By Kellie R. Stark, CFA, Vice President

 After the toughest bear market since the 1930’s, all of us have given some thought to the burning question of whether or when the market will rebound.  We, at Westwood, are certainly no exception. 

As we left 2001, most investors looked cautiously forward to 2002 and a recovery in the markets.  Given that 1939-1942 was the last time the markets had posted three consecutive down years, we thought we had seen the worst returns of the bear market.  An end to the economic slowdown and corporate scandals also helped to paint a brighter picture for the markets.  Instead, 2002 gave investors plenty of new issues to worry over.  Increased risk aversion hurt the economy and financial markets throughout the year.  Investors spent the year concerned primarily about economic uncertainty, corporate accounting abuse, lack of corporate governance, and geopolitical fears centering on terrorism and a potential military conflict with Iraq.  What was supposed to be a better year, instead turned into a third straight year of losses. 

2002 now ranks as the fifth worst performing year and eighth most volatile year out of the last 74 years.[1]  Technology and Telecommunication Utilities were the worst performing sectors for 2002, but all sectors posted losses for the period.  For most of the year, a preference for dividend paying securities continued to help Westwood’s performance as investors rewarded value-type securities.  A strong rally in the most beaten down and lowest-priced securities in October and November were a reversal of this trend, but these stocks were unable to hold their momentum in December. 

Now, as we head into 2003, we wanted to give you our “Top 10” reasons why the market could rebound.  

1.        Investor Risk Aversion Appears to be Falling:  In the fourth quarter of 2002, the best performing sectors, Technology and Telecomm Utilities, were the highest risk sectors.  In July and again in October, the equity risk premium built into security prices reached the 95^th percentile of risk aversion.[2]  As the risk aversion abates, the implied equity risk premium begins to fall, lending support to equity prices. 

2.        Subdued Expectations:  Long-term expectations for earnings growth have fallen and many investors are now expecting market returns for 2003 between (5%) and +10%.[3] 

3.        Economy Is Showing Signs Of Improvement:  The US economy grew more than 3% in the last year as we emerged from recession.  Productivity continued to rise and real capital spending grew 5% in the last two quarters of the year.  Investors looking for improved utilization rates and falling unemployment levels have not fully recognized the improvements already made in the economy. As we look forward, Westwood believes that the prospects for economic expansion and a rebound in corporate profits are in place.  We expect the economic recovery to continue in 2003, albeit at a modest and uneven pace.  Although cautious on the consumer, we expect an increase in consumer spending.  Personal expenditures, in combination with inventory restocking efforts and a gradual resumption in capital expenditures, should provide support for the economy.  Competitive pressures will encourage companies to continue to raise productivity levels and keep operating costs low.  Together, these will bring about a recovery in corporate profits.

4.        Investor Place A Premium On High Quality, Specific Stocks:  We are unlikely to see corporate earnings growth similar to the levels posted by some in the late 1990’s, but economic growth should support a very respectable, 10% level of growth.  Cleaner and more transparent corporate disclosures should help investors in their search for the high quality companies.  Investors have increasingly placed a premium on specific stocks with ‘clean’ financials and stories while avoiding and placing high risk premiums on those companies perceived as unsafe.

5.        Fixed Income Yields Are At 40-year lows:  Investment grade bonds finished the year as one of the top performing asset classes and for the third straight year, outperformed relative to bond manager expectations.  Given the generational low levels of interest rates, capital appreciation from current levels appears unlikely.  Our outlook for the bond market calls for short-term interest rates to increase as economic activity improves while long rates remain largely unchanged given the benign inflation environment. 

6.        Defense Spending Activity:  In the recent past, Congress has been adding to the budget requests of the President.  Looking forward, it appears that the FY04-09 defense budget will grow at a compound rate of 8-10% in the procurement and R&D accounts.  The current military buildup and growing defense budget dollars flow not only to the large contractors but trickle down to those who support these firms.  While the impact of a war is unpredictable, the earnings growth shown by firms in the defense industry will ultimately provide support to, and drive a portion of, the overall level of corporate earnings growth.  Higher levels of corporate earnings support higher share prices through improved valuation levels. 

7.        Elimination Of The Double Tax On Dividends:  If the double taxation of dividends is eliminated, as proposed by the President, shares prices could be given a significant amount of support by making stocks more attractive relative to fixed income products and improving after tax returns.  Estimates for savings for the taxation elimination have been projected to be $26 Billion in the first year, which could help share prices rise by 2-6%, or more.[4] 

8.        History Is Now Firmly On Our Side:  The markets have not posted four consecutive losing years since the 1929-1932 period.  With history on our side, we can hope that we will not see a fourth down year.  In addition, over the last seventy years, the third year of nearly every presidential term has seen market returns average nearly 20%[5].   

9.        US Dollars Retreat From 2-Year Strength:  After two years of unprecedented strength, the US dollar has retreated.  The dollar’s level is now back to its 2000 levels.  A weakened dollar can provide earnings support for domestic companies selling outside the US by making their products more attractively priced and therefore, stimulating exports. 

10.     Corporate Pension Funding:  For the past 30 years, US law has required funding of long-term pension liabilities.  While many pensions are technically under funded, the vagaries of pension accounting are not currently requiring funding of these pensions.  Many corporations however, have chosen to make funding contributions sooner than required in an effort to put the issue behind them and to improve shareholder confidence in their financial strength.  As these companies make cash contributions to their pension plans, the bulk of the funds will be generally invested into the equity markets.  

So, after three disappointing years, there is no shortage of reasons for investors to expect more of the same.  However, our view is that while 2002 was bad, there are a multitude of reasons for investors NOT to expect more of the same; moreover, investors should look forward, positively and with hope for a better 2003. 

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This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.