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General Market View

January 22, 2001

The three major indexes finished down in 2000, but that doesn't tell the whole story. The most interesting aspect of the year was the constant flow of money back and forth between "old economy" and "new economy" stocks. In the end, the NASDAQ suffered a 39% drubbing and was down over 50% from it's springtime peak. At the same time, many businesses that were unloved during that speculative frenzy recovered and recorded significant gains by year end. I suspect that many value oriented investors benefited from that change of heart.

With aggregate stock prices down and another year of reinvested capital and economic growth behind us, I'd like to be able to tell you that last year's correction removed the excesses from the market and economy. Unfortunately, I don't believe that's the case. No doubt, there are more pockets of value than has been the case. However, stocks in aggregate remain extremely high based on PE ratios, price to replacement costs, and other traditional methods of valuation. The general valuations aren't as extreme as before, but the huge move of money from the NASDAQ to other sectors of the market more or less just changed the face of the excesses.

As always, I'd like to point out that some areas of the market that "seem" fairly priced "may not be". Corporate America is still earning higher than average profit margins across many industries. If those margins are sustainable, higher than average prices are justified because of the higher level of free cash that is generated. However, it's been my view that over the long haul those margins are at risk. Therefore, stock prices that fully reflect very high margins as sustainable provide almost no margin of safety.

There is a growing possibility that some high margins will be tested shortly.

The part of the earnings and asset price equation that is often overlooked by mainstream analysis is credit expansion. In our system, some credit literally comes "out of thin air". The act of granting credit "out of thin air" stimulates business activity and/or asset prices. Therefore, when credit is made available on a large scale beyond the level of available savings, it can create a "temporary" boom in asset prices, earnings, and the economy.

However, in a well balanced economy there are relationships between savings, investment, the cost of capital (interest rates and stock prices), the return on capital (interest rates, stock prices, the return on active business investment), productivity, economic growth and many other factors. Even though these relationships can temporarily be short-circuited by an overly easy or tight monetary policy, they will generally reassert themselves over time as either the Fed addresses the situation or the system corrects itself. In my view, much of the boom of the late 90s was credit based. Credit was way too easy.

By raising rates the Fed started to address the resultant imbalances.

As a result, the US economy began the desired slowdown. But now, a recession cannot be ruled out. Generally, long-term investors shouldn't be overly concerned about these sorts of fluctuations in the economy, but in my opinion, "things may be a different this time." (Didn’t the bulls say that about the NASDAQ at 5000?) There is still substantial evidence of significant imbalances in the U.S. economy. The stock market remains extremely high, personal savings are very low or non-existent, credit growth in many areas has been much faster than GDP growth, and the US is running a huge current account deficit.

All these are classic signs of the type of economic bubble that ends with serious consequences.

As regular readers know, I suspect that the Fed and Treasury Department erred repeatedly during the middle to late 90s by underwriting and expanding the excesses with bailouts and further easy credit. I believe the authorities should have checked the situation when thing were still manageable. They had opportunities.

As usual, this Fed was quick to respond to the bear market in stocks, tougher credit conditions, and the growing risks of a serious slowdown. The Fed lowered rates 1/2 percent in a surprise move that seems to have temporarily renewed investor confidence. More cuts are likely to come. Only time will tell whether it will be enough to forestall a recession and put markets on firmer footing.

My main concern is that a correction that did little more than take valuations from "preposterous" to "overvalued" prompted (or forced) another large surprise rate cut.

So far, little has been accomplished in the way of removing other potential credit and savings imbalances.

You have to wonder what impact a "mean reversion" would have on confidence, corporate earnings, investment, and ultimately economic activity. I think that's an issue that should remain in the back of investors' minds.

Last year my quarterly market summaries focused primarily on the depressed stocks in the property casualty and food industries. Both of those sectors rallied sharply from their most depressed levels and I have since reduced my exposure significantly.

It appears that the best values are located among small and micro caps. The trend towards indexing and the desire for liquidity is leaving many fine companies ignored and unloved. It's impossible to say when a change in the flow of funds will occur, but I think that patient investors will ultimately be rewarded with huge gains. Perhaps the catalyst will be takeovers by larger companies that at these prices might prefer to buy the expansion they desire rather than build it.

There are no specific industry sectors that I like at this point, but I will point out my preferences from time to time as market conditions change.

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