First Quarter 2002

Market Review & Outlook

With everyone convinced that the Fed has completed their interest rate reduction cycle, the focus has now shifted to speculation regarding when the rate hike cycle will commence. We are of the opinion that interest rates may not rise significantly as soon as many analysts are now forecasting. Our reasons for this are two-fold: McTeer and Greenspan. When asked when interest rate moves will be made, considering their time lag, Federal Reserve Bank of Dallas President and voting FOMC member, Robert McTeer answered "When unemployment gets down below 5% and is falling, and when capacity utilization is 77%, then talk to me about lag because I might be more willing to go with a preemptive policy." With unemployment currently at 5.7% and rising and capacity utilization below 75%, McTeer is obviously unwilling to begin raising rates too soon. Although McTeer is an influential member of the FOMC, Greenspan's opinion still carries the most weight among the voting members. Greenspan is well aware that whatever happens to the U.S. economy over the next year or so will happen on his watch. There are many possible scenarios about how the interest rate cycle and resulting economic conditions unfold, but let's focus on two possible scenarios: raising rates too early and raising rates too late. If rates are hiked too soon, it could stall, or even end, the recovery, sending the U.S. into a double-dip recession. If the rate hikes begin too late, the economy could recover much faster and more briskly than anticipated, become overheated, and eventually lead to inflation. Given these two options, perhaps extreme, we believe that Greenspan will opt for a chance of inflation over sending the U.S. into a deeper or double-dip recession.

So what does this mean for interest-rate sensitive investments? The play in short-term bonds is not completely over for this cycle and the decline of short- and intermediate-term bond funds over the past five months was probably premature. We would therefore expect these funds to achieve new highs over the next few months. Long-term bonds however, are not as easy to forecast due to the fact that they are more sensitive to inflation worries. We would tend to avoid long-term bonds at this time. If the Fed is going to err on the side of a robust economy, then high-yield bond funds would also be expected to perform better than average for the remainder of the year. Our Flexible Income program monitors the investment choices among these various segments of the bond and income markets in an attempt to provide our clients with a conservative investment alternative.

Equities should also be expected to benefit from this interest rate scenario as business borrowing is typically tied to the Prime Rate, which is expected to remain at historically low levels. We have already begun to see the signs of stabilization in the U.S. equity markets. The wild monthly and quarterly swings that became commonplace over the last two years were somewhat tamer during the first quarter. The accounting scandals that have been surfacing are perhaps the last phase of unwinding the bubble of the late 1990s, and the ensuing "new era" of accounting, and accountability, will lay the foundation for the next bull market. However, the next bull market will try to differentiate itself from the last one, especially in the following areas:

• Volatility - believe it or not, the mega-bull market of the 1990s was one of the least volatile times in the history of the U.S. stock market. Investors should expect the next bull market to be less smooth, marked by more frequent and deeper corrections (mini-bear markets).
• Earnings - investors will be looking much harder at company earnings this time around, and a phrase you are likely to hear numerous times is "quality of earnings."
• Dividends - dividend-paying stocks were shunned in the 1990s, but there is no easier way to demonstrate quality of earnings than by paying a dividend. Investors should expect stock dividends to resume a significant role in analysts' stock valuation process.
• Returns - the return on equity investments will likely be lower this time. Depending on your exact measurement points, and the time frame involved, equities returned an average of 15% - 20% annually during the last bull market. Most investors have already accepted the fact that those returns should not be counted on going forward. A more moderate forecast of 8%-12% is now much more likely.

How will the next bull market end? It is far too early to try to speculate on that, but human nature being what it is, there is a high probability that it will once again involve greed and over-extension in some areas of the market.

Visit the news archives for previous Quarterly Updates