With looming war questions, international discord, and a heightened security presence from Main Street to Wall Street, there are plenty of concerns that seem to be mounting. As Americans, the possibilities of facing both terrorist attacks and putting our military in harm's way raise concerns for ourselves, our families, and especially our troops, and circumspection is understandable. As investors, however, we believe that such caution is not in the best interest of long-term wealth creation, as our economic recovery and upside market potential have become so overwhelmed by the daily, sometimes shrill, media reports of international drama and rising duct tape sales. Put simply, with more and more focus on war and terror, there's been less and less attention paid to our recovering economy.
It was Henry Ford who said, "Obstacles are those frightful things that you see when you take your eyes off a goal." In our country's current situation, the frightful things may indeed be legitimate when looked at as concerned citizens, but as investors, those same concerns are in many ways obstacles to clearer thinking when regarding the long term strength and ongoing recovery of the U.S. economy. It may not feel like it while watching the market gyrate with a foreign statesmen's latest pronouncement, rather than react to earnings reports and economic indicators, but the market ultimately will follow a growing economy. A closer look past the static reveals an economy that continues to demonstrate it is on the mend.
For example, the 2002 productivity figure of 5% is an astounding achievement for our economy, especially in light of September 11th's economic repercussions, the distracting accounting scandals, and wealth destruction that occurred during the year. To our thinking, the strength of the productivity number signals that the positive effects of technological advances, streamlining, and a refocus on balance sheets continue to ripple through corporate America, driving improvements to their bottom lines. Another measure that may foretell a strong surge in earnings in 2003 is the currently high levels of operating leverage among American corporations. This ratio, which divides a company's fixed costs (including interest) by its total sales, signifies the heavy toll that reduced revenues have had on companies, especially after the buildup of fixed costs during the 1990s. Now, however, the high fixed cost ratio that has had such a detrimental effect on corporate profits in the past few years is poised to provide a lever that could boost profit margins significantly even with an only incremental increase in demand. That's because with such high operating leverage, companies can very quickly benefit from economies of scale, pushing new revenues almost directly to the bottom line. If productivity can continue at or even near such a pace, or if demand picks up, economic growth in 2003 could be inspiring, while earnings recovery could be more robust than many anticipate. The effect on cash flows and profits could generate numbers good enough to recapture the attention of many investors. We continue to position our portfolios for such recognition by the market.
With the amount of stimulus pumped into the U.S. economy in recent months, it appears that talk of deflation is subsiding (notwithstanding the fact you can still get a hamburger for $1). Even so, there has been scant recognition of a very different trend: Another factor off the radar is the emergence of increased pricing power, at least within the commodity sector. While the rise of gold prices has been reported in earnest as a barometer of war fears, other commodities, including many industrial materials, have also seen prices rebound sharply. That signals pricing power, along with new demand. On a related note, another positive sign here is that while the manufacturing sector has increased productivity, it has barely increased its labor costs: Such a dynamic should also lead to higher profits and cash flow. Also, the decline of the U.S. dollar during 2002 may cause hand wringing in some circles, but its effect on our economy's ability to compete overseas is already improving trade flows in some sectors. As the sole engine for global growth, the U.S. remains by far the world's only economic superpower. Although the dollar has climbed down from the hard-to-sustain high levels of the 1990's, a strong global rebound is still dependent on the world's largest economy, and our economic stature is barely dented by dollar fluctuations. While many investors' eyes are on the dollar, the observation that business pricing power is gaining traction is yet another element of a recovering economy that has yet to be fully appreciated by the market. Waiting on the sidelines for such recognition may work, if one is prescient, or very lucky. For our portfolios, we are positioned for the market's recognition now, because we know it will occur, but we don't know when. In the interim, market volatility provides us with opportunities to purchase securities further out on the risk spectrum, enhancing our portfolios' upside potential at decent valuations.
Another sometimes overlooked factor in the current scenario is the improving credit situation, which also holds upside potential for those portfolios holding more credit-sensitive securities. As the stock market imploded during the past three years, the destruction of wealth had a detrimental effect on companies gaining access to capital. The vicious cycle of lower valuations causing tightening of credit causing further drops in valuations demonstrated just how brutal it could be in the summer of 2002, when new issuance of bond and convertible debt came to a standstill, and valuations crumbled amid heavy-debt sectors such as telecom. While many companies were overextended and had excess capacity, the creative destruction wrought last summer has resulted in strengthening balance sheets and less overcapacity issues for the survivors.
With greater confidence in their viability, along with greater confidence in corporate reporting, the credit spigot has been turned back on. Beginning in the fourth quarter of 2002, and continuing so far in 2003, the debt market's revival has recast the outlooks for a number of businesses. With the improved outlook on corporate America's debt, we expect credit spreads to continue to trend downward, however bumpily, back towards historical norms. New, cheaper access to capital could benefit many businesses' growth rates and hence their equity valuations, while at the same time boosting prices among lower-rated, higher-yielding convertible and corporate bonds as credit spreads narrow. While it's true that the path to this outcome is neither promised nor likely to occur without back-tracking, we once again are focusing on extending our portfolios' exposure to credit-sensitive holdings, in anticipation of such a recovery.
Like the rest of America, we wish for the safety of our families and our servicemen and women, we have concerns about the unknowns that lie ahead in the geopolitical arena. The markets have their own set of unknowns too, but dealing with this type of concern is actually quite simple for us. We believe that as investors, paralysis is not an option: We continue to pursue the long-term financial health of our clients and customers, adhering to our core principles and experience through numerous periods of market turmoil. Throughout those periods, we've learned that managing the trade-off between risk and reward is a critical component of long-term success. While that sometimes means reducing upside potential despite overwhelming market optimism (as we did in 1999), it can also mean increasing risk exposure at market lows, as we are doing today. While almost any news event can drive the market on a daily basis, over time, economic fundamentals ultimately move markets. When the market refocuses on its own strengths and potential for recovery, we believe that investors that have properly positioned their investments will have the greatest likelihood to fully participate in a market rebound.