Market Perspective Full Year 2002 and Outlook

Although the concluding quarter of 2002 did provide some respite to beleaguered investors, the social, economic, and financial hardships of 2001 continued almost unabated in 2002.  News of accounting fraud and Wall Street deception replaced the negatives of the Internet bust and September 11th.  U.S. stock returns, measured either by the S&P 500 Index or the average diversified equity mutual fund, were the worst since 1974 and about twice as bad as 2001.  Decreases in U.S. interest rates were again positive for bond markets.  Overseas, investors generally faced conditions paralleling those in the U.S., but results were somewhat better than in the U.S. because currency gains for unhedged U.S. investors partially offset negative local currency returns.  

Overall, 2002 was a year of serious losses, mitigated to the extent your portfolio had significant exposure to bonds and real estate, energy, and commodity stocks.  Diversification again controlled losses for those willing to spread their risks.

Economic Review

The U.S. economy officially entered recession in March 2001, but it appeared to begin recovering by yearend 2001.  It grew at a respectable annual rate, slightly above 3%, between the end of 2001 and September 2002.  But corporate-governance scandals and tensions with Iraq hurt confidence and increased uncertainty, damping business investment, hiring, and consumer spending late in the year.

Consistent with a tepid recovery, U.S. inflation remained under control, increasing slightly to about 2.4% in 2002 versus 2.0% in 2001.  The core rate of inflation actually declined to 1.9% compared with 2.7% in 2001.

Economic activity was equally bad outside of the U.S.  Euro nations continued to experience slow growth or even stagnation.  Economically speaking, Japan remained a mess, and officials continued to do little to address the bad loan situation.  Outside of Japan, economic activity in the rest of Asia was the best worldwide, as exports were aided by some recovery of the U.S. economy.  Most developing countries, being suppliers of oil & gas, basic materials, and technology components, continued to be hurt by the economic woes of the developed world but were aided by the strength of commodities prices. 

The real estate market soared to new heights in 2002, as battered stockholders sought shelter in real estate investment trusts (REIT's), office buildings, and even their own homes.  Home values rose an average of 6.2% in the year ending September 30, far better than the annual average of 4.6% since 1980.  The latest price gains came on top of already impressive appreciation in recent years.  In fact, some are starting to wonder if real estate is the next asset bubble.

Real estate strength and consumer spending have been aided by extraordinarily low mortgage interest rates, which fell as low as 5.93% in 2002.  Low rates made it easier for buyers and also prompted a mortgage refinance boom, which provided consumers with nearly $100 billion in additional spending money last year according to the Wall Street Journal.

Equity Review

Stocks lost money for the third year in a row.  Further, poor results were not limited to tech and telecom and became widespread, especially in the third quarter when selling was merciless.  Among Morningstar's 27 stock fund categories, only two provided positive results: real estate and precious metals.  Almost all U.S. and international stock funds posted negative returns for the year.

Investors suffered losses of $2.8 trillion in U.S. stocks last year, as measured by the decline in market value of the stocks in the Wilshire 5000 Index, which includes nearly every publicly traded company based in the U.S.  The total value of U.S. stocks peaked at about $17 trillion in March 2000, and as of year's end, had fallen to about $10 trillion.

Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:

*          Mutual fund return data are from Morningstar.

**      Capitalization-weighted index of 500 very large U.S. companies.  The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors.  Recent median capitalization of approximately $45 billion.

#      Index of small U.S. companies.  Recent median capitalization of approximately $568 million.  Somewhat overweighted toward financial stocks.

##      International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the highest weightings).  Returns are unhedged and converted to U.S. dollars.  No emerging market stocks are included.

For the first time in several years there were only limited disparities among the various segments of the U.S. stock market; the convergence of results was due to widespread, rather indiscriminate selling:

1.         The average value fund lost 16.1% in 2002, a hollow victory over the average growth fund, which stumbled to a 27.8% loss (data per Morningstar; value and growth refer to contrasting stock-picking styles).  The underperformance of growth styles continued from prior years but narrowed; the lingering disparity has roots in the tech/telecom mania of 1999.

2.         The market was almost indifferent as to market capitalization.  The average large cap fund lost 23.2% last year.  By comparison, the average mid-cap fund lost a quite comparable 22.0%, and the average small cap fund was also deeply in the red, a loss of 21.3% (data per Morningstar; market capitalization generally corresponds to and indicates the size and age of a company).  Accordingly, large caps trailed smaller capitalization stocks for the fourth year in a row, after a long period of large cap outperformance in the mid-1990’s.

Longer-term data now reflect the extent of the bear market correction: many funds now must report 5-year results that are negative.  Also, due to on-going cycling of market leadership, the longer-term comparison between value and growth and large and small shows only modest differences.  The table below showing annualized five-year returns indicates the data:

As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. 

After outperformance three years in a row, the results of active fund managers were less than the S&P 500 index of blue chip stocks, but only slightly.  The typical fund holds at least some small and medium cap stocks, but their performance was about in line with large caps.  Thus, management fees were probably responsible for funds being at a small disadvantage of .5% in this year’s comparison to the index.

REIT’s and other real estate securities had very good results for the third year in a row.  The strength was due to investors’ search for lower price multiples, more reliable earnings, and higher dividend yields. 

The negative returns for broad market indexes were generally representative of performance at the level of individual stocks.  In 2002, for the three U.S. stock exchanges combined, 3,903 stocks advanced and 5,598 stocks declined.  The corresponding advance/decline ratio of .70 is consistent with downward results for indexes in 2002.  The history of the advance/decline ratio for the last twelve years is shown in the table on the next page; returns for the equally weighted version of the Wilshire 5000, a broad market indicator, are included to aid in calibrating the data shown for the advance/decline ratio.