The Contrarian's Dilemma...Contrarian thinking and investment decision making is an art. An acquired feel for the rhythms and circumstances of any current market environment set against the context of personal prior period experience. We remain firm believers that questioning and ultimately positioning against the extremes of crowd behavior remains a valid investment discipline. As this bear market in equities wears on in both duration and percentage price destruction, we need to continually force ourselves to address and question the proposition of becoming more constructive on macro common stock possibilities. As always, maintaining flexibility in thinking is the key to successful longer term investment results.

We've come a long way in this bear toward destroying many a cherished belief regarding common equity that took years to instill in the broader investment community during the prior bull market run. Anecdotes surround us that pessimism and negativity have moved ever nearer to centrist thinking than not over the recent past. The media has learned to sell bearish copy just as it sold bullish copy all the way into and past the equity market peak. The NASDAQ has experienced a near 1929 like collapse. The S&P 500 has witnessed a virtual replay of the significant 1973-74 episode, a price destruction event that drove the public from the equity market for years to follow. Folks like Bob Prechter are being allowed airtime on CNBC to seriously espouse views of impending economic depression. During the final bull blow off some years back, Prechter would have only been granted precious minutes on CNBC to be ridiculed as a clown. Visual sociological markers of corporate executives being led away in handcuffs adorn the front page of trusted print news. Increasingly, Wall Street firms and the broader professional investment community are writing more pink slips than they are trade tickets. We see many a stock price now resemble a cheap call option, the difference being lack an official expiration date. Many of these companies may end up being investment homeruns if they can simply survive over this cycle. Needless to say, our contrarian antennae are fully extended.

In the same breath, being investors with what we hope is a pragmatic sense of historical precedent both regarding the financial markets and the psychology of human decision making, we need to remember that Main Street bull and bear market cycles come along maybe once in a generation. Cycles characterized by significant public participation. By extension, that also applies to psychological participation on the part of human beings that direct large institutional pools of assets and the human beings that make up the foreign investment community. As much as we would like to lean against the increasingly icy winds blowing at the corner of Wall and Broad, we must respect the fact that the pocketbooks of Main Street drove the prior mania and it is only very recently that those pocketbooks have begun to close. Leaning against the wind as a contrarian during the latter half of the 1990's was often times a very expensive exercise in beating one's own head against the wall. It was a period to have been respectful of the bullish consensus for a good while and try not to jump the contrarian gun. Trying hard not to commit the all to easy investment sin of attempting to impose one's own will on the collective marketplace.

In like manner, will it also be correct to remain part of what at least appears to be a growing circle of bearish thinking for maybe longer than seems intuitively appropriate? We hate to be part of the crowd, but when Main Street is so heavily involved, maybe blending into an increasingly negative crowd for a period and looking for significant extremes in investor behavior as real contrarian signposts will be the key to success in the quarters and years ahead.

The Shock Was So Great That I Am Quivering Yet. I've Tried To Forgive, But I Cannot Forget...As we mentioned in our September discussion, it has only been recently that equity mutual fund flows in this country have gone negative on more than just a temporary basis. Over the last four months, we are looking at close to $90 billion having been redeemed in the domestic equity fund complex. Throughout this bear cycle to date, the public has bought the market rebounds post what appeared to be spike lows. Until now. At the margin, crowd behavior is changing.

More importantly, the following chart stands as testimony to what has been at least up until now the ingrained belief among the public that long term holding of equities was the proper course of investment action in either bull or bear environment.

As is clear in the above chart, the year 2000 registered net positive equity fund inflows. Likewise 2001, albeit at a greatly reduced rate relative to the blow off that was 2000. YTD 2002, equity mutual fund redemptions total somewhere in the vicinity of ($25) billion. Given that close to $90 billion has been redeemed in the prior four months, net equity fund flows were significantly positive through the first five months of the year. This chart is graphic evidence that the public has been buying all the way down...until now, that is.

Although the public, through the vehicle of the equity mutual fund, is but one component of macro market investment demand, the influence of public decision making via this investment medium has grown increasingly more meaningful as the decades have passed. As we have said many a time, what scares us most in the current cycle are our next door neighbors.

SPQR (Senatus Populusque Romanus)...Many centuries ago, the senate and people of Rome were a force that dominated the then economy of the planet. In today's equity marketplace, US households have the largest vested interest in ultimate outcome. Tangentially, the US equity market does have a direct bearing on the domestic economy itself, and in turn, the global economy, given the significant current dependence of foreign economic advancement on the US consumer import market. As per the 2Q 2002 Fed Flow of Funds report, US equity ownership breaks down as follows:

Close to 60% of total equity market ownership is made up of households and equity mutual funds. And, as you know, the public is also a significant indirect owner of equities via public and private pension funds and insurance related products. For now, common stocks as a percentage of household financial assets rest near the highs of the last half century, excluding the most recent bubble top blow off period.

As you can see, current household ownership of equities relative to total household financial assets is simply miles away from what would rationally be considered levels of disenchantment or disgust. Set against the context of history, the current reading may not even be representative of a level that could be characterized as "concerned".

Question. If Main Street is being increasingly delivered a bearish message by various forms of media as well as the strong message implicit in daily price action, will the public ultimately act accordingly in liquidating more and more of their common stock exposure, regardless of price? Just as they increasingly accumulated greater and greater absolute dollar amounts of common stock throughout the latter 1990's regardless of price, based largely on the powerful conditioning of positive reinforcement. As you know, very serious equity mutual fund redemptions have not even started yet. $90 billion in short term net redemptions basically fits through the eye of a needle in terms of total equity market capitalization.

The contrarian's conundrum of the moment is one of timing. Especially given the extremes of the prior cycle. Again, despite contrarian tendencies otherwise, it just may be appropriate to blend into a potentially increasingly disenchanted crowd and attempt to identify extremes in negative behavior as we move forward. We're just not convinced that we have witnessed extremes in public behavior as of yet, despite what "feels" like price extremes in certain segments of the equity markets. The facts tell us that at least so far, the extremes we have experienced in price are largely the result of a lack of buying as opposed to the capitulative behavior that is significant volume based selling.

As a last comment on characteristics of public equity exposure, here's an update of a chart we showed you last month. As of August month end, cash in equity mutual funds totaled 4.8%. Equity portfolio managers actually sold more equities than were redeemed in August. And it's a good thing as the estimate for September equity fund redemptions is approximately $15 billion or a bit north of that figure.

Planning Ahead?...Although this has only recently popped its head up as a topic in the broader investment community (despite the fact that the data has been in plain view for many years now), many a corporate defined benefit pension plan has become under funded in the past few years. As you may remember, after years of outsized investment returns that were the gift of the prior bull market in equities, formerly over funded plans were the treasure trove of many a corporate executive in terms of bringing over funded plan assets onto the immediate P&L as theoretical profits. The bear market of the last few years has virtually brought this practice to a screeching halt. Nonetheless, what remains today are many an under funded plan and maybe more importantly, a corporate sector that is simply using unrealistic assumptions in the process of establishing forward actuarial estimates.

As of the end of 2Q, equities as a percentage of pension plan assets stood as follows:

Post the recent July lows, many a major institutional pension fund in this country stood up and allocated more assets to common stocks (the recent number in the chart above should actually rise in 3Q). Given the consultant driven nature of asset allocation decision making in these plans and the fact that the equity markets had dropped rather dramatically into July, many an institutional plan had become under weighted in equities as a simple result of price decimation. Over the short term anyway, this has been an incorrect decision.

Recently, plan sponsor/investment industry mag "Pension and Investments" studied the assumed rates of forward investment return for the 100 largest corporate defined benefit plans in this country. As you know, the higher the assumed rate of return, the lower the level of current cash contributions needed to fund the plan for accounting and DOL (Dept. of Labor) purposes, all else being equal. The following table depicts the five companies with the highest assumed rates of investment return on plan assets and the five lowest:

Although the study only provides data through 2001, here are some of the highlights more than well worth noting:

• In 2001, eight companies raised their assumed return levels and sixteen lowered them among the 100 sample group.
• The average expected rate of return among the 100 count sample was 9.3%. The median return assumption was 9.5%.
• 25% of the sample had return assumptions between 10% and 11%.
• 95 of the 100 companies that made up the group experienced negative 2001 plan returns.
• 64% of the plans had a return assumption of 9.5% or greater. 88% of the plans had a return assumption of 9% or greater.

Can large pools of assets such as these plans really earn a 9% annual compound investment return over say the next five years? Over the next ten? Losses in "paper" plan sponsor assets over the last few years have been staggering in absolute dollar terms. Will plan sponsors continue to reallocate more and more assets to common stocks if they continue to fall, just for the sake of maintaining a given asset allocation structure? The fact that many plans are under funded and that assumed investment returns appear a bit of a stretch in the current environment just increases the near term ante for corporations in terms of needing to fund these plans annually from current earnings. Will corporate management's force assumed returns lower or force a lowering of allocation to common stocks in deference to sheer risk management at some point if the equity markets continue to slide (simply in order to attempt to preserve their quarterly bottom lines)? Not only has the public been buying equities all the way down in this so far in process bear market in equities, but their corporate plan sponsor counterparts have been doing exactly the same thing. Although defined benefit plan sponsors will usually act with a much longer investment time horizon in mind, they are only human. If the bear market in equities is prolonged, just how long do you believe corporate management's will implicitly be willing to fund stock losses with increasing pension plan contributions from current earnings?

Our last comment on the plan sponsor crowd is in regard to the growth of the hedge community over the recent past. One avenue for potentially increasing returns at the plan sponsor level is to step out a bit on the risk curve and fund "alternative investments". One of the most popular alternatives for sponsors in the past few years is to increase their "investments" with hedge managers. Although plan sponsors appear blind to this simple truth, they are essentially increasing their allocation to a vehicle that in many cases is shorting the very equities they are long in much larger dollar proportion than their allocation to hedge assets in the first place. Within the context of the total plan portfolio, is this just a bit self defeating? If nothing else, it sure as heck is in a secular bear market.

Hands Across The Water...As a final comment on where we stand in terms of supply and demand for equities this cycle, a brief look at foreign purchasing of US common stock assets is in order. As per recent data (2Q 2002), and unlike US equity mutual fund participants, foreigners continue to purchase US equities, albeit at a much reduced rate relative to prior years. In the following graph, 2002 data is annualized:

During 2000, foreigners purchased $193.5 billion of US equities. In 2001 the number was $121.4 billion. So far this year it's just shy of $35 billion with a marked fall off in the second quarter at $10.9 billion relative to $23.7 billion in the first quarter.

The public have been net buyers all the way down. Institutional plan sponsors have been buying (adjusting asset allocations) all the way down. And the foreign community has so far been a net buyer of US equities all the way down. Although our contrarian instincts compel us to at least question the negativity around us, we hesitate in acting out any of our contrarian fantasies of the moment for one very simple reason - no one has sold. Unless this time is truly different in the annals of human behavior, every equity bear market of the magnitude we are experiencing has not ended prior to capitulative selling on the part of multiple investor constituencies. Given recent action in domestic equity mutual funds, we'd suggest that this is a very critical juncture in the relationship between the public and the equity markets. A juncture that demands weighing current contrarian instincts against supply and demand fact of the moment.