We’re just about at the midpoint of 2003. It’s supposed to be a time when the ‘mood’ for the year is established and firm. Events of the first six months dictate how we feel and impact how we see the next six months playing out.

We feared another corporate scandal. It hasn’t happened. We feared a major terrorist attack on U.S. soil. It didn’t happen. We feared a war in Iraq. It happened. We feared a lengthy war. It didn’t materialize. We feared that a Connecticut housewife would bring down a multi-trillion dollar economy with her questionable stock sale. Martha Stewart was indicted yesterday and no one seemed to care (unless rational decisionmaking is the logical outcome of sensationalized headlines).

With all of this ‘certainty’ behind us, why are we more confused than ever? A terrorist act probably won’t happen but we might have deflation. Another corporate scandal seems unlikely but what about this new tax package? Saddammay not have had weapons ofmass destruction but is the housingmarket cooling?

It’s always interesting to gauge investor sentiment. This time is no different. Speaking on the war in Iraq, Martin Indyk, former U.S. ambassador to Israel, said, “Pundits see the future with 20/20 vision and recall the past with selective amnesia.” It makes one wonder whether we as individuals are guilty of the same ‘crime’ when we play Alan Greenspan for a day.

In my commentary of January 6, 2003, I noted, “The best risk-adjusted long-term returns will be found in the equity markets. It’s unfortunate that the public has a short-term memory. If history is any guide, negative investor sentiment suggests a strong year for equities. Many investors continue to flock to bonds due to extreme pessimism about the prospects for economic growth and performance of the equity markets.

Indeed, investors have placed a premium on perceived safety. As a result, Treasury bonds are overvalued and yields are unsustainably low.”

While six months is clearly not a trend, note the following market indices as of the close on June 4, 2003:

  • DJIA: +8.4%
  • S&P 500: +12.1%
  • Russell 2000: +17.8%
  • NASDAQ: +22.4%

Has investor sentiment improved dramatically? Doubtful. Has the daily self-doubt diminished? Unlikely.

Have the headlines subsided? Never – how else can themedia get us to buy newspapers and watch TV?

What has happened is that an emphasis has been placed on economic fundamentals marking a return to rational investing. As Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” His quote might be paraphrased and updated to read, “In the short run, the market is emotional. In the long run, it is rational.”

At the height of the market in 2000, margin debt as a percentage of total consumer debt reached a peak of 20% versus a fifty-year average of just under 6%. Very simply, investors assumed the most risk by borrowing money at what in hindsight was the most inopportune time. Today, margin debt as a percentage of total consumer debt has returned to historical levels. The faceless internet allowed investors to trade (read: not invest) stocks without the fear that their friends would know they did something stupid (like investing his/her retirementmoney inWebvan!). Is it coincidence that fewer online broker ads are shown on TV?

The conclusion is that Alan Greenspan’s theory of “irrational exuberance” has come full circle and market volatility should bemuted in the future. Speculators thrive on volatility – investors prefer the basics.

So what do we look for during the remainder of 2003?

  • Interest rates are clearly headed up. While the next Fed move may be a small decrease, the trend is for rising rates. It is difficult to imagine lower rates over the next few years barring an economic or geopolitical calamity – particularly since the real Fed funds rate has been below zero for almost two years which is unsustainable in a growth-oriented economy. Further, federal and state deficits suggest further bond issuance offsetting any potential repurchase of long-term debt securities. Net issuance necessarily suggests higher interest rates and lower bond prices. Short maturities are the best protection against rising interest rates.
  • Stocks have ‘room to run’. Improved corporate profitability and penurious bond yields are but two of the reasons that stocks have improved so far this year. Forward PEs are in the middle of historical ranges (and on the low end if tech/telecom stocks are removed). Stocks should trend higher barring an unforeseen economic or geopolitical shock.
  • Neither inflation nor deflation is a concern. Those believing inflation is a concern point to the cost of the military conflict with Iraq and the increasing federal deficit. Those believing deflation is a concern point to excess global capacity and the downward trend in the price of many goods and services. Further examination suggests that increased demand – as indicated by recent surveys of manufacturing and non-manufacturing sectors conducted by the Institute for Supply Management — will be offset by productivity increases until excess capacity is utilized. This should stem the tide of falling prices. Businesses will feel pressure to raise prices only when this capacity is utilized.

Inflation is a monetary phenomenon – namely, too much money chasing too few goods and services. Thus, it is anticipated that the Fed will, in the future, restrict the creation of new money and credit supplies. The Fed will not finance an increase in demand for goods and services. In sum, inflation may eventually become a problem but it is not now one and it is not inevitable regardless of the size of the federal deficit.

Finally, I want to brieflymention the recent tax changes signed into law about two weeks ago. Major changes include acceleration into 2003 of the marginal income tax rate decreases that were to be phased in over the next couple of years, a cut in the dividend and capital gain tax rates and an increase in the amount that small businesses may deduct for equipment during their first year of operation. Note that the changes are more political in nature than beneficial for many investors. President Bush faces an election year in 2004 and needs a strong economy to secure a second term. Financially, the changes provide benefits that are marginal at best except in extreme cases. In sum, major shifts in investment strategy in light of the tax changes wouldn’t be prudent. As I’ve always stressed, taxes are an important part of investing but they should never be the tail that wags the dog.