03/19/02     Opinion in some quarters is that a new bull market is now in force, giving the green light for unrestrained purchase of equities.  While the worst may be over, lingering effects of the deflated bubble economy will be a damper on equity results for some time.  The new “neutral” Greenspan interest rate policy really means that interest rates will soon be moving up from 40 year lows, a negative for bond and stock prices alike.  Bond investors sitting on a 20% return over the past two years are better prepared than those whose results were worse than or equaled the S&P 500’s 20% decline over the same period.

 

     Reported corporate earnings are going to be held hostage to:  draconian accounting rules;  a likely cap on consumer spending (record levels of consumer debt, exhaustion of home equity collateral and rising unemployment);  delay in resurgence of business investment (present overcapacity);  and the dead weight of increased interest charges on (again) record levels of corporate debt.

 

     Returns on the assets of corporate defined-benefit pension plans have been strong contributors to reported earnings over the past few years, companies coasting on accumulated surpluses.  This is no longer the case –  IBM’s $10 billion pension fund cushion was virtually wiped out last year, falling  to $600 million.  Many large companies assume a 10% annual return on pension fund assets.  For the two years ended ’01 returns should have cumulated to 121% of starting value.  Assuming an 80% equity asset allocation and the two-year returns for bonds and equities cited above, the calculated result is only 88% of starting value.  Suddenly, the fund is 38% behind the curve.  This shortfall must be made up going forward, plus amounts by which actual future positive results fail to reach actuarial assump-tions.  Current low cash yields on bonds and low earnings yields on equities are not conducive to double digit annual returns.  Companies must resume contributions to their defined-benefit pension plans (about 50% of the retirement plan universe), penalizing reported earnings.  Not to mention the balance of payments deficit, which will soon require a $2 billion daily injection of foreign capital to keep the U.S. economy on an even keel.

 

     Market risk is asymmetrical at the moment – present valuations cannot be sustained if earnings are worse than expected;  better than expected earnings are unlikely to move valuations much higher.

 

     What to do?  In the fixed-income area there are many good quality preferred issues yielding 8% to 9%.  There are also some misunderstood and mispriced corporate bond issues maturing in less than five years which offer, in our opinion, well-protected double digit yields.  Equity selection is more problematic, turning on individual risk tolerance and investment horizon.  Candidates can be found in energy, health care, financials and certain areas of technology.

 

William Wright