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November 1, 2002

November 1, 2002

I’m happy to report that the market turn we forecast in our September 30th letter, where we said we could see a bottom “in October 2002 or in a few months…” began on October 10, 2002. The rally has carried the Dow up almost 20% and many beaten down tech stocks bounced up 40-50%. Over the last few days a normal corrective phase has begun and should continue until 30-50% of the recent rally has been retraced. After this correction we expect the market to again move ahead. We are looking for a rising market over the next few months that could possibly extend for 1 to 2 years.

What Lies Ahead

We see a return to the patterns of market rise and fall that were prevalent from the mid 1930’s to 1992. During that period, which was interrupted by the Second World War, the Korean War and the Vietnam War, the market generally rose for intervals lasting 2-3 years (sometimes as long as 4 years) and then would be likely to correct for 9 months to 24 months. This pattern of 1-4 year bull markets followed by shorter bear markets has prevailed for most of modern stock market history. There were two extraordinary exceptions. The 1990’s high tech bubble and the wild bull market of the 1920’s.

Historically, however, the market is a discounting mechanism, anticipating economic activity 6-12 months in the future. We expect future economic growth to be slow but steady and rising for 2-4 years before it is interrupted by a recession. This is usually preceded by generally rising equity prices before a correction.

We believe a secondary influence on stock prices is the continuing decline in the absurd P/E ratios the market has awarded to so called “growth” stocks. Many of these remain overvalued and ripe for a continued correction. However the shares of many fundamentally sound, growing companies remain undervalued. As the market consolidates we expect investor money will continue to seek out reasonable value. In essence, P/E ratios matter again. Looking for low P/E ratios and solid growth continues to be our style of stock selection.

What Will The Dollar, Euro, Yen Do?

We have been expecting the Euro to rise versus the U.S. dollar. This has not occurred. The U.S. dollar Euro relationship has been fairly constant since July. We believe the potential for a war with Iraq has been keeping the dollar up. In uncertain environments people seek out the dollar for security. Statements by European economic officials that have undermined conservative economic stewardship have also put the brakes on the Euro’s rise. We still expect the Euro to rise but at a slower rate perhaps 5 or 10% per year.

What Will War Do To The Market?

It depends upon the type of war. A quick victory or peaceful resolution would improve investor psychology. A protracted or up and down war with some successes and some failures would be bad for the market. A losing war always hurts psychology and negatively impacts the economy and the market.

What Is The Stock Market?

The stock market is a “reflection of the psychology of the investing public” as many commentators have noted over the last 2 centuries.

Three factors make up market psychology.

(1) Investors sense of security (based on past events, primarily the immediate past.)

(2) Investors sense of stability (based on current events.)

(3) Investors sense of opportunity (based on perceived future events.)

Where Does Market Psychology Stand Today?

(1) Investors sense of security (based on past events) has been badly shaken by the major market decline caused by the collapse of the bubble valuations for tech and growth stocks in 2000-October 2002. This factor is negative.

(2) Investors sense of stability (based on current events) has a lot to do with the current economic condition. Economic growth is positive although moderate. Consumer spending is okay and housing demand continues strong. Manufacturing is weak but services and retail are modestly positive. On balance we have a modestly positive economic growth environment.

(3) Investors sense of opportunity (based on perceived future events) is improving. Stocks are generally cheap, and some are very cheap. This is a positive opportunity. War in the middle east is an uncertainty. A quick victory is a positive. Protracted fighting or the perception we are losing the war would be very negative for investor psychology. This is a positive so far as hostilities have been delayed.

In summary, market psychology is balanced between fear of the past patterns being repeated and hope that low valuations will cause investor optimism. Today, hope has the upper hand and will continue to send the market higher, barring a big war.

We believe that in the long run investors are rational. They will choose low valuations and good prospects over high valuations and fad psychology. The fad psychologies that create bubble valuations have been present forever in markets and in the U.S. markets. Booms in investor optimism often lead to bubbles. The railroad bubble of the 1870’s, the roaring 20’s with the advent of the auto, telephone and other technologies in wide use and the technology bubble of the 1990’s have many things in common. More importantly, the periods between the bubbles like the 1934-1992 period also have patterns in common. In coming years, we expect to see a return to these patterns. Not the bubble patterns.

In this pattern of 2-4 years up 1-2 years down, the investor who goes long in bull trends and sells short in bear markets (or gets our for those clients who do not wish to sell short) is most rewarded. This has been our investment style for three decades and we see it as the best investment approach for the future.

In our opinion the period from 2000 to 2020 should resemble this. Long up trends will not be sustained because economic growth, while positive, will not be exceptionally long lived.

It will not be long lived because of the following factors (1) a more competitive global economic environment, (2) because military expenses and military initiatives will increase the costs of government, (3) and because budget deficits will increase the cost of capital and (4) uncertainty about victory will lower optimism. Because of these factors the likelihood of shorter periods of economic growth (2-4 years) followed by short recessions will mean shorter bull and bear markets.

Thus, the skill of buying and selling becomes paramount. Buying and holding worked well between 1992 on early 2000, but from 1934 to 1992 and between early 2000 and the present an ability to buy correctly and sell opportunistically has been necessary for good market performance. We believe it will continue to be important over the years to come.

Areas Of Opportunity

Banks – Many bank stocks have been battered due to increasing fear of bad loans on their balance sheets, and attacks on their investment banking practices.

Utilities – Utilities have been battered as profit margins are squeezed by higher energy prices and low demand hurt profits. Yields are good. Long-term growth is excellent.

Medical Services – Medical services are growing as Americans and Europeans age. More services per capita due to aging population.

Business Services – Businesses are working to cut costs as economic uncertainty creates demand for cost cutting.