The Bear Reality

October 4, 2000

Dear Investor:

More troubling than this bear market is the denial that surrounds it. Few pundits are willing to call it like it is. However, a quick scan of index returns year-to-date is denial-proof:

S&P 500: – 2.9%
Nasdaq: – 15.1%
Dow: – 6.8%

The current bear market possesses three distinct claws: a swooning euro, stratospheric oil prices, and deteriorating earnings. The one that concerns us most is the last. The first two are transitory, self-correcting imbalances that will be old news by the time this letter reaches you. We will analyze each in turn:

(1) A Swooning Euro
The weak Euro is good news for European exporters, bad news for US multinationals, and a big red herring for the world. Despite the potential for an outright collapse of the currency, this is extremely unlikely. The European Central Bank (ECB) has created a floor on the value of the Euro by intervening to support the currency at just below $0.85. Since interventions are rarely successful long-term, it’s likely that the Euro will drift lower once again. But the ECB has defined a floor below which speculators will be unlikely to stray. Most important, currency swoons are self-correcting: A weak Euro has increased the demand for European exports. Such exports are swapped for dollars which in turn get converted back to Euros, rebalancing the currency. Of course, these euros could be reinvested in dollar equities, but this is less likely to occur in a deteriorating US market. Finally, according to the Economist, the fundamental value of the euro resides close to $1.10. Currencies should revert to fair value eventually.

(2) Stratospheric Oil Prices
Crude oil prices reached $38 per barrel at their recent highs. The recent turmoil in Europe has sparked fears of a worldwide energy crisis. The potential exists. Oil is uniquely qualified to maul a bull market: its high prices are “stagflationary,” restraining growth while igniting inflation. And since oil prices are denominated in dollars, a weak Euro is really a function of elevated oil prices. However, the world (with the exception of Venezuela and Iraq) is committed to lower prices. The Saudis just announced an intention to lower prices on the heels of barrel prices returning to $31. Intelligent OPEC member anchor nations such as Saudi Arabia and Kuwait realize it would be foolish to maintain artificially high prices, since that would only prompt more strategic oil reserve releases, new conservation initiatives, and poor relations with the US, Asia and Europe. Nonetheless, the problem is not really a shortage of crude oil so much as a shortage of refined products (i.e. heating oil) in the US. Refineries are running at nearly full capacity (estimates are at 96%- 98%) and the potential for a massive shortage there is real. The supply-demand curve of oil is of more concern than the Euro. Yet, oil too contains a self-correcting price mechanism: an increase in OPEC production coupled with a slowdown of the US economy will stabilize prices. Releases from the strategic reserves have smoothed price spikes. We are, however, watching closely for signs that oil prices are not returning to sustainable levels.

(3) Deteriorating Earnings
Whereas the first two items contain self-correcting price mechanisms, the last does not. Earnings can deteriorate for a long time without prompting any gravitational pull in the other direction. Earnings growth, especially in the tech sector, is rapidly deteriorating. The earnings deterioration indicates that tech spending is indeed cyclical and that the notion of the business cycle still remains strong. Much attention has surrounded oil prices and euro levels, but few analysts focused on a little noticed announcement on September 15 that US consumer prices fell 0.1% in August, the first decline in 14 years , signaling a significant economic slowdown. This is a potent omen for lower earnings.

The tech bear market is no surprise to those who experienced the Spring internet collapse and the unjustified risk of that subsector (something we won’t be shy about saying we anticipated); see 1999 4 th Quarter Letter and 2000 1 st Quarter Letter). The problem is that large cap tech bellwethers such as Intel, Cisco and Microsoft are all facing dramatic slowdowns in sales which are piercing their lofty earnings multiples.

The percentage by which tech stocks are off their high prices is a reflection of these massive earnings disappointments:

Cisco – 31%
Amazon – 69%
Dell – 52%
DrKoop – 94%
Intel – 47%
Priceline – 91%
Microsoft – 53%
TheGlobe – 95%
As of 10/4/00 Morningstar Inc.

And there are countless other examples. The average consumer internet stock is trading 80-90% off its high.

On September 7, prior to the recent September Nasdaq swoon, we reduced blue-chip tech positions in conservative-mandate and tax-deferred portfolios in order to lock in the significant gains of 1999. We believe there is still another shoe to drop on the Nasdaq that will follow from the intense deleveraging in the internet sector. Though the secular pattern to technology spending is clear as far as the eye can see, the cyclical situation is another story.

Of the three bear elements mentioned above, weak earnings is of the greatest fundamental concern. Recent warnings by Intel, Apple, Eastman Kodak and Alcoa show that earnings deterioration is diversified across many areas. The mitigating point is that worldwide GDP is still on target to exceed 4% for 2000 and perhaps 2001. Strong global growth indicates that this bear market could be relatively short-lived. In fact, it could be nearly over now that most earnings deterioration has been discounted by the Nasdaq. We would not be surprised to see a fall rally after the final shoe drops. But we are also selectively trimming tax-deferred healthcare/biotech positions to lock in the substantial gains in the year’s best-performing sector, now that the Vanguard Specialized Healthcare Fund and the Invesco Health Sciences are up 45.3% and 26.4% respectively year-to-date.

Perhaps the most disturbing sign is that complacency still reigns. To date, we have not heard a single Wall Street analyst call this bear a bear. That in itself is a harbinger of further pain. Day traders have been used to mop the trading floor, but many investors are still under the misconception that stocks always go up. These net buyers of stock are not prepared for what could be the first year of negative stockmarket returns since 1990.

The most important strategies for a bear market are to maintain the ideal asset allocation for individual account mandates, take gains where appropriate to preserve capital and, finally, to harness growth from undervalued sectors. We are resolutely applying all three strategies to each and every account.