burdensome, not more so.

While many see the trade deficit as the source of dollar weakness, in truth, the causality is uncertain. Do we buy more foreign goods because we have attracted excess foreign capital, or do foreigners invest here because they have a trade surplus and are looking to invest in a safe, liquid locale? The capital inflows into the U.S. are a mirror image of the trade deficit, by definition, and it's impossible to discuss one side of the coin and not the other. We also don't know if there is a magic limit on the size of the trade deficit/capital surplus. But going beyond simply credits and debits, the value or attractiveness of a currency is underpinned by relative economic prowess (e.g. productivity, growth) and the ability to service outstanding debt. In these terms, we believe the story for the dollar is relatively positive: the U.S. continues to grow faster than Europe or Japan, and our debt-servicing burden is lower. The U.S. capital markets are the most liquid in the world. And relative demographic trends further favor the U.S. in the long run versus other developed countries. In summary, there are many reasons why the U.S. should continue to attract plenty of foreign financing and investment. In our opinion, the facts are supportive of an end to the dollar slide, although the timing is, as usual, uncertain.

We must admit, however, dollar fears have not yet had a serious impact on U.S. stock market investors. It would be difficult to say folks are broadly pessimistic: equity prices are up in recent months, analysts expect continued profit growth in 2005, and valuations remain tightly bunched near "fair value" (P/E ratios on forward estimates are in the mid-to-high teens). In short, the environment is similar to the situation we found ourselves in twelve months ago when we saw the market fairly priced, but also admitted the challenge of finding new equity ideas. And it's not just equity investors who are experiencing déjà vu: long-term interest rates are almost exactly where they were a year ago, and we will again express our belief that at current levels, it's tough to imagine bonds beating stocks over any reasonable time horizon.

There are a few additional factors in stocks' favor at this point, some of which we have highlighted in recent commentaries. We remain impressed with the strength of corporate balance sheets following an extended period of repair. The deployment of that capital to better uses - the merger & acquisition market is heating up and some of the cash is being returned to investors through share repurchase and dividends - is encouraging. And while valuations are by no means dirt cheap, we believe they look reasonable when one considers the context: interest rates remain low (lower than the budget surplus days of the 1990s), and investors enjoy the lowest taxes on capital (gains and dividends) in many generations. As always, there will certainly be surprises, but at this point, we believe our portfolios are well-positioned to generate acceptable absolute returns. Unlike some of our peers, we still think equities are the place to be.

The anxiety over the dollar is, actually, understandable. The decline has been meaningful over the past two years, and it's an easy story to write: after all, economic pessimism sells. And everyone "knows" the dollar will go even lower! But in the context of a twenty-year chart, the dollar's weakness is no more than a blip, just as some of the climate data cited by Crichton. As we have always tried to counsel our clients, an intense focus on getting the right stocks into the portfolio is worth a great deal more than trying to guess the outcome of a headline-grabbing macro issue that may be specious in the first place. And in a broader context, our skepticism of such commonly held fears is so strong because we remember so many failed "sure things" in the past. Our focus is not conventional wisdom or headlines: it is on the facts and the fundamentals.

Edward S. Loeb