Client Update - September 22, 2008

In the past several weeks we have had many questions about market conditions and the safety of the money market accounts at the custodians we use. In order to update you, we have enclosed a market update and a report from the custodian for your assets detailing the protection afforded their accounts and money market funds.

To further protect the assets placed under our care, we have substantially all of our clients’ cash in U.S. Treasury money market funds which are the safest available. In contrast, Certificates of Deposit (CDs), that in the past have seemed so safe, are now causing investors much worry as they contemplate the fact that not only may their interest be at risk, their principal might also be in jeopardy if the issuing institution declares bankruptcy.

During the late 1980s and early 1990s almost 1,500 banks across the country went bankrupt. So far this year, only a few dozen banks have followed suit. We expect many more to follow, especially the small to mid-size banks. However, the banking industry will continue to play a vital part in the economic well-being of our country. Many banks are in very good condition, and the banking sector will offer some great investment opportunities going forward. This was confirmed by this morning’s news that Goldman Sachs and Morgan Stanley have applied to the government to become bank holding companies.

In summary, the custodians we use for your accounts are among the very safest in the world (safer than banks, savings & loans, and credit unions). Additionally, the money market funds we use are safer than other financial institutions, their CDs, or savings accounts. By design, we chose to place your funds only with custodians of the highest caliber in preparation for the remote possibility of the events we’ve all seen in recent weeks.

Client Update - September 21, 2008

While the past year has been full of major-headline financial news, we have experienced a lifetime of it recently and the past week alone has been nothing short of historic:

Sunday – Lehman Brothers, a 158 year old investment bank, declared bankruptcy after being unable to find any other firm around the world to merge with and the U.S. Government declined to help. Seeing the writing on the wall, 94-year-old Merrill Lynch agreed to be purchased by Bank of America for $50 billion (one-half of the company’s market value six months earlier).

Monday – Over the weekend AIG, the largest U.S. based insurance company, had gone to the U.S. Government and requested $20 billion to protect its credit rating, but was denied on Monday. The stock market was down 5%.

Tuesday – AIG was downgraded by credit rating agencies because of its weakening financial condition and plummeting stock price. The fear permeating the stock market now began to spread into the safer areas of the bond market. Usually a safe haven, most areas of the bond market began to drop as investors panic-sold bonds to (1) cover margin calls on their falling stock portfolios, and (2) move their funds into money market accounts. Late in the evening, AIG announced that the Government had provided the $85 billion necessary to boost its credit rating back up to where it had been on Monday prior to the downgrading. Yes, that’s right, what cost $85 billion on Tuesday would have cost $20 billion on Monday! The stock market was up 2%.

Wednesday – The fear permeating the stock and bond markets now began to spread into the very safest and most critical area of our financial system. Several well respected money market accounts announced that they were in jeopardy of principal losses and not being able to guarantee full return of the investors’ money. This caused further panic and selling in both the stock and bond markets. Financial system and economic problems appeared to be worsening and spreading. The stock market was down 5%.

Thursday – Realizing that a Depression-era run on the bank and a complete financial meltdown was at hand, the U.S. Government, after the stock market closed, announced that it would protect $3 trillion in money market accounts using the Exchange Stabilization Fund created in 1934. A mid-day rumor that this might occur and another that a bank bailout package was being discussed caused the stock market to rally late in the day from being down 2% to closing up 4% for the day.

Friday – The Government announced that a broad plan of policies and $700 billion in bailout programs are in the works to shore up our failing financial system. This news and the suspension of short-selling on 799 financial stocks pushed the market up 5% at Friday morning’s open before closing up only 4% for the day.

We have been exceedingly busy over the past weeks and months monitoring the financial markets and your portfolio. We will remain diligent in staying on top of the fast changing events. Thursday, when even money market accounts were in jeopardy, we came very close to moving all accounts substantially to the sidelines. However, due to various government bailout programs, we do not believe that it is best to be all out at this point in time. Nonetheless, we believe a more conservative stance is warranted. When the market recovery occurs there will be plenty of opportunities.

Client Update – July 15, 2008

The first half of 2008 dramatically reinforced the idea that over the short term the stock market is predictably unpredictable. A sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with the market dropping 8.4% for the month and almost 3% in the second quarter. The phrase "June gloom" is used by residents of the Southern California coast to describe the cold and fog that persists this time of year, and it could also be used to describe investors’ moods as the quarter came to an end. The S&P is now down 12% for the first half of this year, and is about 18% below its October 2007 high. The market offered few places to hide. Mid- and smaller-cap stocks fared better than large in the second quarter, but still got slammed in June and now have high single-digit losses for the first half of 2008. Vanguard’s Total International Stock Index also had a rough month, losing 9% in June and 2.2% in the second quarter. Foreign stocks are now down 10.9% through the first half. REITs were hit hard, dropping 11% for the month. Domestic high-quality bonds were flat in June and down just over 1% for the second quarter and up 1.1% for the year.

As always happens in an environment of fear, we are asking a lot of questions. What is going on, and how bad could it get? What else should we be doing in your portfolios? This environment is in many ways unique and presents its own set of challenges, which we’ll address more specifically in a moment. But more generally, we want to start by saying that we’ve been through a number of crises over more than two decades of managing portfolios, and while each of these periods presented its own particular challenges, one thing that is common to them all is that a sense of accelerating bad news, escalating risk, fear, and panic were almost always present.

Looking back to March, the Federal Reserve’s unprecedented actions to shore up credit markets and create liquidity led many to hope that we were past the worst of the financial crisis and that the stock market had hit bottom. Today it seems that while the Fed’s actions may have significantly reduced the risk and fear of a full-scale financial meltdown, the losses from bad loans are not only continuing, but are continuing to be worse than expected.

The positive impact of soaring home prices and easy credit is now gone, and with it has gone a major source of consumer spending. Add in the impacts of high levels of household debt, higher gas and food prices, a weakening labor market, and, by one measure, consumer confidence at a 28-year low, and it seems increasingly likely that consumer spending will continue to deteriorate. The damaging combination of a slowing economy and higher inflation has also led to questions about the ability of the Fed to support economic growth and employment without stoking fears that it has gone soft on inflation. At their latest meeting in June, the Fed held rates steady and expectations of higher rates later this year has also hurt stock prices. What it all means is that risks to the economy remain high, and the financial markets are now more fully discounting this risk, which is an unemotional way of describing the battering taken by stocks in recent weeks.

As always, there are positives. Outside the financial sector, corporate balance sheets remain generally healthy and earnings have been okay. One source of strength has been exports, which have managed to offset much of the impact of the housing decline on GDP. But this could diminish if our slowing economy means we also export economic weakness to the rest of the globe.

"History is merely a list of surprises. It can only prepare us to be surprised yet again." —Kurt Vonnegut

One possibility is that things will get worse before they get better. Even without a bad recession, fear and pessimism can take hold of investor psychology and send the market down further than what would be justified by long-term economic fundamentals. Though it is easy to put too much weight on negative scenarios when bad news dominates the daily headlines, our economy and financial markets generally find a way to work through all the problems and heal themselves. History is full of awful events if you look back over the years, but the economy is bigger and stronger and the markets are higher.

In this type of environment, a sense of perspective and a reliance on our investment discipline helps us avoid becoming panicked by short-term concerns and paralyzed by longer-term uncertainty. Like it or not, we are always faced with making decisions in an uncertain world and this will not change. However, our experience in past market cycles and our analysis of the current market environment leads us to two important conclusions.

First, as we have written in previous commentaries, we know that we can’t avoid all losses, but we do understand that it is our job to protect your portfolio from the full impact of a bear market. As such, we have adjusted most portfolios several times and significantly reduced stock market exposure. We know that it is prudent to be more defensive when little else is working. In due time, we’ll have the opportunities we need to produce the returns you need.

Second, big market downturns invariably present opportunities, and without them, we would not have had the chance to identify some of the tactical allocations that have added value to your portfolios over the last 18 years. Bubbles lead investors to make errors in judgment and misprice assets on the way up. On the way down, assets often fall to bargain prices when investors are in the grip of fear. Our investment discipline (and our focus on what is knowable) can help us identify those asset classes where investor panic has led to excessive undervaluation. Once again, there are several that may be headed in this direction that we are monitoring carefully.

For the 10 years through the end of June, the S&P 500 has compounded at just under 3% annually. From June 1988 to June 1998 the S&P 500 returned a whopping 18.6% annually. During this time interest rates fell, the growth rate for corporate earnings climbed, investors took their enthusiasm too far, stocks became overvalued, setting up the market decline from 2000 to 2002. So in a sense, the low returns of the past 10 years have forced investors to give back some of the excess earned in the previous decade. When both periods are combined, stocks have returned a little more than 10% annually in the 20 years through June 2008. That’s in line with their very long-term average.

Market conditions may continue to be challenging. However, we believe we can add value from both our tactical asset allocation and security selection decisions. In terms of our current portfolios, we continue to hold lots of extra cash as a margin of safety and to allow us to quickly deploy it back into the market to take advantage of the inevitable market upturn or any intermediate trading opportunities. Once the market begins its "real" upward movement we think an overweighting of large-cap growth stocks, foreign markets and high-yield bonds will add great value much like they did in 2003-2004.

We remain confident that our investments will beat their benchmarks over the long term. Many of the managers we use and respect tell us they are buying shares of high-quality companies at bargain-basement prices. Consequently, even though the overall market does not look compelling, the current economic and market turmoil is creating significant return opportunities at the bottom-up individual stock level. Indeed, it is often when the overall trend is negative that disciplined investors can build a portfolio for long-term outperformance by carefully taking advantage of the opportunities created by these dislocations. It requires patience and the ability to weight long-term analysis above short-term fear, but it is what distinguishes successful investors. At market tops and bottoms, what feels right isn’t. The proverbial mattress, or a CD may feel like the right thing today, but the odds are great that one year from now it will be obvious why they weren’t.

Irrational Exuberance

Just like the masses that arrive in Vegas daily hoping to win quick and leave before the odds catch up with them, today’s market speculators are playing a losing game. Speculators’ appetite for risk seems insatiable and in contrast to current economic and political conditions. The stock markets have hit new highs and money is flowing into increasingly risky investments. The billion dollar question is whether this speculation will be justified or will end badly.

It is the nature of the market (investors & speculators) to extrapolate both the good times and the bad times into the future. Twice in just the past six years the general public has been dead wrong and paid a dear price. They expected markets to continue to rise in early 2000 and to continue falling in late 2002. The current environment is closer to 1996-1997 where the market was slightly over priced but continued to rise for several more years. From here, if the stock market rises too fast relative to corporate earnings growth (as it did from 1997 to 2000), then it will again end badly. However, if it rises more in line with future earnings growth, then all will be well.

At this point, we do not believe this will end like the market crash of 2000-2002 when the S&P 500 was down almost 50%. Currently, we still see some upside in the U.S. stock market, however, many are clearly betting on the past winners and fail to see the changes ahead. This is as dangerous as driving looking only in your rearview mirror. Housing, energy, value stocks, and junk bonds are yesterday’s winners.

Going forward the U.S. economy faces a prolonged period of slower growth. Such an environment requires a different type of portfolio than has worked over the past 4 years. We contemplate several adjustments over the next few quarters to minimize risks and continue to find opportunities for good returns.

The environment where good economic conditions excessively rewarded risk taking is over.

Client Update – April 2006

Rising interest rates, fear that the housing market may be starting to roll over, a growing current-account deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions; but many of these issues are more than noise, and require that we evaluate and try to put them in an investment context.

Given an almost endless list of positives and negatives to consider, our goal is to make a realistic assessment that weighs optimism and pessimism fairly. We give more weight to factors that are material and knowable, and then try to evaluate how they might relate to a clear argument for making a move in your portfolio. Therefore, over the past several years we have made many strategic changes to portfolios due to opportunities and threats created by ever-changing geopolitical and economic events.

There are problems on the horizon. The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline significantly (e.g., a weak dollar would lead to higher interest rates and a recession; lower housing prices could hurt consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement. All these variables—as well as others—contribute to our belief that the market is fairly valued at this time.

Though there are still plenty of risks in the outlook, and the U.S. and global economies remain volatile, we continue to find opportunities to take advantage of the market and its volatility. We seek opportunities where others see problems. For example, as the dollar falls in value, foreign stocks and bonds reap the benefit. Thus we are inclined to stay with a positive view and will continue to find investments that add value and minimize risk.

Client Update – June 2005

As of this writing, we believe the S&P 500 is roughly 10% below fair value. This surely doesn’t qualify the market as vastly undervalued, especially in light of the significant risks that are out there, but it does provide some cushion.

For us, our analysis always comes back to valuations. There is never a shortage of things to worry about (see our “media” article on the back), but understanding the extent to which those risks are already being reflected in market prices is the key to making good investment decisions.

A very simplistic analysis of return expectations goes something like this: assuming that valuations return to “fair,” that we collect about 2% per year in dividends, and that earnings grow at 3% on average (a conservative number, which is about half their long-term average growth rate), we’d be looking at returns of roughly 7% for the S&P. These valuations also tell us that some level of pessimism is already priced into stocks, so the market is discounting a less-than-rosy outcome. And even if returns end up being only modest, we’d expect our investments to be able to add a bit of extra return above what the market provides.

What’s an investor to do in such an environment? As our natural bias is to err on the side of conservatism rather than exuberance, we are, for the time being, content to hold slightly below-average positions in high-quality bonds and neutral weightings in stocks. This is not exactly an exciting strategy but we are not inclined to take on more portfolio risk until the Fed’s monetary tightening cycle (raising interest rates) is closer to a peak.

Our obligation to you, as always, is to understand the risks associated with your portfolio, and select the investments that best reflect your tolerance for risk and the realities of your financial situation. Further, due to the ever-changing nature of world economic conditions and political events, we continue to do this on an ongoing basis.

Client Update – June 2004

Rising interest rates, fear that the housing market may be starting to roll over, a growing current-account deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions; but many of these issues are more than noise, and require that we evaluate and try to put them in an investment context.

Given an almost endless list of positives and negatives to consider, our goal is to make a realistic assessment that weighs optimism and pessimism fairly. We give more weight to factors that are material and knowable, and then try to evaluate how they might relate to a clear argument for making a move in your portfolio. Therefore, over the past several years we have made many strategic changes to portfolios due to opportunities and threats created by ever-changing geopolitical and economic events.

There are problems on the horizon. The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline significantly (e.g., a weak dollar would lead to higher interest rates and a recession; lower housing prices could hurt consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement. All these variables—as well as others—contribute to our belief that the market is fairly valued at this time.

Though there are still plenty of risks in the outlook, and the U.S. and global economies remain volatile, we continue to find opportunities to take advantage of the market and its volatility. We seek opportunities where others see problems. For example, as the dollar falls in value, foreign stocks and bonds reap the benefit. Thus we are inclined to stay with a positive view and will continue to find investments that add value and minimize risk.