As if markets haven't had enough uncertainty to contend with, the Enron, Anderson, Global Crossing debacle caused investor scepticism to soar to new and dizzying heights in the first quarter. Many aspects of corporate accounting practices have been rightfully called into question and investors have embarked on a Salem-like hunt for other examples. What is perhaps most shocking and disappointing to us is that in many cases, the practices used were not illegal but simply considered “aggressive accounting”.

Amidst an ocean of bad news served up daily in the fall-out, there are several positive longer term implications. First, corporate disclosure will no doubt improve in the wake of Enron, witness the current pressure on G.E. to provide more segmented reporting. Second, the quality of earnings will also increase with more conservative accounting and companies with the highest quality earnings will be awarded premium multiples in the market. And finally, corporate officers and board members will likely have to exercise a greater level of due-diligence than in the past. Longer term, these are all positives for equity investors. From a broader perspective, Enron et al may represent part of the cathartic cleansing that equity markets require to correct for excesses such as that which happened in technology shares in the last cycle.

Since September 11th markets have been completely event driven. And now, all eyes are focused on the Middle East. The threat of war in the region is real.

With so much attention focused on the ‘events’, it seemed that the actual state of the economy was often overlooked by investors during the quarter. Our view suggests that while the U.S. economy is exhibiting very positive signs of consumer strength and confidence, we are not yet on solid footing. Simply-put, to date the consumer has been solely responsible for all signs of life in the economy while housing has been the key stabilizing factor driven in large measure by the massive decline in lending rates and to a lesser degree by the mild winter weather. Housing remained strong throughout the slowdown in the economy thereby bolstering consumer spending.

However, we believe it would be unrealistic to expect that the economy can make further progress without other sectors beginning to contribute. It would be a stretch to expect any further pent-up consumer demand to provide additional lift. What investors need to see is a recovery in corporate earnings and an upturn in corporate spending on plant and inventories. Yet there is a total lack of pricing power in virtually every sector and intense global competitive pressures are pervasive. As an aside, we suspect that the admittance of China to the WTO last December will simply serve to intensify competitive pressures, most noticeably in the manufacturing sector. Our concern is clear. While the overall economy may be in recovery, corporate earnings may not rise quickly enough in the near-term to support a continued recovery in share prices given current market expectations. From a portfolio perspective, it would seem almost more important to try and avoid companies that could report disappointing earnings rather than seeking companies that could surprise on the upside.

Perhaps the best that can be said is that the corporate sector adjusted very rapidly to the downturn and presumably is in a better position today than 18 months ago in terms of operating costs and inventories. As we had commented in our last letter, the U.S. remains home to the world’s most resilient economy. We should not lose sight of this fact despite near-term pressures. Earnings will re-bound, as confidence spreads. It is not a matter of if, but rather when earnings growth can support current multiple levels in the market.

We remain convinced that carefully selected equity investments can outperform during the cycle ahead. Our view is that equity markets will only pay-up for immediate earnings in companies with solid, transparent accounting. We believe that current earnings expectations remain excessively high in many sectors, especially technology and that a consistent recovery in earnings remains elusive for the near term. Sector rotation within markets will likely remain rapid. With all these forces at work, it is a challenge to be a long term investor in today’s markets. As we stated previously, while our growth expectations are diminished from 18 months ago, we believe that 12-15% earnings growth is a realistic hurdle in the current environment.

Current sectors of focus include:

1) Energy
- Demand will grow as economies recover
- Tension in the Middle East will only serve to heighten supply fears
- Canadian oil sands constitute an under-valued global asset
- Junior oil and gas companies are poised to outperform

2) Specialty Retailing
- Stand alone retailers are gaining market share relative to department stores
- Discount and housing-related retailers will exhibit the highest near-term earnings gains

3) Industrial
- As the economy recovers, the automotive and housing related sectors will exhibit strong top and bottom line gains

4) Specialty Financial
- Select financial services companies in insurance and private wealth management offer strong growth opportunities

The economy is on the rebound and growth equities will eventually take the upper hand. The worries remain premature tightening at the Fed, and, the volatile situation in the Middle East.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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