Investors began the year worried about the possibility of a double-dip U.S. recession (a double dip occurs when the economy begins recovery from a recession and then slips back into recession). As January began, U.S. equities extended the fourth quarter rally, and there was hope after three straight years of declines that the bear market would end soon.

By the end of the first quarter, questions about the health of the global economy remained unresolved. Evidence released during the quarter pointed to a continued weak, if not recessionary, U.S. economy. The U.S. Labor Department reported an unexpected drop of 308,000 jobs in February, the third drop in four months. Consumer confidence fell to 10-year lows, and retails sales fell 1.6%. Housing starts fell 11%, and new home sales dropped 8% in February. Indications of manufacturing activity, including factory orders, durable goods orders, and the ISM survey, also slumped. Despite these reports, many took the optimistic stance of linking the weakness to geopolitical uncertainty, higher oil prices, and bad weather. The Fed noted at the March FOMC meeting, "While incoming economic data since the January meeting have been mixed, recent labor market indicators have proven disappointing. However, the hesitancy of the economic expansion appears to owe importantly to oil price premiums and other aspects of geopolitical uncertainties." While there was reason behind such views, a driver of economic growth in the quarters ahead remained unclear even with resolution of the Iraq war and settled oil prices.

Economic growth around the rest of the world was similarly dispiriting. Higher oil prices and sluggish organic growth continued to haunt the euro-zone. Domestic demand remained nonexistent in Germany's economy, as evidenced by recent consumer spending data. Indeed, more and more economists have begun to realize that Germany's problems are structural, having been hidden by the strong global demand during the late nineties. Meanwhile, consumer confidence plunged in France. Unemployment for the euro nations was at its highest level in over three years. In Asia, particularly Japan, fears about a deteriorating scenario in North Korea, the rise in oil prices, and lack of progress in structural improvements made business conditions decline from previous lows.

As 2003 unfolded, the volatile geopolitical backdrop overwhelmed any optimism from the yearend stock rally and President Bush's proposed tax cut. In particular, the decision of several U.N. members not to support the U.S. was disruptive. The disappointing economic news didn't help matters. Consequently, the S&P 500 and Dow Jones Industrials indexes fell 14% between mid-January and March 11th.

 The good news is that the fear and uncertainty about war in Iraq have been largely resolved, and a dreaded long and costly war has been avoided. These positive developments have prompted a gain of almost 12% in the Dow since March 11th. Nonetheless, some have wondered why the hoped for "bounce" in stock prices has dissipated (at least as of this writing) even as news from Iraq has become ever more positive. The answer according to some on Wall Street has been that investors have returned to their pre-war focus on the economy and company profits. Clearly, there are many different issues facing companies and their stocks in the quarters ahead. Further, the threat of global terrorism and attendant security costs are a continuing negative influence, and "winning the peace" in Iraq may prove far more challenging than winning the war. Probably the best observation at this juncture is that we just can't ever adequately explain short-term stock market movement. Overall, it seems to us that a breakeven return for U.S. stocks year-to-date through mid-April (again, as of this writing) seems about right given the "big picture" as it exists today.

Caves & Associates continues to believe that these negative forces and challenges will be overcome by the resiliency of the U.S. economy, assisted by current monetary and fiscal stimulus and additional expected "pump priming" by the Bush administration as the President turns his attention to the economy and re-election next year. Nonetheless, allocations for defensive asset classes such as bonds need to be maintained at about policy targets to offset the tenuous elements of the current global situation. We are sympathetic to remarks by Bill Gross, managing director at PIMCO funds, who has an excellent track record as a macro-economic and market guru. Looking at risk/reward trade-offs he said recently, "At this point, I'd still rather be in an overpriced corporate bond than an overpriced stock."