Quarterly Review & Outlook

The equity markets continued their rebound that started during the 4th quarter with the S&P500 rising 12.66% for the 1st quarter of 2012. The European Central Bank (ECB) and the U.S. Federal reserve continued to provide an enormous amount of money in order to prop up the European banking community and the U.S. economy. Since December, the ECB has provided over $1.3 trillion in cheap three year loans (1%) to the European banks. The European banks, in turn (with a wink and a nod), turned around and bought the weaker European countries sovereign debt. The markets responded very favorably as the immediate crisis was averted. However, providing weak banks with funds to invest in weak sovereign debt is far from a permanent solution. One pundit opined that this is somewhat akin to tying two drowning people together and hoping that will help them both to float.

Our defensive approach has significantly inhibited your portfolios performance over the past quarter. Our performance was so out of whack during the quarter that we reviewed our historical track record to see if we had ever lagged the S&P to this degree during the quarter. We found one period, the 4th quarter of 1998, where we lagged the S&P by a greater margin. We remember that era well. The markets were booming, valuations were at historical highs and, to quote our 1st quarter 1999 letter, “We have continued to tilt your portfolio toward funds that are value oriented. By definition, this has lead us away from growth stock styles. Although there continues to be a “casino mentality” with technology and internet stocks, some cracks in the foundation are beginning to appear. The volatility of internet, technology and growth issues has risen dramatically over the past six months and the market has punished companies who have missed their quarterly earnings. We continue to believe that the large cap growth and technology sector of the market, which represents a large proportion of the S&P 500 and the NASDAQ, is overvalued and subject to significant downside risk.”

It took almost another year for the bubble to burst but our conservative approach rewarded our client’s patience when the “tech wreck” finally hit and the markets declined precipitously from 2000 to 2002. At the bottom of the market in the 3rd quarter of 2002, our composite portfolios lost a cumulative total (from December 1999 to September 2002) of about 8% versus a loss of about 42% for S&P 500.

We are not happy with our underperformance but we are also not happy with the levels of risk we perceive in the markets. As we have discussed in many previous letters, we view risk management as a crucial element of the portfolio management process. Historically, we have reduced client’s equity exposure when we perceive market valuations and risks as higher than normal. We have always been early and as a result, we have “left money on the table” in the short run. However, our long term track record of mitigating severe market declines has been quite good.

The current environment contains a great number of systemic risks that many are well aware of (e.g. Over indebtedness on the part of individuals and governments, high unemployment, poor demographics and very sluggish growth in developed economies). Our dilemma is to try to gauge which risks are greatest and when will they rear their ugly heads? We are reminded of a study that was done by three physicists (Bak, Tang & Weisenfeld, 1987) concerning chaos theory, complexity theory and critical states. These three phenomenons occur frequently in nature as well as in financial markets. They use as their example the phenomenon of continually placing a grain of sand on a table. At some point in time, the next grain of sand will cause an avalanche. Sometimes, it’s just a small one, other times most of the sand pile collapses. Was there any predictability in being able to forecast the timing and magnitude of the avalanches? After millions of test simulations they found that there was no typical outcome and that the piles were completely chaotic in their unpredictability. To quote from a book on this subject by Mark Buchanan, called Ubiquity: Why Catastrophes Happen:

“To find out why [such unpredictability] should show up in their sand pile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, ‘ready to go,’ color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile.”

“Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sand pile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.”

Scientists refer to this phenomenon as a critical state. Critical state can mean the point at which water would convert to ice or steam, or when a critical mass induces a nuclear reaction, etc.

“But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]… In the sand pile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.”

They asked themselves, could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes, or as wholesale changes in an ecosystem – or as a stock market crash? “Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?”

“There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.”

The following paragraph draws a critical conclusion that is relevant to events in nature as well as markets:

“In this simplified setting of the sand pile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.”

The aforementioned “Red Spots” are now commonly referred to as “fingers of instability”. Ironically, there was an article written in 2006 by the late Hunt Taylor (a well known investment manager) that forecast that the complexity and interconnectedness of the markets would eventually lead to a meltdown. He was two years early but who would have known that a meltdown in the relatively small sub-prime market would be the catalyst to a worldwide meltdown in all the major financial markets?

Our belief is that the current fragile state of the developed world’s financial and economic system, the unsustainable level of debt in the developed world and the lack of forceful political leadership, here and abroad, constitute a much larger than usual number of “fingers of instability”. We do not know the event that may trigger a correction in the markets nor the timing of such an event. We do, however, have a high degree of conviction that a negative event is likely to occur within the next two years. We believe that capital preservation is the key for now and that, eventually, valuations and opportunities in the financial markets will become compelling. In the short to medium term, things are likely to remain very challenging. We’ve seen this movie before. Our challenge is to preserve and modestly grow our client’s capital in the short term so it will be available to take advantage of opportunities that will undoubtedly emerge later on. Thus, we expect we will continue to maintain our defensive stance until circumstances dictate otherwise. We greatly appreciate your support and confidence and we shall continue to endeavor to manage client portfolios in a prudent manner.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters

Quarterly Review & Outlook

The equity markets staged a strong rebound during the 4th quarter with the S&P500 rising 11.74% for the quarter. The strong move during the quarter turned a loss of almost 9% in the S&P500 through September 30th into a slight gain of 2% by the end of the year. In retrospect, our move toward a more defensive stance in August was a bit premature. While our defensive stance helped mitigate losses in client portfolios for the first 2/3rd of the year, it also restrained gains in client portfolios for the last 1/3 of the year.

Investors experienced a rollercoaster ride in 2011, first enjoying four months of optimism that carried the S&P 500 to a gain in excess of 8% by late April. Then the focus shifted toward the Euro Crisis and gridlock in Washington during the summer that climaxed in August with four consecutive 400-point swings in the Dow resulting in a decline of almost 13% by early October. The markets then experienced a snapback rally for the rest of the year which left the broad averages essentially flat for the year. What looked point-to-point as a relatively calm year masked a great deal of increase in volatility and peak-to-trough moves in excess of 18%.

While there are a great number of concerns and issues for the markets to focus on, the overriding concern relates to the health and viability of the Euro and the debt issues of the EC’s weaker members (the PIIGS). The Euro crisis is a problem that has been brewing since the inception of the euro and there is no painless solution. It is not sustainable to maintain a currency where there is no common fiscal and monetary governing authority and where there are huge differences in productivity and labor costs between the various constituent members. Germany now holds most of the cards with respect to future options and who knows how long the thrifty Germans will be willing to fund the profligate Greeks? The possibility of Greece leaving the Eurozone is now being openly discussed, with the focus on attempting to fashion an “orderly” as opposed to “disorderly” exit that could severely stress the European financial system. Given the interconnectivity of the world’s economy and, particularly the world banking system, Europe’s problems have become the world’s problems.

One somewhat bright spot is that it appears the U.S. economy is muddling along with low but positive GDP growth. The other source of growth is in the developing nations. If this growth were to persist it may be enough to offset the likely recession in the Eurozone. However, the World Bank has just warned that the developing economies are at real risk if the Eurozone crisis escalates. “Developing countries should hope for the best and prepare for the worst,” the World Bank said in releasing its latest global forecast, which calls for slower global economic growth even if the Eurozone muddles through. “An escalation of the crisis would spare no one. Developed and developing-country growth rates could fall by as much or more than in 2008-09.”

We believe there is an abject lack of leadership in the developed nations. We are in the midst of a long deleveraging process that requires tough choices where every participant will be required to make shared sacrifices. While politically unpopular, the longer we wait to address the issues, the more painful the process will be. Although we have little confidence in the world’s current crop of political leadership, we do possess a great deal of optimism with respect to the “creative destruction” of the capitalistic system. If the politicians are unwilling to resolve the spending and debt issues, then the markets will ultimately force necessary fiscal reforms. It took 40 years of debt accumulation for us to get to this point, and it will probably take a few more years to get us on a path to recovery.

There are some encouraging signs on the long term horizon. U.S. energy self-sufficiency is a distinct possibility. There are copious amounts of Shale oil and natural gas in the continental U.S. Also, increased offshore drilling, and conservation measures should enable us to be largely energy self-sufficient in the long run. We are at the early stage of an American manufacturing renaissance which will accelerate in the years to come. Our labor force is competitive in the higher value-add products that a growing world economy needs and we’re making things again that people want to buy. The housing drag is likely near a bottom and eventually, the housing industry will be a contributor to the U.S. GDP instead of a drag.

In the short to medium term, things are likely to remain very challenging. The longer term is beginning to look more and more positive. Our challenge is to preserve and modestly grow your capital in the short term so it will be available to capitalize on opportunities that will emerge later on. Thus, we expect that we will continue to maintain our defensive stance until circumstances dictate otherwise. We greatly appreciate your support and confidence and we shall continue to endeavor to manage your portfolio in a prudent manner.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters

Quarterly Review & Outlook

We made a number of portfolio changes in August with the goal of reducing the overall levels of risk in client portfolios. We realized gains on our small cap holdings as the overall level of valuations in the small cap sector were near their historical highs. Additionally, we initiated positions in funds, such as Forester, that concentrate in the very large cap – multinational companies. This is one of the few areas where we find reasonable valuations and decent dividends.

Our defensive posture helped mitigate the impact on your portfolio during the third quarter. All of the major indices suffered double digit losses during the 3rd quarter. Our letter last quarter discussed the concerns we had about the Greek debt crises as well as a slowdown in worldwide economic activity. The markets took the accumulating evidence to heart, resulting in a significant decline in overall equity valuations. We see nothing on the horizon to modify our view that we are in a long term de-leveraging process that will result in lower levels of economic growth, higher than “usual” levels of unemployment and greater than “usual” levels of volatility. This past recession was not the “normal” type of recession that we had experienced post WWII. We (the developed economies) have accumulated too much debt and made promises that we cannot afford. It will take an extended period of time to unwind the liabilities and every constituency will have to endure some disappointment. The weakened state of the developed economies makes them more susceptible to exogenous surprises otherwise known as “black swan events”. However, in spite of the dour macroeconomic environment, opportunities and favorable mispricing should continue to present opportunities.

We continue to expect the economy will grow for the balance of this year at subpar (but positive) rates with the risks of another recession within the next year increasing. The subpar growth is unlikely to help the unemployment and housing situation. Although the equity markets have rebounded strongly thus far in October, we prefer to err on the side of caution and plan on maintaining our defensive stance.

Given the uncertain environment we operate in, we believe you might find it helpful if we communicated our thoughts and views to you more frequently. As you are probably well aware, we do an extensive amount of reading on a continuous basis. Beginning next month we will select one or two salient articles that we have read and will forward them on to you via email. Should you not wish to receive these articles please let us know and we will take you off of our list. By the same token, should you know of someone you think would benefit by receiving our monthly emails, please let us know and we will be glad to add them to our list. We look forward to beginning this service and hope you will find the articles informative and enlightening.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters

Quarterly Review & Outlook

The consistent positive momentum in the markets for the past 10 months came to an end in May as investors focused their concerns on the continuing Greek Tragedy, slowing economic indicators and the U.S. Debt Ceiling standoff. The S&P 500 was essentially flat for the quarter as the losses in May and June offset the April gains. But for the rally in the last week of June, which was due to the EU “kicking the can down the road” with Greece. The S&P500 index would have been down about 4.3% for the quarter and almost flat for the year. Our risk adverse posture slightly outperformed the broad equity averages for this past quarter and we continue to believe that the current, very uncertain, environment warrants caution.

There are a number of unusual risks existing in the macro environment that lead us to our cautionary stance, among them:

1) Greek debt crisis: The EU, ECB (European Central Bank) and the IMF recently arranged for a modest restructuring on Greece’s debts in the hope that buying more time will help Greece extricate itself from decades of financial malfeasance. It will not! Greece is so over its head in debt that there is no way they can pay down their debt to a reasonable level. Every expert that we listen to believes that the only way out for Greece is to default. It’s not if but when. The recent financing just buys them some more time. The problem isn’t just Greece; it’s also Spain, Ireland, Italy and others. Greece is just the canary in the coal mine. Much of the market swoon was attributable to valid fears that a Greek default would lead to a contagion where other countries would default and create a banking crisis potentially greater than that of 2008.

2) Slowdown in the U.S. Economy and end of QE 2: Many economists believe that the majority (if not all) of the tepid economic growth the U.S. has experienced since last August was attributable to the Fed’s QE2 program. This program expired at the end of June. It is questionable if the economy has sufficient momentum to maintain even a sub-par rate of growth with the withdrawal of Federal stimulus. We should find the answer to this question in the next half of the year. The recent economic news has been disappointing and both private and government economists have been cutting their economic growth forecasts for the year.

3) China economic slowdown: The Chinese authorities have been trying to slow down the rate of economic growth in order to lessen inflation risks in their country. There is much disagreement among experts as to whether there is a property bubble in China and if China can engineer a “soft landing” by squeezing some excess out of their economy. Economic data from China is opaque at best. This lack of complete data make it very difficult (actually impossible) to gather all the facts and to arrive at a solid conclusion. Only two things are apparent: 1) There is an excess of new properties in China’s urban areas and 2) China has excess industrial capacity. They may be successful in achieving a soft landing but a “hard landing” would have serious repercussions worldwide.

4) The U.S. Debt Ceiling Impasse and the Three D’s: The President and the House are at an impasse with regard to raising the debt ceiling, budget cuts and raising taxes. The prospect of the U.S. defaulting on its debt would result in potentially disastrous effects on our standing as a reserve currency, our credibility and our economy. Lack of an agreement on or around August 2nd would likely result in a very negative market reaction. The debt ceiling needs to be raised but the Republicans are using it as a lever to address more serious longer term problems. The U.S. is incurring unsustainable deficits, accumulating too much debt and has huge unfunded liabilities from entitlement programs – all of which need to be addressed in the near future. These three D’s, Deficits, Debt and Demographics, and the manner in which they are dealt with, will have serious implications for the near term as well as long term investment environment.

We still expect that the economy will continue to grow for the balance of this year at subpar (but positive) rates but the risks of another recession within the next year are increasing. The subpar growth is unlikely to help the unemployment and housing situation. There are always known and unknown risks with respect to the markets; however, when there appears to be a greater number of risks in a richly valued market (such as now), we prefer to err on the side of caution.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters

Quarterly Review & Outlook

As we were writing this letter, we reviewed our 1st quarter letter from last year. We were struck by the similarity of equity returns for both periods. Bond returns were the exact opposite, however, up in the first quarter of last year but down in the first quarter of this year. You may recall the second quarter of 2010 was a particularly nasty quarter with the S&P500 declining by almost 11.5%. We are not necessarily saying history will repeat itself, but given our concerns about valuations and investor sentiment, we would not be surprised to hear it rhyme.

Since late 1998 we have been cautious toward most sectors of the stock market based on our assessment of equity valuations and expected returns. We do not consider ourselves “Perma-Bears” but we do prefer to dial down the level of risk in client portfolios when we observe equity valuations in the top quartile of their historical norms. Our valuation approach has worked very well over the past 25+ years and has helped to preserve our client’s portfolios during hostile market environments. As a practical matter, it is easier to predict long-term expected returns in the equity markets than it is to predict the short-term direction of the market. Intuitively, people understand that it is less risky to buy stocks when they are cheap but many have an emotional block toward buying when there is “blood in the streets”. It’s more comforting to buy when markets have been rewarding, when investors are in agreement, and when there is the perceived safety of the herd.

One attribute of our value based approach is that we tend to be early. We were early in late 1998 being “anti” tech stocks, but we were subsequently rewarded during the 2000 to 2003 bear market. Again, we were early in 2007 when we expressed our concerns about the housing markets and forecast the likelihood of a recession in the near future (little did we know the extent or magnitude of the recession to follow). Once again, we are early implementing our defensive approach as the markets have continued to climb since the lows of last summer.

We believe a key driver of market returns over the past nine months has been the Federal Reserve’s Quantitative Easing program (QE2) which has injected over $700 Billion into the financial system. The stated goal of the program was to lower long-term interest rates, but ironically, long-term rates actually increased instead of decreasing when QE2 began last August. The Fed’s actions have increased the “risk” trade, pushing investors into more and more risky assets in search of higher returns. Ben Bernanke, the Chairman of the Federal Reserve, has actually been quoted saying the Fed fueled gains in the equity markets were intentional and that he believes the “wealth effect” from the markets will carry over into the real economy.

The stimulus activities of the Federal Reserve have been accompanied by massive deficit spending and borrowing by the Federal government. We find it hard to believe you can solve a debt problem like the sub-prime mortgage fiasco by taking on still more debt. Ultimately, there will have to be some sort of meaningful debt restructuring before we can resume a more sustainable growth trajectory. QE2 has had a modestly positive impact on the economy, but it is scheduled to expire within the next two months. Given the current political environment, it is unlikely there will be a QE3 anytime soon. There is legitimate question whether the economy can continue to grow without further government stimulus.

We expect the economy will continue to grow for the balance of this year at sub-par but positive rates, but this will do little to help the unemployment situation or boost consumer confidence. There are several issues lurking in the bushes that could rear up at any time to upset the apple cart. Some of the concerns we continue to monitor include:

1) Inflation. Inflation is clearly beginning to heat up, and if it persists, it will ultimately become a drag on the economy.

2) Interest rates. Long-term interest rates have been in a sustained down-trend since the early 1980s. Current rates are artificially low due to government actions, and there is little room for rates to fall further. We are already seeing some upward pressure on rates and this will become stronger should inflation persist. The Eurozone has already begun to raise rates as has China and India.

3) Political instability. The uprisings in the Arab states are far from over and it is far too early to predict the ultimate outcome. Oil prices are already reflecting these uncertainties. In the event that the Arab states end up ceding control to more radical regimes, we would expect a further hike in oil prices which would be a large impediment toward further economic growth.

There are always known and unknown risks with respect to the markets. However, when there appears to be a great number of risks in a richly valued market, we prefer to err on the side of caution.

Our investment philosophy and approach is based on fundamental and relative valuations between the various asset classes (i.e. stock, bonds, alternatives and cash) as well as the current and prospective monetary and economic environment. Our analysis is tempered greatly by a long historical perspective. Ideally, we would maximize client exposure during periods of low valuations and favorable monetary and economic environments. In the current environment, however, valuations are not particularly attractive, we have grave concerns about the prospective monetary and economic environment and the historical guidelines are not particularly encouraging.

Notwithstanding our somewhat negative longer-term outlook, the world’s economy is very likely to grow. There are often pockets of opportunities in various sectors, styles and asset classes. We intend to manage client portfolios with one eye on capital preservation and the other eye on potential opportunities. Our current outlook is one of caution that calls for a moderate level of risk, but we remain optimistic that attractive investment opportunities will emerge.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters

Quarterly Review & Outlook

We are disappointed with the performance we generated during this past quarter. Our defensive approach held back much of the potential gains that were generated by our value holdings. The implementation of QE 2 that we discussed last quarter had the (unintended) effect of increasing interest rates and (intended) fueling a significant market rally. We have little thus far to show for the hundreds of billions of dollars spent on QE2. The Republican victories in the house and the last minute tax legislation did help to increase confidence in the likelihood of a more pro-business government which clearly helped the equity markets. Additionally, some recent economic statistics have helped to support the notion that the risk of a double dip recession has abated for now and that the economy is beginning to gain some traction.

We continue to view the equity markets as overvalued, the economic environment as getting better but still very fragile and the excessive level of debt (particularly Federal) as an issue that increases the risk of unwelcomed events. Please note that the best performing indexes were the risker, more volatile indices such as the NASDQ and the Russell 2000 (small caps). This is indicative of a high level of speculation, not dissimilar to what we saw in the late 1990’s just before the Tech bubble. As a point of reference, the Russell 2000 Index (consisting of small cap stocks) was up more than twice as much as the Russell 200 (Blue Chip stocks). We have seen this play before (in the late 90’s) and had the same frustration with underperformance relative to the indices. Our conservative approach worked out well in protecting client’s wealth back then and only time will tell if our conservative approach will help to conserve capital in the year(s) to come.

We thought it would be helpful to share an historical overview of market “bubbles”. Jeremy Grantham of GMO LLC recently published a speech on the topic. Mr. Grantham is a very experienced (and successful) institutional money manager, a wonderful financial historian and a terrific writer. A copy of his speech can be found here: Grantham’s Pavlov’s Bulls. We hope you find it as enlightening and entertaining as we did.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Quarterly Review & Outlook

Not to repeat our 2^nd quarter letter but the equity markets for the third quarter were almost a mirror image of the second quarter.  Equity markets across the board were up rather sharply roughly offsetting the losses that occurred in the second quarter. As anticipated, our defensive approach restrained some of the potential gains during the third quarter, the inverse of the help these holdings had in mitigating the losses of the second quarter. The equity markets have essentially eked out minimal gains for the year but with a lot of volatility.  We find this environment to be embedded with greater risks than usual and we believe it calls for an abundance of caution. 

There are a number of conflicting economic signals that contribute to the level of uncertainty regarding the outlook for the economy.  On the positive side, the Federal Reserve has provided tons of liquidity, held interest rates to almost zero, corporate earnings are higher than anticipated and corporations are sitting on almost one trillion dollars. However, corporations are reluctant to spend these funds on capital expenditures due to a weak economy, sub-par growth and persistent high unemployment. Additionally, the rate of growth in the economy is declining and the ECRI index has been declining for 20 consecutive weeks.  This index is indicating a significant decline of economic activity and should it continue to decline, increases the odds of a double dip recession.

In the short run, there are more positive attributes to the equity markets than negative ones.  There is ample liquidity, positive momentum, positive earnings surprises, positive money flows and a likely election outcome that is expected to be positive for equities. We are not traders and as such do not try to catch the various swings in the markets. Trading is a game best played by hedge funds that have the talent and resources to jump in and out of the markets to pick up nickels and dimes from each trade.  Our approach is more strategic in nature, oriented toward seeking gains from the markets while always focusing on lessening risk. With that in mind, we thought it might be helpful to share with you our current “view of the world”.

One of the strongest factors in the markets is mean reversion.  Mean reversion is a phenomenon similar to the weather.  Whenever markets experience a period of over performance, there is a strong tendency to underperform in subsequent periods. It may be hot during the summer and cold in winter, but the average temperature is relatively constant over the years. Markets have a similar tendency to fluctuate around a long-term trend. They will experience cycles of over and under performance, but in the long run, they tend to “regress toward the mean” or move toward the long-term average. We see a number of areas where we think the prospect of mean reversion is likely to happen over the intermediate time horizon (3 – 5 years).  Most importantly in the area of U.S. debt, equity valuations, corporate profit margins and interest rates.

We have talked many times about the debt problems with the U.S. and developed world economies. The U.S. Government has added an exponential level of debt in an effort to stimulate the economy.  High levels of debt tend to act as a drag on the economy and eventually will have to be reduced to more normal levels.  Currently, the Federal Reserve has all but stated that they will pursue another round of stimulus in an attempt to “goose” the economy. Now referred to as QE2 (quantitative easing version 2), the Fed will be buying mortgage securities essentially by printing money.  There are a number of concerns regarding the efficacy of this approach and many concerns regarding the intended consequences stemming from QE2, principally future inflation and a lower dollar.  We think (as do many others) that QE2 is a bad idea. It will contribute only modestly, if at all, to stimulating the economy and the potential risks far outweigh the benefits. Using debt (whether public or private) to stimulate the economy has become progressively less effective over the past 30 years. Our public debt is already at excessive levels and we do not now need to add to the problem. It is only a matter of time before mean reversion kicks in and the aggregate level of debt declines (it already is in the private sector). Paying down debt is a good thing except it is a short term negative for the economy as funds are diverted from consumption which results in lower demand for goods and services.

Equity markets have rebounded strongly since the June lows and have pushed valuation levels above normal (the Shiller P/E index is now above 21 vs. its long term average of 16). There is nothing to prevent the PE multiple from going higher (it was over 30 at the peak of the Tech Bubble) but the higher it goes, the greater the risk.  Additionally, corporate profit margins are near all time peaks and are likely to move downward in the not too distant future.  Lower margins translate into less profit growth and could put further pressure on P/E multiples.  One of the factors contributing to high margins is low interest rates. Creditworthy companies are able to borrow at historically low rates. IBM recently borrowed $1.5 billion for three years at a rate of 1%, an all-time record for low rates.  The real question is how long will rates stay this low?

This leads us to our last (for now) mean reversion issue – interest rates.  As you well know, short term rates are near zero and long term rates are at historically low levels.  The Fed uses short term rates as a monetary tool and is currently holding rates at so low a level that they effectively can’t go lower.  The real rate of interest (interest rates minus the inflation rate) is at negative levels.  Negative real rates are not a sustainable condition; either inflation turns to deflation (a possibility) or rates go up.  Neither outcome would be viewed as a positive for the equity markets.  Remember when the Prime Rate was 21.5% in December of 1980?  Interest rates have been on a secular decline for the past 30 years and can’t go much lower as zero is the lowest possible interest rate.  Should inflation start to pick up or should creditors demand better yields (i.e. lending money to the U.S. Government) interest rates are likely to increase.  Again, it is impossible to know when but there is a high probability that over the intermediate term (3-5 years) interest rates will rise.

We don’t mean to always cast a dour light on our economic outlook but we do need to look at the weight of the evidence which leads us to our current risk assessment. We believe that half the battle of achieving good long term returns is to minimize losses during hostile market environments.  This is an effective approach that Sterling has practiced for over 27 years: protect principal first!  On a positive note, we do believe in the resiliency of the U.S. economy and are optimistic that we will work our way through these problems, it will just take some time.  Eventually there will be an opportunity to acquire equities at reasonable to cheap valuations and enjoy periods of above average returns. For now, we expect to continue our defensive approach in the management of client portfolios.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Quarterly Review & Outlook

The equity markets for the second quarter were an exaggerated mirror image of the first quarter.  Equity markets across the board were down rather sharply, more than erasing the gains of the first quarter and generating losses in every segment of the equity markets.  Fortunately, our defensive approach worked well and helped mitigate the losses in the second quarter, also, a mirror image of the first quarter.  The equity markets have essentially gone nowhere but with a lot of volatility.  Environments like this are challenging and call for an abundance of caution with an eye toward capital preservation.  As a further update, the equity markets have rebounded rather sharply during July and client portfolios are responding similar to our results in the first quarter (i.e. our equity holdings are doing well and total portfolio returns are being held back by our defensive issues).

The major focus of the markets during the 2^nd quarter was the crises in European sovereign debt, most notably Greece and the rest of the PIIGS (Portugal, Ireland, Italy, Greece and Spain).   The PIIGS are the weakest members of the European Union that are tied to the Eurodollar.  Over the past decade, they have taken advantage of the low cost of borrowing and embarked on speculation in Real Estate and social programs, neither of which were sustainable.  Their debt levels have risen well beyond their annual level of GDP and their deficits are far beyond the EU limits.  Potential lenders became very reluctant (at best) to lend Greece any more capital and it took a concerted effort on the part of Germany and France to agree to bail out Greece (for the time being).  Many market observers commented that the crises in Greece was a harbinger of what may happen in the U.S. should we continue to go down the road of Trillion dollar deficits.  The EU countries, to their credit, have embarked on austerity measures geared to reduce their structural deficits over a period of time.  Since the temporary bailout of Greece the sovereign debt problem has faded off the radar screen but we suspect that it will show up as a bright “blip” again within the not too distant future.

 We have talked in the past ad-nauseam about the structural problems with the U.S. and developed world economies (e.g. too much debt, the increasing burdensome and costly regulation of the private sector, deleveraging, etc).  In a sense, the equity markets are reflective of the push and pull of the short term positives in the economy (improving GDP and corporate earnings) and the negative effects of deleveraging and recent policy initiatives.  The U.S. (and the developed world) are at a crossroads and are walking a tightrope trying to balance between reversing excessive debt levels while trying to encourage reasonable economic growth.  The fragile worldwide recovery is not unlike the patient who is recently been moved out of the ICU into a regular hospital room. The patient fortunately avoided death (economic depression) yet is quite fragile and not well enough to be released.

 The government stimulus likely averted a worsening decline but much of the stimulus is wearing off.  This is reflected in recent economic statistics which indicate that while the economy is still growing, the rate of growth is diminishing and is at sub optimal rates. The rate of economic growth for the 2^nd quarter was just 1.9% (below the 2% necessary to maintain current employment).  The consensus of most economists is for a rate of economic growth for the 2^nd half of 2010 to fall in the 2% to 2.5% range.  While positive, this is barely enough to make a dent in the in unemployment levels.  We have a great deal of concern that, should there be no action on the expiring tax cuts in 2011, we may slip back into a recessionary mode.  The scheduled tax increases amount to a bit over 1% of the GDP.  Historically, tax increases have had a multiplier effect of between 1.5X and 3.5X. Mathematically, it does not take much of a tax increase to “tip over” a slow growing economy.  Needless to say, another recession would not be good for equities or unemployment.

 To quote the current Fed Chairman, Ben Bernanke in his speech to congress last week, we are in “unusually uncertain times”.  Our job during these “unusually uncertain times” is to navigate client portfolios through uncertain waters keeping a close eye toward the risks while striving to make forward progress.  In other words, we plan to continue to place an emphasis on capital preservation while continuing to seek pockets of opportunity.  Again, we hate to cast such a negative light on our view of the future.  We believe it is our responsibility to think independently and honestly communicate our outlook to you even when the “news” is not uplifting.  Our current outlook is little changed from last quarter.  The combined effects of greater government deficits, higher taxes and a lengthy deleveraging process indicate that we will have an extended period of below normal growth and greater risk of “surprises”.  

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Quarterly Review & Outlook

Although the equity markets started out the year on a weak note (the S&P 500 was down 3.6% in January) the markets began to roar back in mid-February and March. Unfortunately, our defensive approach worked a bit too well and our portfolios did not receive much benefit from the bounce back during the second half of the quarter. As we discussed in our previous quarterly letter, we believe that this is a cyclical bull market within a secular bear market. In an environment like this it is our challenge to manage portfolios in a manner that preserves capital yet also takes advantages of market opportunities. The value oriented issues in our portfolios responded well to the market upswing but most of those gains were offset by the modest losses in the defensive portion of our portfolios.

The economy has clearly begun to recover from the depths of the recession and employment is showing modest levels of improvement. The majority of the positive economic statistics indicate that things have stopped getting worse and that there appears to be a modest uptick in the general level of business activity. Given the depth of this recession, a bounce back recovery would be expected. One of the key questions is; 1) will this be a typical post-war economic recovery where healthy growth resumes or 2) is the recovery muted with economic growth at sub-par levels? The equity markets are acting as though they believe scenario 1 is most likely. We feel strongly that scenario 2 is the most probable. Market sentiment and valuations are at the high end of their historical ranges and the risk of scenario 2 becoming the likely outcome cries for an abundance of caution. It is our eye on capital preservation that tempers the level of risk in our portfolios. Only time will tell who is correct.

Our investment philosophy and approach is based on fundamental and relative valuations between the various investment asset classes (i.e. stock, bonds and cash) as well as the current and prospective monetary and economic environment tempered greatly by a long historical perspective. Ideally, we would maximize exposure during periods of low valuations and favorable monetary and economic environments. In the current environment, however, valuations are not particularly attractive, we have grave concerns about the prospective monetary and economic environment and the historical guidelines are not particularly encouraging.

The Federal government has incurred a massive increase in borrowing in an attempt to rescue and stimulate the economy. This economic shot of adrenalin has had its short term effect but at what long term cost? As you are probably well aware, we read a lot of material concerning economics, markets and economic history in part, because we enjoy it, but also to spare you from spending your valuable time on what many consider rather dour reading. We recently read an article from Hoisington Management who we have a great deal of respect for their economic prowess. In their newsletter they reviewed the economic impact of massive transfers of resources from the private sector to the public (government) sector. Quoted below are some of their key points:

“Contradictory Fiscal Policy
The federal government cannot create prosperity by spending funds that it does not have. It can, however, spend us into poverty by taking dollar balances from highly productive individuals and their business entities, through borrowing or taxing. This process of transferring these assets from income and wealth generators to other government applications has profound economic consequences.

Economists from David Ricardo (1772-1823) to John Maynard Keynes (1883 to 1946) to present day scholars have theorized about what this massive transfer of resources from the private to public sector does to overall economic conditions. Our read of history, economic theory, and mathematics leads us to one clear conclusion. The “taking” of funds by central governments to be redistributed to other priorities is, in the end, contractionary.”

Additionally, they reviewed the current economic research on the effectiveness of government spending (the multiplier) and the multiplier effect of tax increases and decreases. (The multiplier effect is a measure of the effect that a dollar change in government spending has on the overall economy.) Research indicates that the government multiplier ranges from .6 to 1.1 with an average of .85. This means that a $1 increase in government spending boosts overall economic activity by 85 cents. Not necessarily a great investment of funds! On the other hand, it has been well documented, by none other than President Obama’s Chair of the council of economic advisors, Christina Romer, that the tax multiplier is -3. Without any legislative action, and before the current healthcare bill, the administration projected that, over the next ten years, taxes will rise $1.5 trillion. The current tax multiplier of -3 indicates that the drag on the economy will be in the range of $4.5 Trillion. Mathematically, there is no way that the current government policies will enable this country to “spend” it way to prosperity. To the contrary, there are recent examples (i.e. Japan) that give us clear historical evidence that governments cannot create prosperity by borrowing and reallocating resources from the productive to the less productive sectors.

We didn’t mean to rant about the current political scene but we do believe that the majority of the actions taken by the current administration are counter-productive and that they will serve as an economic drag on the economy and are disincentives to economic growth. If we are correct in our outlook, the equity markets will eventually have a change (not for the better) in market valuations. As we’ve stated before, there is strong historical precedent to indicate that the deleveraging process (too much borrowing) will take a number of years to work its way through the western world’s economic systems. The combined effects of greater government deficits, higher taxes and a lengthy deleveraging process would indicate that we will have an extended period of below normal growth.

Notwithstanding our dour outlook, the world’s economy is very likely to grow. There are often pockets of opportunities in various sectors, styles and asset classes. We view our task to manage client portfolios with one eye toward capital preservation and the other eye on opportunities. Our current outlook is one of caution that calls for a moderate level of risk. As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Quarterly Review & Outlook

The debt and equity markets continued to generate positive returns as market participants breathed a sigh of relief. The economy stepped back from the precipice thereby diminishing the risk of “falling off a cliff” which was a legitimate concern this time last year. For the year, the equity indices had an outstanding year, particularly when viewed in the context of being down almost 11% at the end of the 1st quarter.

We continue to believe that this past quarter is a continuation of the bounce back from last year and the massive injection of liquidity into the financial system by the federal government. The equity markets have recovered dramatically from the March lows (about 64% in the S&P 500). Whereas, the market, by our calculations, was very undervalued in March, we believe that it is now overvalued by 10% to 25%.

With the benefit of hindsight, we should have been more aggressive during the second half of last year. Our dilemma is one of balancing capitalizing upon short term trends and preserving capital. We believe that the current market environment is driven in large part by the massive injection of liquidity by the Federal Government into the financial system. These “liquidity driven” markets are notoriously difficult to navigate and generally come to a bad ending once the liquidity is withdrawn. The markets last year had a strong wind behind its back in the form of massive liquidity injections, absurdly low interest rates and very reasonable valuations. Our concern for this year is that last year’s tailwind may become this year’s headwind.

The Federal Reserve has made it clear that they intend to stop the quantitative easing program by the end of March. This means that they will stop buying mortgage securities. For the past year, the vast majority of mortgages issued and refinanced have been through the government. This has helped maintain historically low mortgage rates which has helped buffer the decline in residential real estate. Additionally, the Fed’s purchases of mortgages provided the liquidity for the major banks to purchase over $1 trillion of government debt. The banks are loath to lend to non-governmental borrowers – the best credits don’t want to borrow! Besides, why do commercial lending when you (the Banks) can borrow from the government for almost nothing and lend the funds back to the government for 3% to 4%. As the guy from Lenox mortgage says “The greatest no-brainer in the history of earth”! Additionally, the government will need to borrow another $1.4 trillion or so to fund the deficit this year. Who will provide the capital in 2010, and at what rate? Logic would dictate that interest rates can’t go down much further and that there will be pressure on rates in order to attract purchasers.

The economy has also benefited by massive government “stimulus” (spending) last year. As this spending unwinds itself during the first half of this year, it is unlikely there will be a political appetite for another “stimulus” package in 2010. We have seen various studies that estimate that about ½ to ¾ of the growth in GDP during the 2nd half of last year was due to the one-time stimulus programs of the government (i.e. cash for clunkers, 1st time homeowner credit, etc.) The economy appears to be on the mend and we anticipate decent economic growth during the 1st half of 2010. However, once the “stimulus” funds are expended the rate of economic growth is likely to be sub-par. Also, looming on the economic horizon is the expiration of the Bush tax cuts at the end of this year. Without any legislative action, tax rates will be going up in January 2011. Additionally, there is talk in Washington about further increasing taxes on top of the scheduled increases. Increasing taxes in a weak economy is a singularly bad idea. Tax increases will act as a disincentive for consumers and businesses to expand their expenditures just at a point in time when they may well be willing to loosen their purse strings.

We have repeatedly voiced our view that we are in a long term deleveraging cycle that will take years to unfold. A new book by international economists, Carmen Reinhart and Kenneth Rogoff, This Time is Different; Eight Centuries of Financial Folly, has piqued the interest of many financial professionals. In their book, they studied over 250 financial crises over the past 800 years and analyzed them for similarities and differences. The analogies to the current state of US finances are not encouraging. Essentially, they imply that the corrective process of deleveraging has much further to go and that the “pain” cannot be avoided. The natural tendency of governments to avoid “pain” only compounds the problem. They believe that there is no way to avoid it. It is just a matter of when and how long.

Over the past 60 years, we have been the beneficiaries of very favorable economic “winds”. By increasing the use of debt we have grown the economy for many years. The efficiency of debt has greatly diminished over the past 20 years as has the ability to access debt (other than the government). Debt served as a “lubricant” to economic growth. The reduction of debt will likely serve as an element of “friction” to the economy. We do believe that this time it is different. In spite of our Macro view of the world, we do anticipate that most of the economic “news” during the first half will be favorable. Our challenge will be to position client portfolios to capitalize on the market while keeping a watchful eye on the level of risk embedded in our portfolios.

Notwithstanding our rather dour view of the world, we do believe that there will be pockets of opportunity for investment. Parts of the developed and most of the developing world economies are likely to do better than our domestic economy. Additionally, many high quality international U.S. companies are selling for reasonable valuations. We think that the next few years will bode well for funds run by “stock pickers” which constitute most of the funds held in client portfolios. We do think the current environment calls for a higher than normal level of caution and we intend to maintain a defensive tilt in client portfolios.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III