EMERGING FROM THE LAIR: Without doubt, equity investors worldwide are still licking their wounds from the events of the past 12 months. 2002 marked the third year of negative global equity returns as share prices declined due to continued earnings disappointments and geo-political uncertainties. The past three years mark the painful but necessary cleansing from the excesses of the late 1990’s.

Unrelenting selling pressure in July and then September took virtually all equity sub-groups down for the year, the exceptions being gold, energy and pipeline shares. The October-November rally in share prices was, for the most part, characterized by low quality tech and telecom shares that experienced a rebound off over-sold levels.

Our opinion at the time was that the rally could not be sustained as there had not been a broad-based improvement in fundamentals. As a result, we only carefully and selectively increased tech weightings in companies that are exhibiting positive earnings and sales trends rather than speculating on would be turnaround candidates. With respect to our U.S. holdings, we may have forgone some positive returns in the fourth quarter. Yet we refused to buy into purely speculative activity in distressed-level tech stocks. Undoubtedly tech stocks will eventually recover based on improving fundamentals but the timing remains uncertain. At the risk of it beginning to sound like a mantra, selectivity is the key. At the moment, we have an under-weighted position only holding companies that have exhibited positive earning surprises in the third quarter.

Returning to a more macro perspective, we would make the following observations. Firstly, U.S. fiscal and monetary policy is extremely positive for the year ahead. The U.S. Fed has never been so aggressive in history in terms of attempting to stimulate the economy as in the last 12 months. Drastically lower interest rates, reduced corporate taxes, accelerated depreciation schedules and the elimination of the double taxation of U.S. dividends augurs well for U.S. equity markets. In fact, the very recent changes to the U.S. tax code can be seen as pro-investment rather than pro-consumption. Perhaps a precursor of more tax reform to come?

Additionally, corporations have worked hard to reduce their operating cost structures. Any resurgence in final demand should flow rapidly to the bottom line. Weakness in the over-priced U.S. dollar should also assist the competitive position of U.S. producers. This adjustment in currencies based on purchasing parity is long overdue.

There are early and tentative signs that after a three year hiatus, U.S. corporations are finally beginning to re-start capital spending plans. Strength of the ISM numbers in December surprised many observers. This couldn’t come a moment too soon as the housing and retail markets, which have sustained the economy thus far, appear to have topped out in terms of momentum.

On a further positive note, many of our portfolio holdings reported better than expected earnings in the third quarter. Although the market may have refused to pay-up in terms of valuations, the fundamentals seem to suggest that results are selectively turning more positive.

What seems to be giving the market pause is the lackluster trajectory in corporate earnings. Weakness in both the European and Japanese economies is contributing to an overall malaise of end-product demand. Manufacturing cost pressures emanating from a newly resurgent China are being felt far and wide. China has now become “the factory of the world” as U.S. imports of Chinese manufactured goods soar. China is rapidly emerging as the global competitor to beat and its low labour costs are resulting in deflationary pressures that are being felt far and wide.

While we could make the case that many key positive fundamentals are in place for a stronger U.S. economy ahead, geopolitical concerns loom large on the horizon. Iraq and North Korea seem to be dominating the news headlines and the resulting uncertainty is unsettling to equity markets to say the least. And the threat of further terrorist attacks, real or perceived, continues to weigh heavily on equity markets in general. As a result, markets may remain ‘event-driven’ for some time to come.

While we desire to be optimistic about the year to come, we remain concerned that the U.S. economy is missing a ‘catalyst’ to set things right. This catalyst may be a war and subsequent victory over Iraq or some other unknown. Time will tell. For the most part, we believe that these uncertainties are priced into the market thereby mitigating downside risk. Yet, until the situation with Iraq is resolved, we doubt that equity markets can move ahead in a meaningful way. So while overall market risk in our judgment is now lower than in the past two years, intra-day volatility remains very high and equity markets will likely remain range-bound until the many geo-political uncertainties are resolved. We believe that we have entered into a true “stock-pickers” market and patience will reward those investors who focus on improving fundamentals over the next twelve months. There will likely be many tests brought about by market volatility, but improving fundamentals in selective stocks should win in the end. While equity prices currently offer few bargains, we believe that equity returns, as an asset class, will outperform bonds. We simply fail to see how bond prices can advance from current levels.

So as stated in our previous letter, we remain cautiously optimistic about the outlook for equities over the coming twelve months. We believe that careful stock selection should generate positive performance relative to the appropriate benchmarks. We continue to emphasize oil and gas, healthcare, P&C insurance, as well as selected technology shares. With respect to our energy holdings in Canada, we do not anticipate that the Kyoto Accord will have any long-term deleterious effects. We are essentially invested in companies heavily levered to natural gas production. Natural gas is the least polluting of the hydrocarbon fuels and therefore any negative effects from Kyoto are likely to be minimal.

While 2003 will prove to be a year of transition in the economy, we believe our current portfolio holdings are poised to outperform.

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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