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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
July 1, 2003

The 2nd quarter encompassed the end of the Iraq war and the start of the more difficult occupation; the passage of a tax cut that is a major positive for equity investors, and the strong continuation of the rally that began March 11. The 2nd quarter saw a gain of approximately 16% in the Edgewood portfolio. The Iraqi war was shorter than expected, but its aftermath may last a much longer time than most had hoped. However long it lasts, it is extremely important that we get it right or else the geo-political outlook for the rest of this decade could be grim.

The tax cut passed by Congress in May did not eliminate the tax on dividends, but lowered it to 15%. It added a somewhat surprising cut in the long-term capital gains tax to 15%, as well as the accelerating of income tax rate reductions that were supposed to take effect in 2004 and 2006. Combined with the Fed’s two additional rate cuts we are now running at an unprecedented level of fiscal and monetary stimulus. The threat of deflation has been mentioned frequently in the last six months and it appears to be enough of a threat that the Federal Reserve has mentioned it several times in its recent comments on the state of the economy. They are concerned enough to signal that short-term interest rates, at least, will remain low for quite a while. While there are certainly pockets of the economy that are seeing declining prices, mostly in manufactured goods, over 60% of the U.S. economy is now service based and have, at least so far, shown few signs of deflation. Price increases in the service area, excluding health care, may be hard to find, but there is little sign of falling service prices.

As we said in our last letter, the news just had to get less bad for the market to turn. That happened in early March as the run-up to the war reached a point where it became evident that the U.S. was indeed going to invade. This lifted much of the cloud of uncertainty that had hung over events for several months and was the information inflection point the market was looking for. The second quarter was the best quarter for market performance since the fourth quarter of 1998. All of the major indices saw double-digit gains and even better gains from the near-term bottom that was reached on March 10 before the rally began. The breadth of the rally was encouraging, and is usually a good technical sign that the rally could sustain itself for a while.

What is needed now is follow through in the economy. As we mentioned above we are seeing unprecedented amounts of stimulus on both the fiscal and monetary fronts. Housing has remained strong, and will stay that way for a while longer as mortgage rates took another leg down in May. This extension of the refinancing boom will also aid consumer spending while allowing for improvement in consumer balance sheets. Lower rates are also helping corporations ease debt service expenses. The lowering of the dividend tax rate will eventually encourage companies to begin paying a dividend or raise their current payouts. This will put more cash back in the hands of investors that will either get reinvested, saved, or spent. Moving idle cash off corporate balance sheets will be a positive development for the market and the overall economy. What is needed now is an increase in capital spending by corporations that will lead to job creation. Unfortunately this is the hardest item to kick start in the U.S. economy. A weaker U.S. dollar will also help, but that will only come when the economies of our trading partners strengthen.


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