F YOU'RE THE WORRYING TYPE, 2002 has already been a banner year. While financial markets have gone virtually nowhere, investors have fretted over both sides of numerous issues including:

• Poor 4th quarter earnings
• A deepening recession
• Enronitis and earnings purity
• Rapid economic recovery and the potential for rising interest rates
• Accelerating Mid-East conflicts and rising oil prices
• Poor earnings forecasts for the 2nd quarter

A lot of this boils down to the state of the economy and its effect on corporate profits. Most would agree that a return to growth would cure much of what ails the market. But when will this occur?

Economists are about as close to a consensus as they'll ever be. They generally agree that the economy officially entered recession in March 2001. Most also believe the recession ended in the first quarter of 2002. That would be about right since historically most recessions have run from 6-15 months with the average being 9 months.

On the other hand, the vast majority of corporate CEOs and CFOs issuing forecasts are taking a much more somber stance. While 4th quarter 2001 and 1st quarter 2002 results may have met consensus estimates, you have to keep in mind those were reduced estimates. The bar was already quite low.

At this point, few companies are willing to increase estimates for the coming quarters. Most "guidance" is for more of the same: mildly improving but depressed results.

So what's an investor to make of this? Economists are saying all systems should be go for improvement over the rest of the year, but companies themselves don't anticipate marked improvement. Who's right?

Slippery Oil

Bubbling Crude

Source: Baseline Earlier this year, OPEC considered cutting output to prop up the price of oil. As tensions rose in the Middle East, so did crude prices. They moderated when Israel pulled back and the U.S. attempted to broker a cease fire. Regardless, at the end of April, prices at the pump remained well above where they started the year.

Prior to the Israeli incursion into Palestinian controlled territory, tensions were already running high in the Middle East. The U.S. war on terrorism put many Arab allies in awkward positions and the threat of expanding activity into Iraq only compounded the problem. When Israel moved in early April, divisions between East and West became more pronounced.

Iraq -- clearly an anti-U.S. country -- imposed a one-month embargo on shipments of crude to the West and called for other Arab countries to join in. More moderate countries downplayed the call, yet oil prices spiked from below $20 to over $27.

Ironically, it was just a few short months ago that OPEC was considering production cuts to prop up the price. Equally ironic is the fact that despite higher spot crude and prices at the pump, the U.S. supply of oil is actually higher than usual at this particular time of the year.

As we've pointed out before (January 2001 True Facts), with the U.S. moving from manufacturing to a more service oriented economy, oil doesn't play as much as a role as it did during the '70s oil embargo. Nevertheless, consumers still spend a considerable portion of their disposable income at the gas pump, and it's the consumer who plays an important role in spending us out of recession. Higher gasoline prices act as a tax on them, curtailing their spending in other areas of the economy.

Sluggish U.S. and European economies have kept a lid on demand for oil, so most of the recent run-up is attributable to a war premium. Should tensions ease, prices could rapidly move back down into the low-$20 range.

Also related to the lack of demand, other commodities are even showing the slightest hint of inflation. As a result, any pick up in manufacturing activity would immediately result in widening margins and profits. Oil aside, the economists appear to be right about improving economic conditions.

Heightened Interest

But interest rates are another matter. The Greenspan Fed has shown it wants to be out ahead of the curve in heading off inflation. Back in 2000, they were willing to push up rates before actually seeing the whites of inflation's eyes.

Anticipation

Source: Baseline Investors bid up bond yields after the Fed moved to neutral in March. The bet is on higher interest rates sooner rather than later, especially if the economy strengthens earlier than originally anticipated. Even so, inflation as measured by the CPI doesn't seem to warrant the increase.

That's why bond investors got spooked when Fed governors started making upbeat comments about the economy and the signs of recovery. In March, when the FOMC moved to a neutral stance, bond yields spiked by 1/2%. Investors reasoned that if the recovery is coming sooner than expected, rate increases would, too. Immediately following the March FOMC meeting, the futures market priced in a 60% likelihood of an increase at the next meeting in May.

Since then, developments in the Middle East have sent yields back down. During times of uncertainty, investors often seek out the safety of U.S. government bonds. This increased demand sends prices up and yields down.

Also moderating yields is the fact that a prolonged period of higher energy prices could act as a drag on the domestic economy, delaying the need for credit tightening.

It's our sense that the Fed will move later rather than sooner. With so much political and economic uncertainty, they'll be reluctant to move too soon and risk choking off the recovery before it really takes hold.

Unless there's a major flare-up in the Middle East, bond prices can remain range bound at current levels for quite some time. Longer-term, the trend is obviously up given rates are still near historic lows. That's not necessarily bad either since rates are still well below bull market averages.

So score another one right for the economists. Relatively low and stable interest rates coupled with few signs of inflation are usually bullish not only for the economy, but for financial markets as well.

Recovery from What?

Assuming the consensus is correct, the economy was already sliding into recession when the terrorist attacks sent it into a virtual standstill for the six weeks following September 11th. Everyone wrote off 4th quarter profits.

Surprisingly, activity picked back up in the last few weeks of the year. Consumers went to restaurants, bought Christmas presents, and got new cars with 0% financing. Corporate profits were actually much better than lowered expectations, prompting the belief that the economy had turned the corner in late 2001 or early 2002.

The stock market staged a fairly powerful rally in the closing weeks of 2001. This, too, was interpreted as the market acting in anticipation of the return to economic growth.

But the rally stalled in the first few weeks of 2002. Since then, trading has been choppy with both sharp up and down days. Looking back from September 2001, stocks have recovered from the sharp sell-off that sent them to their lows on September 21. Yet beyond that, stocks have been trading in a range roughly bounded by the September 1 and September 10 levels.

In other words, we're back to where we were before the terrorist shock. The economic and financial bounce we've experienced was a recovery from the downward jolt of September 11, not the recovery that took hold six months before.

Back to Where We Were

Data Source: Baseline Stocks were drifting down as the economy slipped into recession in 2001. The terrorist attacks resulted in an abrupt sell-off in the days that followed, all of it was retraced by the first few days of 2002. Ever since, the S&P 500 has been trading in a range marked by the September 1 and September 10, 2001 levels.

Profit growth must resume before a real recovery can take hold. Not only must consumers continue to spend, businesses must resume capital investment. That won't happen unless corporations see an increase in demand for their products.

Three Possibilities

From where we sit, there are three possible answers, none of which are mutually exclusive:

• Maybe they are. After being pummeled when earnings miss by as little as a penny, why would companies risk being too optimistic? Given today's low expectations, perhaps the best strategy is to come out with a low-ball forecast and hope to surprise on the upside if you mange to beat it.

  In the past, upside surprises have tended to generate a momentum of their own. Investors know that and often jump into stocks of companies announcing an upside surprise. CEOs know a little restraint now can result in a jumping stock price later.

• Maybe they're cleaning up their balance sheets. In the wake of the Enron ordeal, earnings quality is as important -- if not more so -- than the actual profit level. As IBM and GE recently learned, previously accepted "smoothing" techniques won't be accepted anymore.

  This isn't to say that the vast majority of corporations are engaged in accounting shenanigans. They aren't, but many do employ -- quite legally -- complex accounting techniques. Investors are now so gun-shy, they cast a jaundiced eye to anything other than the plain vanilla.

  In order to satisfy these higher standards, companies may need to reclassify, sell, or even write off assets. Look for this to happen in the next several quarters. At the same time, look for it to hold down reported earnings.

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  Bigger Isn't Better

  Data Source: Baseline Since bottoming on September 21, 2001, small (as measured by the S&P 600) and mid-cap (S&P 400) stocks have soundly outpaced large caps (S&P 500).

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• Maybe we're looking in the wrong place. The press focuses on companies that are large and often tech-oriented. These are the very ones that were overbought, overvalued, and overstocked in the bubble of the '90s. They often carry high debt loads and a great deal of their cash flow goes to service that.

  On the other hand, smaller companies didn't participate in the run-up of the '90s. They typically don't suffer from the excesses of their larger brethren. In economic recoveries, smaller companies usually turn around sooner.

  In fact, they already are. As the nearby graph shows, ever since stocks hit their lows on September 21, 2001, mid-cap and small-cap stocks have handily outpaced large-caps.

Until signs of the economic recovery are unmistakable, stocks of all capitalizations will remain volatile with daily sector rotations. Small and mid-cap stocks will continue to outperform large caps up until the end of the year, if not into 2003.

At times like this, diversification across sectors is the safest way to take advantage of buying opportunities. Even economists and CEOs could probably agree on that.

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