Third Quarter, 2000

With this letter we are presenting a picture of economic events which are having a direct impact on investment markets in general and your portfolio in particular. These events call for some changes to the composition of your investments, which are described below.

The bloom is off the rose, as the saying goes - in the stock market and the corporate bond market. The Federal Reserve’s actions to cool the economy through a series of interest rate increases earlier this year are clearly beginning to have their desired results. While economic growth continues in a beneficial way, the rate of growth is slowing across a wide range of industries throughout the economy.

The leading economic indicators have now been flat or down for five consecutive months. Until very recently, complacency regarding the Fed’s efforts ruled the stock market. The prognosis was for continued strong growth with low inflation and increasing productivity offsetting the rapidly rising costs of a tight labor market. In this environment, the prevailing wisdom had been that economic conditions were close to perfect and that no price was too high to pay for stocks with unobstructed earnings growth potential. One should, however, always question the prevailing wisdom.

As a consequence of the Fed’s interest rate increases, companies across a broad spectrum of the economy are now declaring that their sales growth and earnings growth projections for the fourth quarter and 2001 need to be scaled back. As we long suspected would be the case, the stocks of many overpriced companies (particularly in technology) have begun to experience massive declines from overvalued levels in connection with these revised earnings announcements. Now even the top-tier companies are seeing their stock prices collapse just like those of second- and third-tier companies with each announcement of slower projected growth. Home Depot, Intel, Circuit City, Sprint, and Dell are but a few examples of this phenomenon. Of growing concern is the fact that these negative earnings surprise comments are no longer company-specific. Instead, they are more indicative of the broad underlying economic trends in the marketplace.

The prices of a large proportion of technology stocks had risen to unsustainable heights during the past three years. Then in March 2000, the bubble burst and we entered the tech market correction phase in which price/earnings (P/E) relationships began moving back towards historic norms. How long this process will take is anyone’s guess. However, the combination of a slowdown in economic growth coupled with a period of P/E contraction is creating major headaches for investors.

Now investors’ perceptions are slowly beginning to change. Concern is mounting regarding just how "soft" the economic landing will be. Rising production costs and an inability to pass many of these costs along through rising prices may continue to squeeze corporate profit margins. This trend may continue to cause problems in the stock market for many months or quarters to come.

Stock market jitters are not confined to the U.S. European and Asian stock markets are very weak this year as well, which is disconcerting to U.S. exporters. Through September 30, the Dow Jones Global Stock Market Index was down almost 13%.

Slowing economic growth and reduced profit margins don’t bode well for corporate bonds either. Recent news articles describe a growing number of banks which are reporting increases with problem loans within their portfolios. High-yield bonds (those of lowest credit quality) have recently begun to experience severe price erosion in the marketplace as investors – perhaps we should say speculators – perceive these securities to be rapidly increasing in risk. Part of the responsibility for deteriorating credit quality can be attributed to rising energy costs and risky loans to dot-com and telecom startup ventures, but the problem seems to go deeper.

The cost of borrowing money is now rising for businesses at all credit quality levels. As borrowing costs rise, corporate profit margins are squeezed, resulting in lower profits and reduced capital spending plans. (Reduced capital spending means lower sales of technology products.) Many companies of lower credit quality are discovering that they have now effectively been locked out of the credit markets by a prohibitively high cost of debt. Reduced capital spending will work its way through to slower economic growth.

All of these issues are contributing to the unfolding economic slowdown and have affected our thoughts regarding your portfolio as more fully described below.

Actions taken in your portfolio:

1. Because of slowing economic growth and the resulting negative effect on the stock market, we continue to hold the stock portion of your portfolio at the low end of our agreed-upon range. Should further weakening in the stock market occur, some of your bond holdings may eventually be used for selective stock purchases.

 

2. Taken as a whole, the technology portion of the stock market is still richly priced, thus many of these stocks could experience further contractions in their P/E ratios, resulting in sharp price declines in the face of reduced earnings growth expectations. Some top-tier technology companies have already experienced dramatic price declines, creating, in our opinion, very favorable buying opportunities. When appropriate, we will add some of these stocks to your portfolio. This situation of great companies at cheap prices within a generally overpriced industry indicates the importance of selective stock acquisition.

 

3. Interest rates, after subtracting inflation (called "real interest rates"), are at historically high levels. This situation presently favors the purchase of bonds. However, in response to increasing risk in the corporate bond market, we have, for the first time, begun to acquire U.S. Treasury securities for a portion of the fixed income segment of your account. Furthermore, rising producer prices and energy prices continue to keep alive the potential for an increase in the inflation rate. In addition, the Fed remains on an inflation-alert status. Accordingly, we are maintaining your bond portfolio with relatively short-term bonds. Finally, during the fourth quarter we may purchase for the first time bonds which have the unique quality of offering protection from the negative effects of inflation.

Performance

The S&P 500 Index has over the past few years transformed into a large cap growth index with very heavy exposure to the technology sector of the economy. Accordingly, that index is now less representative of the overall stock market than had been the case in past years. We are therefore presenting expanded stock market performance information to give you a more complete picture of domestic stock market activity.