The financial markets haven't been this challenging since 1974.

More than 70 years ago, George Murphy's immigrant parents named him for our nation's first president. So it is especially appropriate that every year on the Thursday before Memorial Day Murph gathers his entourage of Wall Street veterans at Fraunces Tavern in lower Manhattan, where Washington bid his officers farewell. This is a venerable assembly of a dozen portfolio managers, traders, economists and analysts that dates back to the 1974 bear market. Six core players have attended since the beginning, but each year they invite a few other professionals to help keep the dialogue open and provocative. I was lucky to be included this year.

The meeting starts with lunch and goes as long as it takes. Everyone is inside the private dining room by noon, the beverage and sandwich orders are quickly dispatched, and Murph calls the group to order.

"For the benefit of first-time attendees," he began, "this is the 30th annual gathering of this ragtag army of capitalist mercenaries. Our purpose has been the same for three decades, to stake out and defend among very smart friends any money-making idea you feel strongly about. You can recommend a stock, attack modern portfolio theory, fight for market timing or tax efficiency, or tell us how you'll get your supply of apples to sell in the depression. Have at it, boys."

A pretty unceremonious introduction to a meeting with such a fine pedigree, I thought. But Murph's "have at it" was like tossing a torch on a gasoline-soaked woodpile at a pep rally. Kaboom. Three or four separate animated conversations erupted simultaneously around the big round table.

Strong Opinions

Charlie, to my left, is a research director for a Midwest mutual fund. "Mike, I am really concerned about the delayed impact of the '90s technology boom on productivity. Despite Greenspan's enthusiasm, it has a dark side; 4% productivity gains in a 2% GDP world means that companies can keep trimming their workforce. Half a million net jobs have been liquidated in the last quarter. Obviously bad for consumer spending. And with so much excess capacity, companies use cost savings to cut their prices in the hopes of staying competitive."

Wow, what a Gloomy Gus, I thought to myself. "That's interesting, Charlie," I said. "If you think this phenomenon has legs, how do you make money on it?" "Well," he replied without hesitation, "we're launching a new long-short fund." "Aren't you late to the party, Charlie?" asked Greg, a floor trader. "I see the hedgies on the floor every day; they account for about a third of the trading volume.

"Really!" I piped up, wanting to contribute. "My big concern is valuation of stocks, especially after this powerful spring rally we've had. I've been wondering how much impact the growth of short-selling has on volatility and on valuations." My question interested Greg. "I'm not sure what's the best way to analyze their impact, Mike, but I see the panic when the shorts are getting squeezed by good news or a technical breakout. They can move a stock 20% in an hour. And, of course, bad news can do the same in reverse. With the number of hedge funds growing, volatility is here to stay."

Across the table, Marvin, an international economist, had heard me mention valuation. He leaned to one side to maintain eye contact as a waiter reached in front of him and announced, "Turkey club, extra mayo, extra pickle." "A lot of Americans are worried about valuation, but I think we have to keep P/Es in perspective. With the ten-year Treasury at 3.3%, should we really be spooked by a 5% estimate earnings yield on the S&P?"

"I know," I said. "But that estimated earnings recovery keeps getting pushed out. First quarter profits were barely up 1%. That's less than the 1.9% GDP gain. Do economists have an opinion about which earnings figure to use: operating, GAAP or S&P's new 'Core' earnings?"

But someone on the other side of the table had already buttonholed Marvin on another subject. I enjoyed a bite of my New York strip steak, medium well, and listened for another chat I could eavesdrop on.

I glanced over at Murph and was surprised to see that he was not talking with anyone, but listening to one group and then another and scribbling notes in a tiny spiral notebook. Every now and then, he pursed his lips pensively and stared blankly out the small window.

To Murph's right, a strategist and analyst were heavy into the inflation/deflation controversy. "Well, the Fed is clearly concerned," said the analyst, a younger guy still earning his spurs at a large wirehouse. But someone thought enough of him to invite him, so I listened in as he continued. "Their speeches point to low rates as long as necessary, strong money supply growth and no interference with the dollar's fall. Add that to aggressive fiscal policy, and how do we avoid re-inflation? I say we have to reduce our bond positions because of the increased interest rate risk and raise our stock allocations as the only reasonable defense against inflation."

Bill, a balding strategist with a gentle face, listened patiently while the younger man finished. Nodding, and matching the tips of his fingers and thumbs in a kind of pyramid, he offered his opinion in tones so quiet I had to lean forward to hear him. "It's an interesting dilemma, Tim. But it might be a little premature to base your portfolio strategy on an early resumption of inflation. Sure, Fed wants to head off any possibility of deflation because it is a terribly frightening possibility in a culture as dependent on borrowing as ours is. Once deflation gets into the national psyche, it can be nearly impossible to stop without destroying a great many lenders and borrowers alike. On the other hand, they know how to deal with inflation, so the Fed would much rather take that risk. But remember, they might not be able to pull it off."

"What do you mean?" said Tim. "Well, with real interest rates already negative, the economy is still flat-lining. The yield curve is steep, so the next step will be to put some pressure on the long end in the hope of stimulating business borrowing and spending. Fed officials have said they could even let banks use corporate paper as reserves to increase demand for long bonds. A good case can be made that even this will not boost end demand for capital goods; maybe all we'll see is a decline in the carrying cost of debt. This could give corporations more room to trim their selling prices in their struggle for a share of declining demand. Sounds deflationary, doesn't it?"

A little troubled, Tim said, "Yes, but when they run the printing presses faster than the economy can absorb money, doesn't it have to pop up somewhere?" "You are right," said the older man. "It shows up in house prices. They've boomed 38% in five years, versus about 11% for the CPI. But because interest rates are such a dominant variable, the monthly cost of shelter isn't much impacted, so core inflation is still around 1%." These two were still at it when my attention wandered to a pair on the other side of the table tilting about the significance of the rally.

"We've seen the lows," said the chief investment officer of a big investment banker. "It's a clear case of the market anticipating the economic recovery. You know, bull markets climb walls of worry." "Sure feels that way to me," the trader interjected. "And tech names are leading the charge." "Isn't it generally true," I asked, "That new bull markets begin with new leadership? Isn't the resurgence of the old names a sign of weakness?"

"And what's the engine for this economic recovery?" a portfolio manager asked. Just then there were three or four loud clinks of a spoon on a water glass. All heads turned toward Murph and the conversations stopped abruptly. As the big guy put the spoon down and cleared his throat, all the people seemed to settle back in their chairs, and he began.

An Extraordinary Time

"Friends, this is a deviation from the way we usually conduct this gathering, but I would be grateful if you would lend me your ears for a few minutes. I have been taking time off in recent months to think about the comings and goings of the capital markets. And I have arrived at several convictions that I would like to share with you for whatever value you may find in them. Perhaps you could poke at these ideas during the rest of the afternoon. Then I would like to propose an unprecedented second meeting after Labor Day to talk about specific strategies.

"First, let me say that I believe the current environment is the most challenging, the most exciting, the most interesting, the most dangerous and potentially the most profitable of any I have experienced in nearly 50 years on the Street.

"All of us are assaulted daily by waves of fresh data, each promising new insights, yet rarely delivering. We've become accustomed to sorting and analyzing this endless stream of information on the fly, making decisions and taking action, only to return to our homes exhausted each night, no wiser for all our efforts. We've become reactionary and have little time to reflect on the possible meaning of all this information on a big-picture basis. And I think that mass communication and instant data have tended to make professional money managers more clone-like, less willing to take the risk of being different, and perhaps therein lies a great opportunity.

"So I decided to take time out to reflect on the possible meaning of all the churning that I see in the securities markets, in the halls of Congress and statehouses, in the meetings of international bigwigs. One thing I have concluded is that the whole world economy is groping for some kind of equilibrium, some sense of stability. I have listened to your interesting conversations this afternoon, and I can tell that you also sense this extraordinary measure of uncertainty in the financial environment.

"I want to suggest that in such a time, the key to successful investing is to outline for ourselves a finite number of high-confidence beliefs about the economic and market environment, to invest boldly based on these convictions and to continually measure the validity of our convictions against the stream of data from the real world. I would like to share some convictions that I have about the investment environment, and I hope you might weigh in on these issues the rest of the day.

I am convinced that large-cap U.S. stocks on average remain very overvalued relative to current and prospective earnings.

Earnings estimates are too rosy. Profits in the late 1990s represented a larger share of GDP than the historic norm, so a recovery to those levels is a risky assumption. Furthermore, corporate profits going forward will be pressured by global competition, excess capacity, imbedded pension obligations and more rigorous reporting standards.

Domestic demand for goods and services will be sluggish. Companies generally have more incentive to reduce debt than to expand capacity, so it may be a very long time before we see robust capital spending. On the consumer side, aging boomers will be increasing savings at the expense of consumption. Our auto and housing stocks are as new as they have ever been, so when interest rates stop falling, demand in these two large industries seems likely to fall; unless we erect deadly trade barriers, imports will keep gaining share against domestic vendors, with a predictable impact on U.S. jobs and consumer spending.

Business competition will be unusually stiff and only the best operators will survive. Financial flexibility and competitive advantage are critical. Perhaps not a good time to buy the equity index.

This is not a promising environment for riskier credits. A lot of debt will probably have to be written off before the threat of deflation is put to rest.

The spread of democratic capitalism is the most critical variable in emerging market prospects; optimism seems warranted, but it's early.

An increasing role for government will be a drag on U.S. economic energy, regardless of whether it is funded by taxation or borrowing.

In a sluggish economy, longer-term interest rates have room to decline, and P/E ratios have a lot of room to decline. It will not be an environment that can sustain long periods of investor enthusiasm, so rallies in stock prices will be suspect until a sense of stability prevails.

Broad market participation and the surge of hedging activity assure market volatility; we may as well see this as an opportunity.

Now, I hope you will carry on today as long as you like, but I promised Elizabeth that I would take the early train to Ridgewood so we could drive to Spring Lake tonight and beat the holiday traffic. Before I go, may I suggest that we schedule another meeting after Labor Day with the specific agenda of each presenting our best big-picture convictions and how we will implement them in our portfolios. I'll really look forward to that."

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.