We have been writing Investment Outlooks at least quarterly since 1979, but we've never been proven wrong more quickly or definitively than when we turned bullish at mid-year 2002. We had planned to slough this off as being more early than wrong. It was our intention to refer you to our mid-year 1982 Investment Overview which is available on our website (http://www.montgomerybros.com/investment.html ) or by request. The piece started with "… no one rings a bell at the beginning of a bull market" and ended with "Ding, Dong, Ding." The stock market went virtually straight down for the first six weeks of the third quarter of 1982. But on August 17^th (1982), the S&P 500 rose nearly 5% and we were off to one of the greatest secular bull markets ever. Between August of 1982 and March of 2000 (its all-time high) the S&P 500 rose 14-fold interrupted only by a couple of brief cyclical bear markets. We wish that we were expecting an instant replay of 20 years ago. We aren’t.

In 1982, the stock market had been through a secular bear market. The economy had suffered multiple recessions culminating in double-digit interest, inflation, and unemployment rates in the late 1970s and early 1980s. The U.S. was suffering from what Jimmy Carter termed "malaise." The stock market was cheap and either loathed or totally ignored. But under the surface, the fundamentals (political, economic, and investment-wise) were improving. And improve they did, culminating in the economic boom and the parabolic stock market rise of the "new paradigm" during the second half of the 1990s. But, as one of "Murphy's Laws" points out, "when everything is going right, you forget to factor something in."

What had been considered a "new era" is now more often referred to as a "bubble." Whatever it was, it wasn't sustainable. The long expansion of the 1980s was followed by what was one of the shortest and mildest recession on record. The 1990s was THE longest expansion on record and, even after the recent GDP revisions, was similarly followed by a relatively brief and shallow recession (just not as brief and shallow as we were originally told). During the 1990s, expectations, especially for stock market returns, grew out of all proportion to reality. Excesses grew into distortions until, ultimately, reality returned. Unfortunately, the aftermath of the economic boom and wild bull market of the 1990s is proving longer, deeper, and more threatening than we had earlier expected.

As a result of the excesses of the 1990s, the political climate is increasingly worrisome. Montgomery Brothers believes that panicky politicians can do more long lasting damage to the economy and financial markets than all of the crooked corporate executives and conflict ridden Wall Streeters put together. In a well-intentioned effort to rebuild investor trust and confidence, Congress recently passed and the President signed into law the Sarbanes-Oxley Act. In the usual political fashion, this legislation addresses the symptoms rather than the causes of the current situation. Sarbanes-Oxley will enhance corporate governance but it will no more eliminate corporate fraud than the gun control laws eliminate murder. We also worry about the Law of Unintended Consequences. For example, several years ago, in response to a public outcry over what was then viewed as excessive executive compensation, legislation was passed that limited the deductibility of executive salaries to $1 million per annum. It was shortly afterwards that the use of options for corporate compensation exploded. With Sarbanes-Oxley, corporate executives will have more personal liability, which will lead to more lawsuits, which in turn will diminish entrepreneurial risktaking. This is at a time when most are hoping that corporations will start to rebuild inventories and increase capital spending.

Investors want revenge for the money lost during this bear market and are calling for the scalps of miscreant corporate executives. Undoubtedly, some will go to jail and should. But politicians would serve the economy and financial markets better by simplifying the tax code and increasing investment incentives rather than stringing up a couple of CEOs in the town square. The truly unquantifiable problem is determining how long the ramifications and repercussions caused by the excesses of the 1990s will continue to rumble through the economy and financial markets.

Montgomery Brothers long ago became accustomed to the government restating its economic statistics. But even we were startled by the GDP revisions announced in late July. It seems that the economic expansion of the late 1990s was less than previously announced while the subsequent recession was deeper and lasted longer than was initially reported. Rather than one, we actually experienced three consecutive quarters of economic contraction, meeting everyone's definition of "recession." This also puts to rest the discussions of the "disconnect" between the stock market and the economy. Unfortunately, in favor of the stock market. Maybe the government was merely following in the footsteps of all of the corporate restatements. But I missed hearing George Bush, or even Paul O'Neill, vouching for the integrity of the government's financial statements. This could have set a good example for all those corporate executives that must attest to the reliability of their financial statements by August 14.

As is usually the case during recessions and bear markets, bad news crowds out good news. And we've had enough bad news to rekindle the fears and forecasts of a "double dip" recession. A relapse into recessions such as those witnessed between 1972 and 1975, and again between 1981 and 1983, (see charts below) would be bad news for everyone, but especially Republicans. (I can hear the Democrats referring to an economic relapse as the George W-dip Bush Recession.)

"Double dip" recessions really aren’t all that unusual, having occurred in about half of all post-WW II economic downturns.

The biggest near-term risk to the economy is that the bear market in stocks spills over into consumer spending in a self-fulfilling prophecy reversal of the "wealth effect." If consumers curtail their spending (something that is often forecast but seldom occurs), a second leg down would be nearly assured. The good news is that the employment situation, while not great, is slowly getting better; incomes continue to grow, albeit slowly; inflation remains well under control; interest rates are low and should stay so; housing sales are strong and home prices are rising; and monetary growth has reaccelerated.

In the corporate sector, inventories are low and corporate profits are showing a glimmer of recovery. Fiscal policy, as is the case with monetary policy, will remain expansionary. (And both for longer than will be needed, but that's another story.) Unfortunately, the current expansion is anemic and, given the steady drumbeat of negatives, the chances of a "double dip" recession are increasing. The recent GDP revisions merely add to the economic uncertainty.

With the renewed signs of economic weakness come the anguished cries for additional interest rate cuts by the Federal Reserve. If past is prologue, Alan Greenspan and his cronies at the Fed will do the politically correct thing and reduce interest rates further. This, however, might happen later rather than sooner. The longer the Fed waits, the more political such a move would appear, given the November elections. Interest rates, especially at the shorter end of the yield curve, are already at the lowest levels in over forty years. Nevertheless, the futures market and recent sharp decline in the 2-year Treasury yield point to yet lower rates ahead - at least at the shorter end of the yield curve.

The major bond market averages have, in general, outperformed the major stock market averages during the past one, three, and five year periods. The fact that this doesn’t happen very often hasn’t deterred many on Wall Street from advising people to buy bonds. If we do get a "double dip" recession, or worse, Treasuries will do well. Otherwise the return from bonds, especially Treasuries, looks to be about that of the coupon rate you will receive.Corporate spreads remain high, but so does event risk. Nevertheless, high investment-grade bonds look fairly attractive, especially if the economy avoids the dreaded "double dip."

The viciousness of the July stock market decline has caused us to rethink the more constructive stance on the stock market which we adopted at midyear. While we had hoped that the major stock averages were putting in a bottom, apparently more time and testing will be needed. And now, the debate is on. Is this a cyclical or secular bear market?

Between 1901 and 1999 there were 19 Dow Jones Industrials Bear Markets (20% or greater declines). They ranged from the 89% decline of the Great Depression (9/1929 to 7/1932) to the 21% decline during the Gulf War period (7/1990 to 10/1990). These bear markets experienced an average decline of 36.8% and lasted approximately a year and a half. The Dow is down 32% during the past 31 months since its January 2000 all-time high. (The other market averages are down by larger percentages but over shorter periods of time, with the NASDAQ Composite off a whopping 75% from its March 2000 all time high.) Some might argue that since we had a 20+% rally in the averages between late September 2001and mid-March 2002 that we’ve actually experienced two distinct bear markets. Gosh, we could call it a "double-dip" bear market!

Cyclical bear markets tend to be associated with recessions and the resultant declines in corporate profits. Secular bear markets have more to do with valuation and investor psychology. The 1973-1974 bear market encompassed both aspects. The 1980-1982 market was a cyclical bear market which marked the end of a secular bear market, which lasted from 1972 (some say 1968) until August, 1982.

It takes a long, long time to turn investors into stock market fanatics. It took one of the longest periods of sustained up moves on record. From August of 1982 through the end of 1999, the Dow only had two 20+% declines and both lasted only four months. "Over the long run stocks always go up" became the mantra and "buy every dip" became the battle cry. The mania culminated in five consecutive years of 20+% gains from 1995 - 1999. Virtually everyone became a true believer. But now the bubble has burst. We’re into our third year of a bear market. Ugly excesses hidden during the boom have surfaced. Stocks are risky and were overvalued. Investors are bummed. Unfortunately, it will take a longer time for the psychological damage to work itself through the system than we had initially thought.

We believe we’re in a period similar to the second half of 1974. There are very few "V" bottoms to major bear markets. And bottoms seldom occur when everyone is looking for them. While stocks aren’t statistically cheap on an historic basis, especially compared to 1974 or 1982, they are cheaper. Unlike 1974 and 1982, the economy is in good shape and most U.S. corporations are lean and mean. Montgomery Brothers believes that the outlook for a cyclical improvement in stock prices à la 1975 is good. When asked if he ever though it would stop raining, Mark Twain replied "It always has." Bear markets end too! But in this case not as quickly as we had hoped or forecast.

August 7, 2002          John E. Montgomery