Q2 ’03:   More of the Same

The purpose of this quarter’s letter is to review the overall market situation and recap risk parameters.


While clearly a lot has happened in the last three months, things don’t feel much different. The stock market jumped the gun on the Iraq war, beginning its expected rally two weeks before the onset of hostilities. But the rally has been sluggish, taking out the December ’02 highs only just this week. The economic crosscurrents highlighted in the last letter remain and are worse, if anything. On the stimulus side, President Bush and a compliant Congress continue to roll the dice by throwing trillions in tax cuts at the sagging economy, the dollar is down 25% against the Euro (10% trade weighted), and interest rates have hit all-time lows. Still the economy is teetering on the brink of deflation. The result of this massive and unprecedented stimulus is that so far we have seen some improvement in corporate earnings, but those improvements have come mainly at the cost of jobs. The housing sector remains strong but business investment is not picking up. The job situation remains dismal with no indication that it is going to improve any time soon. New jobless claims have been over 400,000 for 15 consecutive weeks and the U.S. has lost over 2 million jobs in the past two years. A variety of deflationary influences (e.g. overcapacity, China) continue to make their influence felt. The Fed has announced its determination to do anything and everything to hold off deflation. Will they succeed? Only time will tell.

International relations have only marginally improved since the war. Trade relations with any country that didn’t support the war (most countries) are tense. The situation in Iraq remains volatile, with Iraqis and U.S. soldiers still being killed almost daily. Lawlessness, Iraqi resentment and the absence of discovery of WMDs are threatening to turn the military victory into a major embarrassment. Volatile seems to be the key word on the international scene, with both hopeful and troubling signs manifesting almost daily. The Administration continues to juggle a huge number of difficult issues both internationally and domestically. President Bush is currently on a European tour to try to shore up troubled relations with our allies there and will soon meet with the major players in the Mideast. Let’s wish him luck.

The stock market is reflecting these crosscurrents. The rally has been sluggish but there is not much enthusiasm for selling either. Technical indicators have gotten as confusing as the economic indicators. Most technical indicators have been overbought for weeks and advisor sentiment (a contrary indicator) is as bullish as it was at the 2000 market top, while price has only just taken out the December high – a bearish divergence. But at the same time market internals show a healthy demand for stock and a steady decline of selling pressure since the October ’02 lows — bullish. Wave analysts are looking for either a new bear market low or a sharp bear market rally followed by a new low. I have read equally impassioned predictions of Dow 6,000 and 12,000 over the last few weeks. Barring some major unexpected event, the market doesn’t appear ready to resolve in a big way any time soon, although it does seem clear that any upside is limited from here.


The prevailing mood has become rather bullish, and talk of risk concerns seems incongruent with the mood and action of the market. Even consumers, while acknowledging that things are not so good now, are quite bullish looking six months out. But it is my experience that whenever I allow myself to be lulled into complacency, I get whacked, and that is what I believe the market is setting us up for. So, while the intermediate trend is clearly up, and we could have a sharp rally at any time, it is good to remember that we are in a major bear market that is not complete by a long shot. Value investors continue to point out that stocks are still overvalued by 30-50%. So enjoy the rally but don’t be fooled into thinking that a rally equals a bull market.

In the time-honored Washington tradition, the Bush folk are pulling out all the stops to buy votes in 2004. If recent history is any guide, they will be successful. We already have more debt than will ever be repaid. Eventually the market will begin to discount that reality. Meanwhile the current account deficit is running $1 million a minute. Last year it was over $500 billion. This is the real deficit. This is money that the rest of the world is giving us to finance our economy so they can sell things to us. With the latest tax cut, could it reach $750 billion this year?

The fiscal irresponsibility being embraced by Washington is truly shameful and is going to have severe consequences at some point. Presently I would expect these consequences to play out after the ’04 election, but make no mistake, the wildly irresponsible tax cuts are setting up the conditions for an economic “perfect storm.” Some say that the Administration wants to create a fiscal crisis in order to gut entitlement programs, such as Medicare, Medicaid and Social Security. This suggestion sounds outrageous but may not be so far off the mark. The Administration recently shelved a Treasury report projecting that the U.S. faces a future of chronic deficits totaling at least $44 trillion. The study’s chief conclusion is that sharp and permanent tax increases or massive spending cuts – or a combination of both – are unavoidable if the US is to meet the healthcare and retirement benefits promised to future generations. Even the Democrats don’t want to deal with this hot potato. So with Democrat complicity, the Administration gave this report the deep six, dismissing it as a “thought-piece” designed to stimulate discussion.

As the Financial Times put it, “The lunatics are now in charge of the asylum.”


Outside of the occasional isolated situation, there are no outstanding near term opportunities in the U.S. right now. For longer term ideas, see the Q4 ’02 letter, “The Big Picture.” Gold should be bought on corrections. Far Eastern currencies are undervalued by about 15-30% against the dollar but will not likely see much movement until the Chinese float the renminbi. This is a good long term play. The wild card here is the Korean situation, and the uncertainty of when the Chinese might float their currency. It could be a long wait. Otherwise, stick with absolute return strategies.


With all the crosscurrents, stocks are likely to continue in a trading range with a slight upside bias until the election. There is the likelihood of the occasional sharp, short term move in either direction. The weak dollar is likely to find some equilibrium soon. An all out collapse is not likely at this point, but neither is a big rally. The Administration likes the weak dollar, and finally fessed up to that fact recently. Interest rates could drift marginally lower, but are about as low as they can go. Again, however, don’t expect a big move up (any move up, really) in rates anytime soon. Fiscal and monetary manipulations should be able to hold deflationary pressures at bay at least through next year.

The main caveats here are the possibility of one or more of the world’s hot spots suddenly spinning out of control or a resurgent Al Queda throwing a wrench in the works. From all reports we haven’t heard the last from them.