First Quarter 2010

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