Last week, WorldCom, the nation's second-largest long-distance carrier, revealed that it had overstated its cash flow by more than $3.8 billion during the last five quarters. Many analysts now see a bankruptcy filing as a strong possibility, which would follow the pattern of Enron, Global Crossing, Adelphia Communications and others. Other major U.S. companies such as Tyco and Xerox are also being investigated for using questionable accounting practices. Corporate chieftains, directors, and their shareholders let greed run amok while stock prices were rising Now that prices have reversed direction and company managements are under the microscope, each new revelation seems to send all stocks lower. Maybe WorldCom will be the straw that breaks the camel's back. Quantifying this dissatisfaction with corporate America, with the accountants who serve them, and with the Wall Street analysts that had more than research on their mind is impossible. One can only assume that what was normal, is no longer; and that the lower end of quantifiable expectations should be one's target.

As portfolio managers, our task is to quantify risk-adjusted return expectations for different asset types, and sectors within assets types. (Thus asset allocation is the first tenet of portfolio management). Forecasting the performance from a bond portfolio is far easier and provides greater certainty than constructing equity returns. Bonds have a final termination date, and interest payments are easy to handle mathematically. Stocks have no terminal end-point, and in most cases, dividend payouts and yields are rather modest. Thus they are more exposed to those who buy or sell based on emotion. Since the disaster of 9/11, America's capitalist nerve has been exposed trapping us on an emotional roller coaster. Just as we think we can see light at the end of the tunnel, a new confession of corporate fraud or "gaming" leads us to mistrust our investment thesis, and the tunnel becomes much longer than we anticipated. This market is no longer about economics or fundamentals. It's about emotion . . . and financial hubris.

At current levels, we find the projected returns for the overall stock market more competitive than they have been at any time in the last three years. Still, our 3-year forecasted returns for the S&P 500 are just approaching 6% . . . hardly a barnburner! Although we project a healthy earnings recovery through 2003, this outlook is tempered by lower projected price-earning ratios. Just how low is low is ripe for speculation. Much of our reduced valuation outlook is a reflection of lower long-term earnings growth projected for the S&P 500 companies (See Chart). Merrill Lynch's analyst estimates of five-year earnings growth for companies in the S&P 500 peaked at 18.2% in the fall of 2000, and currently is 13.1%, similar to the expectations that existed in 1996. Additionally, we believe that inflation expectations will rise gradually over the following two years. As we mentioned in our last commentary, these two valuation variables are working against the backdrop of an improving earnings outlook. However, the rise and fall of growth estimates was pronounced in the telecom, technology and utility sectors. In mid-2000, these three sectors accounted for more than 50% of the market weighting of this index.

THE FUTURE
At some point, probably by 2004, expected growth rates will approach some level of reality (based on past levels) of around 12%, and corporate integrity will have been restored. This would mean that S&P 500 valuations would stabilize around 17 times normalized operating earnings. Subsequently, earnings growth would once again translate into sustainable price increases and the "camel" would be off and running. As for the present, what we have is a lack of buyers caused by the uncertainty of financial outcomes, tied indirectly to the potential for future terrorist acts and past corporate greed. All we can hope for now is rational exuberance!