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

Sometimes, caution is not enough. With the benefit of hindsight, our cautious approach to the markets helped mitigate but not avoid the carnage that occurred during the 4th quarter of last year. Our 3rd quarter letter discussed the virtual certainty of a looming recession and opined that the only debatable issue was “how long and how deep”. We wrote our last letter right around the October lows in the equity markets and expressed a growing level of optimism for the markets based on valuations and poor investor sentiment. Fortunately, we did not (as we implied in our last letter) begin to increase your equity exposure. However, one of our defensive managers (Hussman Funds) did reduce his hedges which resulted in negative performance for the next two months and indirectly, resulted in an increase of your equity exposure.

Looking back, we did not anticipate the broad, worldwide impact emanating from the bankruptcy of Lehman Brothers in mid-September. The credit markets virtually seized up during the quarter. The credit spread is the cost of money between the best credit (US Government) and lesser credits (everyone else) widened to historic proportions. Despite massive government bank interventions, the availability of credit became almost non-existent. Much of the press has expounded on the massive declines in the equity markets. Many don’t realize that the credit markets, which are vastly larger than the equity markets, provide the fuel that drives the worldwide economy. Without the “lubrication” of credit, the economic machine begins to seize. The credit markets have begun to loosen up a bit but are still far from being back to normal.

You might well ask: Just what is normal? In the context of markets, does it mean a return to that which we have experienced for most of our lives (i.e. post – Great Depression markets) or does it mean something else? To us, that is the $64,000 question. By all of the normal metrics, common stocks are at near historic lows and the sentiment is overwhelmingly negative. Ordinarily, one can make a very strong case for jumping into the markets with both feet (as many market pundits have) assuming the world gets back to normal. We think that a good case can be made that, over the last four months, the world has dramatically changed and that the new normal will be different than the old normal and that a different set of spectacles will be necessary to navigate through this new financial environment.

The economic growth over the past 20 years was fueled by the opening of worldwide trade and plentiful and cheap credit. The cheap and plentiful credit part of the equation is gone; and what credit that is now available, will cost more. It is very disconcerting that the new administration is publically making anti-trade comments about our biggest buyer of government debt (China). This is an incredibly irresponsible position which we hope is not followed by further actions that may cause a trade war. The credit issue is enough to deal with; we don’t need to add more problems to our plate.

Corporations and consumers have greatly leveraged themselves over the past 20 years. We are now in the process of deleveraging which will not happen overnight. Consumer expenditures have declined substantially over the last quarter as savings rates have gone up significantly. For the long term, healthy savings rates are a good thing. However, 70% of the U.S. economy is the consumer and the economy retrenches when consumer expenditures decline. We’ve stated many times that recessions are a necessary part of a capitalistic system. This particular one will be deeper and longer than the past two and may set a record with the exception of the Great Depression. A depression is defined by a 10% cumulative decline in GDP. The Great Depression saw an economic decline of 30% and an unemployment rate of 25%. We think it is highly unlikely that we will come anywhere close to the levels reached in the Great Depression.

Predictions on the economy and markets are likely to be more often wrong than right as evidenced by the less than stellar track records of trained economists. Our guess is that we won’t see a bottom until late this year, if not early 2010, and we suspect that the depth of the recession will be deeper than expected by the current consensus – possibly touching the definition of a depression (minus 10% peak to trough GDP). Much of this is already reflected in securities pricing but we suspect, not all.

There have been many comparisons to the “Great Depression” – both with respect to the economy and the declines in the debt and equity markets. The big difference between now and then is the massive amount of government stimulus and a very pro-active government. We think that with the benefit of hindsight, it may be too much stimulus. Additionally, government intervention of this magnitude is almost guaranteed to result in one or more “unintended consequences”. Most market observers are opining on the fact that the equity markets are at historically cheap levels and that the three-to-five year outlook should result in outsized returns as things return to normal. Trying to predict market returns on a year-to-year basis is like trying to guess where the Dow 30 will be on 12-31-09 – pure luck if you’re in the ballpark. We prefer to take a probabilistic approach using three possible outcomes and assigning expected returns and probabilities. Although based on guesses and subject to the “garbage in – garbage out” phenomenon, it helps in framing ranges of expectations. Here are what we expect to be the three most likely outcomes for 2009:

1) The economy bottoms in the 2nd to 3rd 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 but at below optimal rates. 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%

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 make 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.

Leverage has been an increasing component in consumer and corporate expenditures and growth. This factor is finished as of 4th quarter 2008. The process of businesses and consumers de-leveraging will put a further drag on the ability of the economy to achieve optimal growth. The deleveraging process bodes well for the credit markets (given the current exceptionally high yields); however, aggregate growths in corporate profits are likely to be impeded. The heavy hand of new government rules and regulations result in higher costs on business further dissipating the growth in corporate profits. Additionally, the enormous level of stimulus and the rapid increase in transfer of wealth discourages capital formation and growth. Additionally, this high level of stimulus and redistributions will generate dislocations in our economic system and are likely to result in one or more unintended consequences.

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%

After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around the range that it currently is now. If things settle down, the environment for the bond markets will be favorable. Under any of the above scenarios, the equity markets would most likely set the stage for above average levels of returns when looking out over a 5+ year time horizon. We anticipate making modest changes to your portfolio by increasing your exposure to bonds and bond-like funds (i.e. Merger Fund) and plan on maintaining the defensive holdings in your portfolio as well. We anticipate that the volatility will remain high and expect to capitalize on opportunities as they present themselves.

We delayed sending this letter out so that we could update you on your January results. As you may be aware, this January ended up being the worst January on record with the S&P500 declining 8.3% for the month. As a comparison, your family-wide portfolios were down approximately by -2.41% for the month. We are pleased that the defensive holdings in your portfolios did their job in mitigating what could have been a more significant decline in the value of your portfolios. We are modestly optimistic that this may be a positive year for your portfolios. One key to this will be monitoring the trajectory of the economy and adjusting accordingly.

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 indices were essentially flat through August then experienced a precipitous decline of about 9% in reaction to the demise of Lehman Brothers, the Government takeover of Fannie Mae and Freddie Mac, the Federal loans of $85 Billion to AIG and the inability to pass the $700 Billion Federal rescue plan. The credit markets seized up as the Banks became reluctant to lend to each other. The speed and rapaciousness of the declines in the equity and debt markets surprised even the most pessimistic observers. The declines gathered momentum into mid-October when the S&P 500 declined by another 23% as of October 10th. Headlines announced that this was the worst crisis since the depression and that, in all likelihood, we were headed toward another depression. The G7 governments finally sprang into action by providing massive amounts of government credits and capital to help shore up the worldwide banking system. Most of the pundits who were decrying the end of a civilization, as we know it, are the very ones who opined a year ago that the sub-prime mess was nothing to worry about.

We have been negative on the markets and the economy for over two years and have held a portion of your portfolio in defensive issues. The damage that has been done to the equity and debt markets over the past six weeks has been substantial. We thought it would be helpful to take a step back and look at the “big picture” on the current environment and review where we might go from here. The closest historical precedent to the current credit crises was the S&L crises of 1989. The entire S&L industry collapsed which precipitated intervention by the Federal Government by the guaranteeing or purchasing of the real estate that precipitated the crises. The Federal Government allocated the equivalent of about 6.5% (1) of the GDP to contain the S&L crises. This would be the equivalent to about $910 Billion in today’s dollars.

In actuality, the government spent less than half the allocated amount. There was a fairly sharp recession that lasted for 9 months after which economic growth was sluggish for the next few years. Additionally, the S&P 500 experienced a 24.5% decline in earnings from 1989 to 1992. The 1990 recession was precipitated by excessive lending and declining home values (sound familiar?). The recovery was sluggish due to poor consumer sentiment; due, in large part, to the general perception of diminished wealth in declining home values. You may remember that by the mid ‘90’s, the U.S. economy experienced a period of prolonged economic growth up until 2001.

We have been forecasting that we would be in a recession for which there can be no doubt at this juncture. The principal question is how deep and how long? The U.S. is a $14 trillion economy and estimates are that the mortgage problems will ultimately cost about $1 to $1.5 trillion and will be spread among many governments and institutions. The sheer size of our economy and the government’s ability to print money should be more than sufficient to manage this problem. There will undoubtedly be dislocations and unintended consequences; there always is when the government intervenes. While the credit problems are system wide, the actual real estate problems are concentrated in three states (CA, FL and AZ) which account for ½ of the nation’s foreclosures.

As of October 10th, the S&P 500 has declined about 42% from its October 2007 peak, a figure that is comparable to other bear market declines. The valuations are also now at comparable levels of the bear market lows in 1990. One of our most bearish managers, John Hussman of the Hussman Funds, has recently begun to turn positive and has begun reducing the hedges in his portfolios.

Another anecdotal piece of information is that Warren Buffett has begun buying stocks in his personal accounts after holding treasury bills for a number of years. Here is an excerpt from his Op Ed piece in the October 16th New York Times:

“The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today, people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore, accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘I skate to where the puck is going to be, not to where it has been.’

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: ‘Put your mouth where your money was.’ Today my money and my mouth both say equities.”

While we are not proposing that one jump into the markets with both feet, we are saying that we see a light at the end of the tunnel, something we have not seen in a good while. There has been a very quick and sharp decline in the markets, investor sentiment and expectations are at historic lows and the general level of fear at an extraordinarily high level. We realize that these are very unsettling times but it is important to note that this is not the first “panic” in the markets (and likely not the last). There have been other “credit crises” and the world’s economies have recovered and prospered. There are likely to be some additional “surprises” and the news on the economy which will continue to deteriorate as the recession unfolds. Much of this bad news is already priced into the markets. We are not economists, but we wouldn’t be surprised if the economy didn’t bottom until 2nd or 3rd quarter of 2009. Markets always turn up before good news starts to develop, often six to nine months before an economic upturn. We are not saying that we are sounding an “all clear” siren but we are saying that we believe that the vast majority of the bear market is behind us, valuations are now attractive and that we wouldn’t be surprised to see attractive returns from the markets by this time next year.

The level of volatility in both the debt and equities markets has grown much higher than just last quarter. The recent VIX Index (the VIX Index implies the expected volatility in options contracts) almost doubled from it previous high of 45 in September 2002 to a new high of 81, a level that few thought would ever been seen. We anticipate that the levels of volatility will persist for quite some time, given the uncertainties in the economy, and that they will gradually come down as a modicum of comfort comes into the system. There have been many dislocations in equity and bond prices and we plan to make movements in you portfolios to harvest tax losses and to capitalize on what we see as opportunities. As the months progress, we may begin to reduce the defensive issues in your portfolio and increase your expected portfolio volatility.

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 headlines for this past quarter have been Oil, Oil, Oil! As you are well aware, oil prices increased by more than 40% over the past three months. While the equity markets rebounded from their lows of the first quarter in April and May, high energy prices became too much to overcome during the month of June and the equity markets gave back all of their gains and then some. The malaise of the markets spread to other worldwide equity markets most of which have suffered double digit declines during the first half of this year. This has been one of the toughest markets I’ve experienced in my 39 years of portfolio management.

As we mentioned in the last quarterly letter, our expectation that we are or will soon be in a recession is more likely given the “tax” of high energy prices. In addition, the lesser availability of credit, high energy prices and increasing unemployment will eventually take their toll on consumers. Since consumer expenditures comprise 70% of the U.S. Gross Domestic Product (GDP), it’s highly likely that the overall economy will experience a decline in output as consumers retrench. Recessions are a normal part of the economic cycle and the “stimulus” measures emanating out of Washington only serve to delay (and likely exacerbate) the inevitable.

For the past 30 years, the securitization of debt and other innovations in the financial markets have resulted in dramatically easier access to capital and a correspondingly huge increase in overall debt. Three decades ago, a $1 increase in debt would generate about a $1 increase in GPD. This ratio has consistently declined over the years to where it now takes in excess of $5 in new debt to generate a $1 increase in GDP. The current credit crises has substantially affected the availability of credit to both corporations and individuals. The banking system will need time to recover from the sub-prime mortgage crises and banks are unlikely to ramp up their lending programs for quite a while. In fact, we believe that we are in the early stages of a national de-leveraging process that will take many years to play out.

While a lesser level of debt is beneficial to the nation as a whole, the process of de-leveraging diminishes growth and can put strains on the economy. Therefore, we anticipate sub-par economic growth in the economy for the balance of this decade. Offsetting this rather bleak outlook is the prospect for growth overseas as the developing nations continue to experience levels of growth that the developed nations can only dream of. Additionally, weak periods in the markets ultimately create opportunities for the future as valuations decline to very attractive levels. While we believe that it is a bit early, many of our value managers are beginning to see more and more compelling bargains in the equities markets.

The equities markets (S&P 500) are currently within a fair value range of about 15 times earnings. While that valuation standard alone would call for an increase in portfolio allocations toward equities, we have some concerns about the earnings side of the equation. Corporate profit margins and earnings are at historically high levels and are well above the normalized range of corporate profits as a percent of GDP. Over long periods of history, this ratio has a strong tendency to revert to the mean. If this holds true, it would imply that there is going to be disappointment with the level of corporate earnings for the balance of this decade. Were there to be any significant overall earnings decline, today’s “bargains” may become even cheaper.

The level of volatility in both the debt and equities markets is much higher than this time last year. We anticipate that the levels of volatility will persist for quite some time given the uncertainties in the economy, debt markets, and an election year. Higher volatility tends to lead to a higher level of emotional reaction on the part of investors. A bright spot in the market environment is that the current level of investor sentiment is near historically low levels. Investor sentiment is a contrary indicator that usually indicates that when pessimism is greatest, the market may be near a bottom. This may imply that there may be conditions for a short to intermediate term rally, particularly should oil continue to drop in price as it has the past 10 days. While we are still very positive about the prospect for energy prices over the next 3 – 5 years, we do think that $125+ oil prices are a bit ahead of themselves. We would expect a strong rally in the markets should oil drop to around $100 / bbl in the next few months.

These are particularly challenging times to find attractive places to invest where the returns outweigh the risks. As we mentioned in our last letter, “we believe that the challenges of the next 12 months warrant a greater focus on the return of capital than the return on capital”. We plan to continue maintaining the defensive issues in your portfolio and to make gradual, opportunistic shifts toward a more “defensive” side of the equation until such time as we see a more favorable risk / reward outlook for domestic equities.

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

Quarterly Review & Outlook

We have previously expressed our concerns about the rising levels of risk and volatility in the broad averages that have been caused by the disproportionate influence exerted by the technology and internet sector. The overwhelming majority of the gains attributable to the S&P 500 and NASDAQ are attributable to a relatively small number of technology related companies. By definition, many of the companies included in the growth indices are technology related. The following is a table detailing the performance for the year and the 4th quarter for growth vs. value indices in both the large cap, mid cap, and small cap sectors.

The table above illustrates the disparity in returns between growth and value sectors irrespective of the capitalization range. The overweighing of technology companies in the indices skews the returns of the broad averages. Even though the S&P 500 generated a return of 21% for the year, the majority of the 500 companies that comprise the index experienced declines for the year in their share price. The divergences in values between technology and all other types of companies are at an historic level. On the one hand, many technology companies are selling at historic price to earnings multiples and those that have no earnings are selling at ludicrous multiples in relation to their gross sales. Meanwhile many high quality, growing, “unexciting” companies are selling at or below normal valuation ranges and in some cases downright cheap. This has become the most bifurcated equity market that I have seen over the past 30 years and is a phenomenon which is most likely unsustainable.

We are also concerned about the increase in interest rates. During the last quarter, interest rates have risen by 1/3 of a percent to levels that have not been seen since 1997. In the past, a rise of almost 40% interest rates over a year and one quarter would have had very negative implications for the equity markets. Thus far, the market has been immune to this rise in rates. However, we believe that should rates continue to rise they will ultimately exert a negative impact on the equity markets. There are numerous and adequate values in the equity markets, however we do not believe that there is much value in the “technology and internet” sector. We are quite encouraged by the fact that the mid cap and value sectors have had recent periods of out performance relative to large cap and growth indices. We think that there is a likelihood that the valuations in these areas are compelling and that there will begin to be a flow of funds into the mid cap and small cap sectors.

We are continuing to maintain a somewhat defensive posture in client portfolios. We are continuing to maintain an emphasis in the mid cap and the small cap sectors of the equity markets as well as a healthy level of international exposure in client portfolios. We also anticipate the volatility will continue to increase in the equity markets, particularly should interest rates continue to rise. We hope to capitalize on this volatility and, as always, will seek to obtain attractive risk adjusted rates of returns for client portfolios.

We remain optimistic that the year 2000 will continue to provide opportunities for your portfolio. We hope that you are pleased with the performance for 1999 and once again, wish to express out thanks for the trust and confidence you have placed in us and our services. As always, should you have any questions concerning your portfolio please do not hesitate to give us a call.

Sincerely,

James A. Martin, III