The economic recovery gained support from productivity growth as the first quarter ended with improving employment numbers, a low inflation environment and a stronger global market.
Our current outlook on the market remains constructive, meaning that we believe continuing strong economic growth will translate into improvements in both earnings and cash flow in upcoming quarters. In such an environment, bottom-up, company-specific analysis especially contributes to performance, and that plays into our firms strength: our in-depth focus on investment analysis and research. This type of market is quite different from that of 2003, when the markets preference for types of securities took precedence over individual names of securities.
During 2003, as the market recovered from the longest bear market since the 1930s, the market decided that many of the companies with negative earnings would actually survive. Prior to the turnaround in sentiment, the viability of many companies was in extreme doubt. The catalysts for this strong market action were, in our opinion, the bold tax bill of last April and the Iraq war. Both actions gave some sureness to the markets and seemed to cause the upward trend during the latter half of the year.
In that more-confident environment, stocks with negative earnings actually out-performed stocks with positive earnings. Small caps did better than large caps, and cheap, low-price stocks bounced back from oblivion. Typical of the stock market, it foresaw and led an economic recovery that exhibited strong GDP growth in both the third and fourth quarters. In fact, growth was not only strong, but phenomenal. Only a few years ago, such strong numbers (without inflation) were not thought possible by the old Keynesian economic theorists.
Despite the fact our investment process steers us towards stocks that actually have positive earnings and cash flows, we enjoyed solid performance even without fully participating in the bad-apple bounce that defined 2003. That's because although we avoided the most distressed companies, we were properly positioned for the cyclical recovery and invested in companies that either benefited from continued consumer spending or from increases in business spending. Although the quarter saw some dramatic see-sawing of prices, the quarter finished close to where it began. As we noted previously, the stock averages may very well meander about throughout the year, seeking direction. The stock markets wait-and-see game will be looking for verification that cash flow and earnings will be forthcoming, and proper company-specific research will be critical to identifying opportunities.
While focusing on the individual opportunities in the current environment, our top-down asset allocation has us positioned (depending upon strategy) among mid-grade fixed income, mid-grade convertibles with equity sensitivity, growth and value stocks in the mid-cap range and some large-cap cyclical exposure. Because Alan Greenspan is now indicating, without saying when, that interest rates may rise, we have lessened exposure to high-grade debt and investment-grade convertibles that have little equity sensitivity. A rise in rates would provide another sign of a healthier economy, and as such is good news for stocks but bad news for high grade bonds, which lose value when rates rise. High yield bonds, on the other hand, should outperform in a growing economy. Now that the broad upward move in high yields has occurred, our bottom-up, company-specific research is looking for special situations that may benefit from credit upgrades, merger and acquisitions, or debt for equity swaps. Current yields of our portfolios in this area remain attractive.
Overall, economic forces appear strong and will continue to fuel a strong global market and economic recovery. One key driver we see to this expansion is the ability of the economy to grow substantially without inflation: without the serious erosion of capital caused by high inflation, significant growth in both capital investment and wealth creation can occur. Furthermore, productivity growth continues to be a major theme of strong economies around the world. While such excellent gains in productivity do have a short-term effect on job growth, over the long term the best bet for a growing job base is a growing global economy. In fact, job creation has always been a lagging indicator, and we believe that the medias current focus on the issue offers more insight to election year activity than to economics. Even so, such concerns should be mitigated by the strength of the most recent months report, where job growth was exceptional, supporting our long-held view that jobs follow in the footsteps of other phases of an economic recovery.
As usual, there is plenty to worry about. There are concerns that the coming interest rate increases will stem from undue inflation, but we feel that if properly administered, a low inflation environment can continue despite some modest rate increases. As already alluded to, election year posturing may also cause some volatility. Our sense is that the market would not respond well to an unraveling of the growth oriented tax bill implemented one year ago. A relaxation of the war on terrorism would add additional uncertainty to an uncertain world. Uncertainty and divergent opinions on the future are what drive the market, however, and our experience through numerous market cycles tell us that every good market climbs a wall of worry.