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Letter dated January 2002 reporting on the fourth quarter of 2001

     I don’t have a strong bullish or bearish bias coming into 2002, but I am somewhat wary.   Valuations based on 2001 earnings are still pretty rich.  The S&P 500 Index has a trailing P/E ratio of  28.6 (ie, using 2001 operating earnings of $40.16  -- year close of 1148.15 / 40.16 = 28.6).   While such a high P/E ratio would normally suggest a ceiling on the market, a high P/E ratio is more justified when interest rates are this low and if earnings do indeed reflect the bottom of an economic cycle.  Even so, the market is not as “cheap” as one might expect given the decline in prices over the last two years.    

     Certain market leaders are priced with a very optimistic bias.  For instance, Cisco is expected to earn $0.22 in its fiscal year to July 2002.  At the recent price of $21, it was priced at 95 times current earnings.  In its best year ever, Cisco earned $0.53 per share.  So at $21, it was also priced at nearly 40 times peak earnings.  It has to resume an excellent growth trajectory quickly to justify the current price level.   On the other hand, there are still many stocks with reasonable growth prospects that have much lower P/E ratios and thus more attractive prices.  Many of these are mid-cap and small cap stocks.  That is why I screen a big universe to try to find good value. 

     In addition to valuation, earnings momentum is an important consideration in evaluating the overall market. Earnings for 2001 dropped an incredible 28.5% below the prior year’s operating earnings of $56.16.   Earnings estimates were slashed sharply throughout 2001.  Those reductions are starting to slow, and the market is already viewing this change in earnings momentum as a positive.  There are optimistic analysts who see a V-shaped economic recovery and believe that earnings can return pretty quickly to near the peak levels of 2000.  Nevertheless, overall earnings for the first quarter of 2002 are expected to show a drop from the first quarter of 2001.  It disturbs me that for nearly a year, analysts have kept forecasting an earnings rebound to begin a quarter or two quarters ahead.  I monitor changes in estimates closely and can adjust overall exposure accordingly.  Unless and until there are more signs of an actual increase in overall earnings, my sense is to remain somewhat cautious. 

     I consider technical indicators to have little if any predictive value, but moving averages can still be indicative of long term trend.  Many investors are mindful of the market’s 200 day moving average as a guidepost to the long term trend.  The S&P 500 Index did not enjoy a single day in 2001 above its 200-day moving average.  If the index does move above this average, it might well signal a major change in trend.  It briefly poked above the 200 day moving average in early January, but failed to stay above it.  That failure may suggest to some market participants that the overall market does not yet have the strength to sustain a real uptrend. 

     Many brokerage firms expect a year of positive but modest returns.  If they are correct, stock selection is all the more important.  I think that my quantitative earnings-based model has been very useful in identifying stocks that are good values relative to their actual and potential earnings.  If overall returns are modest, I hope that careful stock selection will once again allow us to outperform the S&P 500.