Summer 2001

"The best of times....the worst of times...
or "Thank you Jack Welch!! Goodbye bull market??".

Summer Greetings:

July 31, 2001
(Tyler Bud's birthday)

...the markets

We ended the quarter maintaining our 20% gain in The Model Portfolio for the year. Coupled with our 1% gain last year and 42% gain in 1999, the Model Portfolio has out performed the S & P 500 by 60% over the past three years ended June 30, 2001. For the year ended June 30, 2001 the Model Portfolio had a return of +22% and the S & P 500 for that same period of time returned -14%. For the 3 year period ended June 30, 2001 the Model Portfolio had a annual rate of return of 20% and the S & P 500 for that same period had an annual rate of return of 4%. For the 5 year period ended June 30, 2001 the Model Portfolio had an annual rate of return of 18% and the S & P 500 for that same period of time returned 14%. Past performance does not indicate future performance.

The collapse of the internet and tech stock bubble was predicted by many but acted upon by few. We were one of the few. In November 1986, nine months before the 1987 Crash, our late partner, Don Yarling, said in The Lemley Letter, "The last leg of a bull market is always the most exciting and the most dangerous." History has shown that when markets run to excess and when stock ownership exceeds fifty percent of the population it's time to raise cash. We may have overdone that by being 90% cash, but until we are convinced that this is only a correction and not the end of a twenty-year bull market we plan on remaining cautious.

Truth be told, it is professionally gratifying to know we are fulfilling our responsibilities to our clients. Almost all accounts have outperformed the S & P 500 by at least 30% during the last 3 years. Our philosophy has always been to take gains as they present themselves, to try to hit singles, and to take the home runs when we get lucky. Our main goal has been and remains preservation of capital. While we are not yet "masters of the universe" we want our clients to know that we have delivered the goods. And we also want to thank them for their confidence in us over the years. We take great satisfaction in rewarding that confidence with the recent performance in client accounts in a very difficult time.

...bull market?

With most accounts at 90% cash, we are making a strong statement that the markets have much more downside risk than upside potential. The bull market of the last 18 years started right after Jack Welch took over as CEO of General Electric. GE has been the bell weather big cap stock of this twenty-year bull market, replacing General Motors and IBM for that honor. GE has earned this honor and numerous accolades for Welch by showing consistent earnings, excluding special charges, and sales growth for the past 20 years. Jack Welch is retiring on September 7, 2001.

Both the NASDAQ, which is down an astounding 60% from its high of just fifteen months ago and the S & P 500, which is down over 20% in that same time, are obviously in bear markets. But the DJIA has only dropped a little more than 10% from its high. If past performance of the DJIA versus the S & P 500 holds true, the Dow would fall to the 7800 level to match the drop in the S & P 500.

...why we are bearish

We realize that our view is more bearish than most. We are bearish because stocks are not cheap. Even after the precipitous drop over the last year in tech stock prices. Because of numerous rapid-fire splits over the past few years, stocks such as Motorola and Lucent, et al, all have total market values well in excess of historical norms. Excess valuations are never justified, but they may be explainable if sales and earnings are growing at exponential rates. Over the last few years we have often questioned whether reported earnings represented real earnings. We have also questioned sales growth figures resulting from takeovers at ridiculously high p/e multiples. And we have been wary of sales growth resulting from vendor financing. Vendor financing is a topic we mentioned two years ago in relation to Lucent. Vendor financing means that the company selling the product also loans the money to pay for the product sold to the company buying the product. Since most of those companies being financed were new companies with no track records the sales recorded were not really sales until the companies paid off the debt to the vendor financier. Those new companies are now defaulting on their debts as they file bankruptcy, and that's why Cisco and Nortel et al are taking multiple billion dollar write downs.

Rising home sales and a 40 billion dollar Treasury tax rebate suggest continued economic stimulus. But our gut feeling is that the consumer-spending boom is slowing and that by autumn when third quarter earnings season arrives the numbers will not be good. Land prices are rising at an astounding rate. We attribute this to the punk stock market and the leverage possible on real estate purchases where one can buy with only a ten percent down payment and thirty years to pay. The land boom coupled with the rise in oil prices is similar to the late 1970s. We don't have the commodity boom in gold & silver prices we had then courtesy of the Hunt brothers. We think the comatose bullion markets are more a function of illiquidity than lack of inflation pressure. The new commodity play is electricity and that commodity is showing enough inflation to satisfy any interest rate hawk. In liquid markets such as oil, price inflation has been and is present. Treasury bonds don't reflect this inflation because the supply of Treasury bonds has been constrained by redemption from the rapidly evaporating surplus. In reality, there is serious inflation in food, energy, and housing prices, the three areas that matter to most consumers and the three areas that most economic experts ignore when discussing inflation.

The recent billion dollar write down by American Express in its junk bond portfolio is also a good indication of the current fragility of the interest rate market outside of Treasuries and high grade corporate bonds. The Fed rate cuts over the last eight months have the same purpose as they did in the late 1980s. That purpose is to help the banks absorb the cost of writing off bad loans made in the past ten years. The financial press keeps talking about the drop in rates stimulating consumer spending as credit card rates come down. Under what rock do those writers live? Credit card rates never come down. Only the banks' cost of money drops, which increase the banks' profit margin. The increase in the interest rate spread helps the banks absorb bad loan special item write-offs. And the lower rates lower savers income, forcing them to seek other more risky investment to maintain their standard of living. Once again, as in the early 1980s and early 1990s, the saving public pays for the profligacy of Wall Street and the multinational banking cabal. Do we detect a pattern here?

The present tax rebate debate and the corresponding passing of one of the most convoluted tax cut packages in history may also have marked the end of the twenty year rally in bond prices and corresponding drop in yields. The last two FED discount rate cuts have had no effect on the yields of ten-year and thirty-year Treasury bonds. In fact, yields have risen over the past few months. In our view this price action portends the return of budget deficits and higher long-term interest rates. It is amusing to hear Congressional leaders who favor larger tax cuts say that deficit spending is fine since such deficit spending will stimulate the economy. Think we've heard that line before but not from the lips of conservative economists.

The continuing discussion of changing Social Security is also a negative. The markets abhor uncertainty. Allowing individuals to control what are essentially premium payments is ludicrous. Those folks favoring private control of a portion of funds to invest in the stock market ignore the reality that the majority of folks don't have the expertise to invest prudently. Heck, the vast majority of stock market experts have also been totally imprudent in their investment advice for the last few years. Why not have the Social Security adminstration invest 5% to 20% of Social Security receipts in a broad index like the Russell 5000, if it's determined that some equity investment by the Social Security Trust Funds would yield a better return. Social Security is a social insurance program and if the powers that be determine that stock investment is warranted then all should share the risks and the hoped for rewards. Investment by the Social Security Administration would be cheap and efficient. The reality of allowing individuals to invest Social Security funds in the stock market is that if there isn't any profit for Wall Street and the Multinational banks in whatever action is taken the whole concept will fade away. Which is what we hope it does. The simplest solution to the run out of money in 2050 scenario is to quit adjusting for inflation. BY DROPPING THE INFLATION ADJUSTER IN HALF AND CAPPING THE MAXIMUM PAYOUT AT $2500 PER MONTH, SOCIAL SECURITY BECOMES SOLVENT. But that is too simple. Much better to create an unworkable plan to save Social Security similar to the present ten year tax cut fiasco.

There are two famous Wall Street sayings. The first is: "The markets abhor uncertainty." The second is: "Bull markets climb a wall of worry." Uncertainty refers to a lack of confidence in an expected outcome because of lack of trust in those who are implementing policy. Worry refers to fear of losing hard-earned gains. The reason the "wall of worry" scenario works is that worry of loss of gains encourages weaker stockholders to sell and so stocks continually move into stronger hands at higher prices. On the contrary, uncertainty encourages folks who have no confidence in economic or political forecasts to move to the sidelines by selling stock. In this case stock usually passes to weaker hands i.e., those looking for trading profits, creating the potential for further price erosion if the trading scenario forces selling.

Model Portfolio Transactions

We tried a few trades over the past three months. Most accounts gained five to ten percent but then we gave most of those gains back. It's getting pretty late for a summer rally, and in our memory autumn rallies don't usually start till after a significant correction. So we may keep trying one or two trades like the Schering Plough trades of the past two months but our main goal is to keep our powder dry. We hope to be able to sell most of our Gymboree position over the next few months as we would like to have those funds for higher quality depressed stocks at year-end. Since inception in 1983, the Model Portfolio has grown from $50,000 to $425,000. Thank you bull market.

Winter 2001
Spring 2001
The factual statements herein have been taken from sources we believe to be reliable but such statements are made without any representation as to accuracy or completeness or otherwise. From time to time the Lemley Letter, or one or more of its officers or employees, may buy and sell as agent the securities referred to herein or options relating thereto, and may have a long or short position in such securities or options. This report should not be construed as a solicitation or offer of the purchase or sale of securities. Prices shown are approximate. Past performance is no indication of future performance.