There is little doubt that 2002s market, along with the prior two years, has been disastrous for many equity investors. The fact that this has been the worst three-year performance of the equity market in generations may lead investors to feel that valuations are now cheap. In our view, it appears that the outlier event is not so much the bear market, but the bubble that precipitated it. In fact, the past years correction in valuations is a direct reflection of the overvaluations that occurred because of Y2K and the failure to determine how to properly evaluate technology companies. At this juncture, valuations appear to be fair overall, with some areas that remain overvalued.
Having managed money during the 1970's, we find that the comparisons made by market watchers between today's markets and that era offer some interesting similarities. The price actions of the two markets are very similar, particularly in the unusual volatility on individual issues and the unrelenting downside for weeks on end, as exhibited in 2002's third quarter. However, the economic backdrop between the two periods is very different. The economy is in much better shape today than it was back then. In fact, the current recession is mild compared to previous recessions. Again, the stock market action is more a reflection of a correction from the bubble's overvaluations, as stated above, than a response to a mild recession.
Looking forward, there are some positive signs. The monetary stimulus, as demonstrated by the lowest rates in 40 years, is providing some liquidity, and with it, some (albeit mild) relief. This is typical of mild recessions. Recoveries usually are less robust and tend to stagger along. Following the market's run-up in October and November, December's difficulties made it harder for market prognosticators to proclaim a clear trend for the quarter. That's partly due to the fact some of the quarter's early, and most sizable gains came from beaten down securities of questionable quality, which, by themselves, had a limited ability to sustain the broader market. But other events are offering clearer indications of how the economy may be shaping up.
During the 4th quarter, investors shifted to riskier assets, indicating greater degrees of risk taking in the economy and confidence on the economic front. Whether from Treasuries to junk bonds, or from developed markets to emerging ones, these asset migrations signal more positive expectations by investors. Furthermore, the economy continues to grow moderately while interest rates remain very low and productivity remains very strong. The balance sheets of corporate America continue to improve in most industry groups as access to bank capital and to the debt markets have gotten better. Indeed, this quarter's flurry of new activity by high-yield debt issuers indicates a different outlook on these business' prospects. Not long ago, companies experienced near-total blockage in their efforts to get access to capital, especially those with lower credit quality ratings. Many such firms are simply too small or too new to have established better ratings, and many will become successful some enormously so--but only with access to capital. That makes new debt issuance critical in the long run, but in the short run, the surge also indicates the market's emerging confidence and willingness to take on risk. Similarly, another major shift and possible indication of the flight from quality to riskier assets may be discerned in the dollar's ongoing weakness.
Equity financing would be an extension of these trends, and despite current difficulties, we expect IPO activity to improve in the coming quarters, helping to solidify balance sheets further. We also believe that business capital spending should rebound as balance sheets are further stabilized and ongoing pricing pressures generate more productivity enhancing investments. The telecomm, utility and some technology industries will see further consolidations, either through merger & acquisitions or bankruptcies, and will continue in this vein until they achieve correct capacity levels.
What does all this mean for the financial markets? Because the destructive phase of capitalism has nearly run its course, we think the creative growth phase will emerge soon. (Of course, capitalists must be rewarded and encouraged to risk capital: fiscal, monetary, regulatory, and judicial policies are critical to creating growth potential, and will either promote or retard progress.) Corporate America's cleansing from debt, excess capacity, and crooked management is last year's news and consequently built into market prices. Now, with the financial markets instead looking forward and shifting to riskier assets, they may be indicating more confidence in the future.
Unfortunately, the war factor looms, and the fluidity of the geopolitical situation means that investors' outlooks can change frequently, perhaps daily. With such questions hanging over the market, it's no surprise that not all investors have embraced the signs of an economic recovery, and some remain tentative. The risks here are not to be taken lightly. They are serious and can have a profound impact on the future direction of the financial markets. The present dilemma for investors is that these unknown risks are difficult, if not impossible, to assess. It very well may be that these geopolitical risks have always existed throughout the Cold War era. Today, with information more available, these risk factors are being better understood by the general public--and the marketplace. Our view is that the concerns in fact may be providing an opportunity for investors. A safer, freer world provides the necessary underpinning that is required for expanding markets and opportunities.
Still, it's been said that rising markets climb walls of worry. America has faced much tougher environments and managed to come out stronger each time. We feel that this cyclical environment offers investors the opportunity to take advantage of good investments at reasonable prices in the greatest economy in the world. With the proverbial wall of worry in place, the shifting of assets indicates that some investors are, like us, anticipating the next upswing in the market to begin.