Thoughts on the Aftermath of Tuesday's Terrorist Attacks

September 13, 2001

To Our Clients and Friends:

For everyone affected by Tuesday's tragic events, our prayers are with you.

Though we remain numb, and it is difficult to think about investing at a time like this, we've heard from many of you asking for our thoughts on what the possible economic and investment impact might be.

First, there is a desire at times like this to say something definitive, to reach for certainty. And though there are some important things we can say with a high degree of confidence, it is early and there are many things we simply don't know about the short-term economic and financial market ripple effects. One thing we do know is that there will be no shortage of perspectives, as many commentators and industry insiders will be compelled to offer an opinion. Some of the insights will be profound while others will be absurd and extremist. We urge you to resist buying into any precise analysis of the short-term impact on the economy and the markets. Our experience in past traumatic events such as the 1987 market crash, Iraq's invasion of Kuwait, the Gorbachev coup, and the financial stresses in the summer of 1998 (the Asian crisis and Long-term Credit debacle) is that the fallout is fluid and hard to fully assess in the immediate and emotionally charges aftermath.

So what value can our perspective bring now? The following are our thoughts with respect to what we know and what we don't know.

What We Don't Know

Much of what we don't know has to do with the near-term economic and financial market impact. Foreign markets sold off sharply yesterday but most European markets rebounded today. That's encouraging but it is too soon to conclude that the financial market impact is over.

The Economy and the Stock Market

If a stock market sell-off occurs, the rationality of the sell-off will be a function of its magnitude relative to the degree of economic slowdown (over and above what it would have otherwise been). There will clearly be some economic impact though we are not in a position to gauge the magnitude. Though our decisions won't be influenced by any economic forecasts, the following are some thoughts about some of the economic channels that could be impacted:

• Business activity: The shutdown of air travel will obviously have a temporary impact on the travel industry and general business activity. Conferences, events and meetings all over the country have been cancelled. There will also be a cost to hotels, restaurants, etc.
• Consumer Confidence: Consumer confidence has already been closely watched in the midst of the economic slowdown we are experiencing. At least in the near-term it seems likely that this event will have some depressing impact on confidence if for no other reason than consumers will, themselves, be confused about the economic fallout. If the stock market experiences a short-term emotional sell-off this could also depress consumer confidence.
• Business Confidence: If businesses believe that the near-term impact will further depress the economy they may be less willing to make capital investments. Capital investment is already depressed as a result of the technology/telecom collapse.
• Oil Prices: The immediate impact has been a rise in oil prices. Why? There are two reasons. First is a reactionary fear that retaliation in the Middle East could disrupt the delivery of oil. Second, there might be a building of inventories by the oil industry, as was the case after the Iranian revolution in 1979. We believe a sharp sustained spike in oil prices is unlikely but obviously our confidence in making a forecast like this is not high. OPEC has made a statement implying that it will boost production if necessary to maintain stable oil prices. If oil prices do spike this will have a negative impact on the economy. Oil is a commodity that finds its way into many products and the transportation of many goods. Its economic influence is not what it was 25 years ago but it is not insignificant either.
• The Dollar: With a large current account deficit the U.S. relies on large flows of foreign capital. If foreign investors lose confidence in the dollar and it substantially weakens it could result in higher interest rates and inflation.
• Specific industries will be impacted, most obviously the insurance industry. While the extent of claims will likely take a long time to play out, it seems likely that there are going to be some property & casualty, life, and reinsurance companies that are going to get hit. (We think it makes sense to let the stock-pickers we trust take responsibility for sorting this out.)

So it seems very likely that there will be some negative economic fallout. Again, we don't pretend to know how bad it will be, though we suspect the impact is more likely to be marginal than major if the impact on consumer and business confidence doesn't last long. Any analysis also has to recognize that there will likely be a monetary and fiscal policy response. It seems more likely than ever that the Fed will continue supplying liquidity and lowering short-term interest rates. The Fed has plenty of experience dealing with uncertain market environments and has acted decisively in the past. There is likely to be a fiscal policy response as well that will benefit the economy.

How might the U.S. market react? Two factors will drive the response. First will be the emotional response. It is especially hard to know what this might be because the immediate emotional impact will have subsided a bit by the time the markets open again on Monday. We don't even want to guess how markets will behave over the first couple of trading days but it is possible that it will not be what investors expect.

The second factor that will drive the response is the actual economic impact and the resulting hit to earnings. This may be a more gradual influence on the stock market as investors assess the ripple effects over time. Our experience suggests that the analysis will change and evolve during the next few weeks as the policy response becomes clearer. It is also quite possible that investors will not make the correct assessment. After the market crash of 1987 the consensus was that the economy would fall into recession. It didn't. While we awaited the U.S. attack on Iraq in the fall of 1990 the consensus was that Iraq would be a more formidable military opponent and the flow of oil could be further disrupted. The expectation was that the market would plunge when the war started. Instead it surged as it immediately became clear that the war would be short. We have great respect for the stock market's ability to surprise.

So far we've given considerable space to what we don't know. Why? Mostly because some of you have expressed your desire to have us frame some of the possibilities. Having done that we'd like to focus on what we do know and what we can do for our clients.

What We Do Know:

It is true that this sickening tragedy is unprecedented. But, we can still say that with respect to the investment environment, it is not unprecedented that we are in the middle of a potentially volatile environment that makes investors nervous because of short-term uncertainty. From past experience we've gained clarity as to how we can add value for our clients in such an environment and this is what we do know. It is most definitely not from pretending that we can forecast what can't be confidently forecasted.

There are two ways we can offer enormous value to our clients.

1. We can offer a calm, rational and honest assessment to our clients that is focused on long-term thinking. We know that the fear will pass and whatever economic drag that occurs will also pass. We all know this but we need to be reminded of it during emotional and confusing times. We have seen times of fear and uncertainty before, and that is no reason to panic - this is a short-term crisis, but things will work themselves out over time.
2. The second way that we can add value is by how we react to events as they unfold. If markets panic and plunge there is no need for us to forecast how the economy might look over the next six months in order to make a decision. We know that the economy will turn up again and given current stock market levels a steep drop from here will result in excellent long-term value. There is no doubt that the impact will be painful given the stock market weakness already experienced in recent months. We don't want to minimize that reality if such a decline occurs. But, as disciplined investors we will want to take advantage of the opportunity given us so that we can make up for the losses as quickly as possible. Rational investors have a sizable advantage during times of emotionally driven market turmoil. We will let you know promptly if we make any investment moves.

Concluding Thoughts

We don't know what short-term damage will occur to the markets (nor does anyone else). But the long term is always our friend and the greater the damage the greater the investment opportunity. We are financial advisors, not CNBC talking heads. We have no agenda beyond that of your financial well being. You need to understand that nobody has the short-term answers, and that long-term truths are far more reliable and therefore a far more sensible basis for investment decisions. In that regard, our country, economy and financial markets have proven resilient time and again, through wars, terrorism, assassinations and financial crashes.

Again, we will let you know as the situation unfolds if we decide to make any investment moves. And, as always, we will share our quarterly client letter with you shortly after the quarter's end. In the meantime, our role will continue to be to fulfill the most important reason you hire us: to make informed and rational decisions on your behalf to your benefit, no matter how great the emotional sway of difficult time.

Very truly yours,

ZRC Financial Services, LLC
A Registered Investment Advisor

By:
         Richard P. Clarke

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