A year ago, after two years of a sharply down market, we were cautiously optimistic about the prospects for the economy and the stock market. That confidence, unfortunately, proved to be premature. Stocks declined for a third year and the bear market became the second worst in the past hundred years. The economy did in fact begin an expansion but so far it has been a modest recovery. Normally business spending for both inventory and job creating capital investment would be advancing strongly by now. That process is being delayed. Capital investment by businessmen requires risk taking and managements continue to be very cautious.

On top of a slower than expected recovery, investors had to deal with a confluence of confidence undermining events last year that was unprecedented. Revelations of corporate fraud at several large companies, most notably Enron and WorldCom, the prospects of war with Iraq, and the ongoing terrorism issue were the primary contributors.

While much uncertainty, particularly the Iraq issue, carries over into the new year, economic visibility has improved. The unemployment rate has stabilized at six percent, not bad by historic standards – at least for the ninety four percent who are employed, and fourth quarter surveys are indicating the pace of business capital spending is accelerating. Also additional economic stimulus is expected out of Washington, including the prospect of investor friendly tax cuts.

In January the natural process is to focus on the year ahead. But successful investing requires a longer-term outlook and by that standard we have the most valid of reasons to be optimistic. Growth stocks are once again undervalued.

The S&P 500 is currently trading at sixteen times this years expected earnings and the consensus five years earnings growth rate for the companies in that index is eight percent. That is well within the range of normal valuation. By way of contrast, the average future growth rate for the companies in your portfolio is twenty percent and the average price earnings ratio is nineteen times. The companies in the S&P 500 are valued at two times their growth rate and the growth stocks you own are valued at one time their growth rate. It has been a long time since growth stocks have been this attractively valued.

During the three-year bear market day-to-day market volatility has increased and added to investor concerns. The best way to deal with market volatility is to stay focused on how the companies are doing because that is what determines how the stocks will do. The earnings of a company growing at fifteen percent per year will increase by fifty percent in three years and will double in five years. That is the primary factor that ultimately drives stock prices.

In 2002 the bond market continued the trend established in 2000 and 2001 and interest rates declined. Over the past three years the rate of return on the bond component of your portfolio has averaged close to ten percent, nearly double the seventy-five year average return of five percent. Interest rates are now at levels not seen since the Eisenhower administration. As the pace of the economic recovery accelerates, interest rates, as in past recoveries, should begin to increase. That will put modest pressure on bond prices. We are preparing your bond portfolio for the expected rising rate environment by reducing the average maturity. That process involves selling the longer-term bonds and replacing them with shorter maturity bonds.

For the first time since 1931, stocks have declined broadly for three consecutive years. While it has been a most challenging market, fortunately, it has not been the worst economy, not even close. As we look forward to an accelerating economic recovery the probabilities favor a return to a positive stock market environment. Once again we extend our sincere thanks to our clients for their continuing support during this most difficult time.

We always enjoy talking with our clients and encourage them to call any time with questions or comments.