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

Quarterly Review & Outlook

The debt and equity markets had one of the best quarters they have seen in years.  In fact, since 1983 (when we started our firm), there have been only four quarters where S&P 500 returns exceeded the return of this past quarter. Mathematically, that equates to less than 5% of the occurrences. Surprisingly, (and disappointingly), the majority of the gains for the quarter came from finance-related companies (i.e., banks and brokers) that are of a more speculative nature.  The high quality multinationals with strong balance sheets substantially underperformed the more speculative companies. 

Benjamin Graham, the “Father” of modern security analysis, opined that in the short run, the market is a “voting” machine; while in the long run, it is a weighing machine. This means that the market is risky in the short run due to its wild price movements but it becomes more rational over time as market values reflect reasonable valuations.  

We believe that this past quarter is reflective 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 50% in the S&P 500).  Whereas, the market, by our calculations, was very undervalued in March, we believe that it is now overvalued by between 10% to 25%.  As was demonstrated during the 1995 – 2000 period, the markets can become and stay overvalued over a sustained period of time. 

We exercise a risk averse process when managing portfolios.  When valuations are attractive, we will ramp up the level of portfolio risk.  When valuations are high, we reduce the level of portfolio risk.  We reduced the level of portfolio risk earlier this summer as we thought equity valuations were at fair levels.  With the benefit of hindsight, we were way too early in reducing portfolio exposure – a phenomenon we have frequently encountered in the past.  We have yet to be able to figure how to play “musical chairs” until the very end without ending up standing when the music stops.  Historically, we just leave the party early and let others have the last bit of “fun”. 

The current consensus is that we have avoided a second “great depression” (probably true) and that the credit markets as well as the economy are healing.  It is very likely that the GDP will be positive for the second half of the year.  Much of the growth in the economy has come from government spending (cash for clunkers, 1^st buyer home credit, etc.) which is unsustainable. The question is: will the economic boost by the government transition over to an economy that continues to grow due to continued increases in business and consumer demand? 

As we have mentioned before, our economy faces some significant headwinds over the next few years. The de-leveraging of consumers and businesses still has a long way to play out.  The increase in government regulations and direct government involvement in businesses has historically acted as a drag on economic growth.  Additionally, the gigantic increase in the government borrowings and deficits are bound to have a negative impact at some point in the not too distant future.  Additionally, the residential real estate problems are far from being resolved. We continue to feel that there is a significant risk of a “W” form of economic recovery where after a modest recovery, the economy slips back into a recession in a year or two. 

We have modified the economic scenarios that we think will be the three most likely outcomes for 2009.  (The old estimates are in parenthesis.) 

1)    The economy bottoms in the 3^rd to 4^th quarter (3^rd to 4^th) 2009.  Credit markets stabilize over the next 6 months and the equity lows of November 2008 are tested but not violated.  Equity markets move higher by year-end and GDP begins to grow in late 2009 at a below optimal rate.  Life begins to return to normal. This scenario would be very positive for the debt markets as risk premiums move substantially lower and also positive for equities as confidence in the corporate profit outlook for 2010 improves.  

Assigned probability = 75% (25%) 

2)    The economy bottoms in late ’09 early ’10 and the economy grows at an exceedingly slow rate for the following 1-3 years.  Credit markets stabilize over the balance of 2009 with a higher than normal level of volatility in both the equity and debt markets.  The equity markets do not exceed the March lows (establish a new low with the S&P falling to near the 700 level). The S&P finishes 2009 within a range of plus or minus 5% (loss in the 10% to 15% range).  

Assigned probability = 20% (60%) 

3)     The economy continues to deteriorate well into 2010 and does not recover until late ’10 to early ’11.  Credit markets do not improve and remain in this “semi-frozen” state for the balance of 2009.  Volatility increases to levels seen in the October – November 2008 period.  Corporate profits plummet, unemployment reaches 12%, government stimulus has little effect and we are in a worldwide mini-depression. Credit market returns would be coupon minus defaults.  Equity markets suffer another steep decline with the S&P reaching the 600 level.  Traditional “growth” assets (houses, stocks, private equity, business values, etc.) continue to experience substantial declines in market values.

Assigned probability = 5% (15%) 

After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around a trading range of about 10% – 15% of the 900 range of the S&P500. We continue to feel that in this environment, it is prudent to maintain a reasonable level of defensiveness. We continue to believe that the current rally is a bear market rally.  

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 bounce-back rally that began in mid-March continued through most of the 2^nd quarter and helped push the broad averages into the black for the 1^st half of 2009. Most of the gains for the 2^nd quarter occurred in April and May as the S&P 500 was essentially flat for the month of June.  Bonds also had a rewarding quarter as the credit markets continued to improve and credit spreads narrowed. 

The market’s healthy rebound from the early March lows is largely attributable to; 1) a Newtonian reaction to the severe declines of the past two quarters and 2) a growing sense of optimism that the economy may be bottoming.  There has been much said about the appearance of “green shoots” appearing on the economic landscape. The massive government stimulus and rescue packages to the banking community were bound to have a stimulative effect on the economy.  At the very least, it did help to contain the damage and prevent the world economy from falling off a cliff. 

A few examples of the “green shoots” are a surprising increase of 17% in new housing starts in May, lower (but still huge) new unemployment claims in June, and positive earnings surprises from the banking sector. We believe that all of these early harbingers should be taken with a grain of salt. Even with the increased housing starts, the housing market is unlikely to see much improvement for many years, the rate of the newly unemployed is still at extraordinarily high levels and the boost in bank earnings is largely attributable to changes in the “mark-to-market” component of their illiquid portfolios.  As we mentioned in our last quarterly letter, the encouraging news is that the markets appear to be stabilizing and the economy is getting worse at a slower rate.  We may well have an environment, in the next quarter or two, where the GDP experiences a modest level of growth. 

Any level of economic growth would be a welcome relief, however; there are significant headwinds that the economy will be facing over the next few years. The de-leveraging of consumers and businesses still has a long way to play out.  The increase in government regulations and direct government involvement in businesses has historically acted as a drag on economic growth.  Additionally, the gigantic increase in the government borrowings and deficits are bound to have a negative impact at some point in the not too distant future.  We think the economy is in the process of stabilizing during the 2^nd half of this year but our concern is growing that we may see a “W” form of economic recovery whereby, after a modest recovery, the economy slips back into a recession in a year or two. 

We have only slightly modified our economic scenarios that we think will be the three most likely outcomes for 2009.  (The old estimates are in parenthesis.) 

1)    The economy bottoms in the 3^rd to 4^th quarter (2^nd to 3^rd) quarter 2009.  Credit markets stabilize over the next 6 months and the equity lows of November 2008 are tested but not violated.  Equity markets move higher by year end and GDP begins to grow in late 2009 at a below optimal rate.  Life begins to return to normal. This scenario would be very positive for the debt markets as risk premiums move substantially lower; and also, positive for equities as confidence in the corporate profit outlook for 2010 improves.  

Assigned probability = 25% (20%) 

2)    The economy bottoms in late ’09 early ’10 and the economy grows at an exceedingly slow rate for the following 1-3 years.  Credit markets stabilize over the balance of 2009 with a higher than normal level of volatility in both the equity and debt markets.  The equity markets do not exceed the March lows (establish a new low with the S&P falling to near the 700 level). The S&P finishes 2009 within a range of plus or minus 5% (loss in the 10% to 15% range).  We think this scenario is the most likely as we believe that we are entering into an environment that will be different than that of the past 35 years.  Consumers will be spending less and saving more for years to come.  Long term, this bodes well for the U.S. economy but will be a drag on economic growth as this process takes place.  

Assigned probability = 60% 

3)     The economy continues to deteriorate well into 2010 and does not recover until late ’10 to early ’11.  Credit markets do not improve and remain in this “semi-frozen” state for the balance of 2009.  Volatility increases to levels seen in the October – November 2008 period.  Corporate profits plummet, unemployment reaches 12%, government stimulus has little effect and we are in a worldwide mini-depression. Credit market returns would be coupon minus defaults.  Equity markets suffer another steep decline with the S&P reaching the 600 level.  Traditional “growth” assets (houses, stocks, private equity, business values, etc.) continue to experience substantial declines in market values. 

Assigned probability = 15% (20%) 

After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around a trading range of about 10% – 15% of the 900 range of the S&P500. We continue to feel that in this environment, it is prudent to maintain a high level of defensiveness. We still believe that the current rally is a bear market rally.  We reduced some of the more volatile holdings in client portfolios in May and replaced them with a less volatile fund (Nakoma Absolute Fund).   

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 sun began to come out in March after a dreadful January – February period. As you are probably well aware, by early March the S&P 500 had slid another 25% on top of last year’s decline of 37%.  The markets began to recover during the balance of March and ended the quarter down “just” 11%. The sun continued to shine in April as the S&P 500 rose another 9.7% bringing the index to just 2% below where it began this year.   

We hope you are pleased that we were able to avoid most of the carnage this year and that we are up slightly through April.  This naturally leads to the question: where do we go from here?   Many market strategists are opining that the March lows were the lows for the market and that we are now in a new bull market. While a number of technical indicators tend to support that position, we continue to be skeptical. It is quite common to have rallies exceeding 20% within a bear market.  In the present case, the market has rallied about 30% off its March lows. 

The economy is continuing to decline although the rate of decline is slowing down – a good sign for an eventual recovery.  The economic news is viewed as getting better because it is not getting worse, continuing to decline but at a slower rate. The reality is that no one can predict the future and our crystal ball is no clearer than any others.  However, there are some macro-economic principles that we can use to help frame probable outcomes for the next 18 – 24 months. 

“The future ain’t what it used to be.” – Yogi Berra 

As we mentioned in our last letter, the world has radically changed over the past year.  We are witnessing a massive de-leveraging of the worldwide economy that is, at best, only halfway through the process. Twenty five years ago, a 1% increase in debt would produce almost a 1% increase in GDP. By 2007, it took more than a 4% increase in debt to raise the GDP by 1%.  The de-leveraging of corporations and consumers is likely to be a drag on the economy for years to come and, we believe, will limit economic growth to sub-optimal levels.  The consumer accounts for 70% of GDP and have, counter to the trend of the past 20 years, begun to save money. In short order, the personal savings rate has gone from a minus number to a positive 4%.  Long term, this is good news but in the short run, it is a negative as consumers that save don’t spend. 

In the short run, the massive government “stimulus” is bound to have an impact on the economy.  Markets usually respond well to government spending (as they have done recently) as it is perceived that they are getting something for nothing.  Eventually, there is a price to pay.  The deficits going forward defy imagination!  The sheer magnitude of the Federal deficits plow new ground and we don’t know what the unintended consequences will be.  But we do know that there will be consequences, perhaps inflation? Rising interest rates? A declining dollar? Something totally unanticipated?  We believe that the recent government “stimulus” actions will lessen the steepness of the economic decline (were there no stimulus).  However, injecting massive amounts of money into the economy (money we must borrow from others) is not a long term positive and is likely to extend the duration of the decline and lessen the rate of recovery.  

The basic problem is that there is too much debt on the part of corporations and consumers.  The debt ratio will come down by some combination of repudiation (bankruptcy) or repayment.  This is a natural part of the capitalist system.  Historically, recessions have served to reduce speculation, clean up balance sheets (reduce debt) and scare the heck out of people so they become more prudent (for a while).  Recessions “clear the deck” and set the stage for renewed economic growth.  Since the1990’s, politicians have realized that recessions are injurious to their health should they occur during their re-election cycle and they will do everything within their considerable power to diminish or forestall a recession.  This worked during the 1990 and 2001 recessions (which barely counted as recessions). By 2007, the excesses had grown so large and the tools available to the government so limited, that it was only a matter of time before a catalyst (Sub-Prime crises) would tip us over into a recession. The massive amount of “toxic” assets held by banks (estimated at more than $4 Trillion) will eventually have to be dealt with.  The resolution of this debt problem will not happen quickly.  

We’ve seen the de-facto nationalization of most major banks.  It’s possible that the banking system will muddle through but one thing is clear: the government is in the banking business as well as the car business and insurance business. Like it or not, we have entered into a new environment where business has a new partner – an activist government.   Increased regulation will mean additional costs, less flexibility and a drag on corporate profitability.  Coupled with the ongoing de-leveraging, it’s hard for us to envision that corporate earnings and P/E multiples will return to their 2007 levels anytime soon. 

We have only slightly modified our economic scenarios that we think will be the three most likely outcomes for 2009.  (The old estimates are in parenthesis.) 

1)    The economy bottoms in the 3^rd to 1st quarter (2^nd to 3^rd) quarter 2009.  Credit markets stabilize over the next 6 months and the equity lows of November 2008 are (tested but not) violated.  Equity markets move higher by year end and GDP begins to grow in late 2009 at a below optimal rate.  Life begins to return to normal. This scenario would be very positive for the debt markets as risk premiums move substantially lower and also positive for equities as confidence in the corporate profit outlook for 2010 improves.  

Assigned probability = 20% (25%) 

2)    The economy bottoms in late ’09 early ’10 and the economy grows at an exceedingly slow rate for the following 1-3 years.  Credit markets stabilize over the balance of 2009 with a higher than normal level of volatility in both the equity and debt markets.  The equity markets establish a new low with the S&P falling to near the 700 level but recovering somewhat by the end of the year.  The S&P finishes 2009 with a loss in the 10% to 15% range.  We think this scenario is the most likely as we believe that we are entering into an environment that will be different than that of the past 35 years.  Consumers will be spending less and saving more for years to come.  Long term, this bodes well for the U.S. economy but will be a drag on economic growth as this process takes place.  

Assigned probability = 60% 

3)     The economy continues to deteriorate well into 2010 and does not recover until late ’10 to early ’11.  Credit markets do not improve and remain in this “semi-frozen” state for the balance of 2009.  Volatility increases to levels seen in the October – November 2008 period.  Corporate profits plummet, unemployment reaches 12%, government stimulus has little effect and we are in a worldwide mini-depression. Credit market returns would be coupon minus defaults.  Equity markets suffer another steep decline with the S&P reaching the 600 level.  Traditional “growth” assets (houses, stocks, private equity, business values, etc.) continue to experience substantial declines in market values. 

Assigned probability = 20% (15%) 

After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around the range that they are now. If things settle down, the environment for the bond markets will be favorable.  Under any of the above scenarios, the equity markets would eventually set the stage for above average levels of returns when looking out over a 5+ year time horizon.   We feel that in this environment, it is prudent to maintain a high level of defensiveness. We believe that the current rally is a bear market rally and we anticipate that we will become more defensive in client portfolios should the S&P 500 continue to advance.  

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

If one just looked at the numbers for the past quarter you would probably surmise that the equity and debt markets had an OK quarter and that returns were in the mid-range of the historical averages. In actuality, the movements of the debt and equity markets were anything but “normal”. In late July through mid August the problems in the sub-prime credit markets spilled over to the rest of the credit markets to such an extent that the availability of credit (willingness to lend) evaporated for all but the most credit worthy borrowers. From mid July to mid-August, the S&P500 dropped by more than 9%. Corporate and non-government bonds also experienced precipitous declines in value. There were genuine concerns that the “contagion” in the credit markets would spill over to the “real” economy and push us into a recession.

The Federal Reserve came to the rescue by lowering the discount rate and the Fed Funds rate by ½%. Additionally, the Fed injected unprecedented amounts of money into the economy and made it clear to the markets that the Fed would stand ready to supply additional liquidity, if necessary, to maintain order in the capital markets. The equity market reversed its decline and ended up generating a new high for the year. The debt markets also stabilized as a result of the Fed’s easing. The credit markets willingness to lend is a crucial factor necessary to generate economic growth. We have gone from an environment of “easy money” to and environment of “tighter” money. The easy money environment led to very loose lending standards and imprudence on the part of borrowers. It will take a while for the economy to work through these problems and credit problems are bound to act as a drag on the economy.

We have mentioned in previous letters our concerns about the dependence of borrowings that have been necessary in propelling the economy for the past five years. Whether it be from consumers borrowing against their home equity loans to maintain spending to large leverage buyouts providing liquidly to the equity markets, this cycle of borrow and spend has all but ended this year. We believe that the recent contraction in the credit markets has significantly raised the probability of a recession beginning sometime next year. Please bear in mind that we are not predicting a recession but that the odds of a recession have increased over the past quarter.

Recent economic statistics have confirmed that the U.S. economy has slowed down. What we don’t yet know is if the decline in credit availability and housing values will cause a decline in spending on the part of U.S. consumers. Consumers account for more than 2/3rds of our nation’s economy and any meaningful decline in purchasing will have a negative impact on economic growth.

One possible offset to the negative outlook for the U.S. economy is the vigor and health of the worldwide economy which, particularly in Asia, is continuing to boom. Will the health of the worldwide economy be enough to prevent the U.S. from entering into a recession? It’s a distinct possibility that only time will tell. We do believe that risk levels have increased slightly since the last quarter and that it is appropriate to increase the defensive component of client portfolios over the next quarter.

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