Quarterly Newsletter – April 2009

We would like to start out by saying that this letter will not answer the big question – “when will it stop?” It would be comforting to believe that this question is answerable. Perhaps that is why we are susceptible to articulate (or loud) hucksters who claim to know. But deep down we understand that it cannot be known.

It is of course obvious that we are living through and witnessing history. One reads about big events in the past, such as the revolution or the depression, and wonders what it was like to live through them. We are doing so now. The market fall from October 2007 through February 2009 (17 months) has been greater than the fall for the first 17 months of the depression, and therefore the worst 17 months since at least 1926 (as far back as our data goes). The five weeks ending April 10 of this year, in turn, have been the best five weeks since 1938. And of course there is absolutely no telling if the current market fall is over or will return for greater horror.

It is impossible to live through this and not be stunned, and more than a little terrified. Does this market collapse mean there will be another depression? And if so, what would the consequence be – and what is the best way to think about and deal with this?

There are, of course, parallels with what happened in 1929 and today. Both then and now events can be described as a reduction in aggregate demand (total spending), itself caused by a collapse in confidence which was/is in turn caused by a stock market fall and subsequent financial turmoil. The stock market drop in 1929, however, was followed by two gigantic policy errors. First: the Federal Reserve allowed the money supply to contract drastically. They failed (refused, actually) to defend the banking system from the panic and runs that followed the market fall. This failure meant a further reduction in confidence and also a loss by employers of their payroll and working capital. Companies by the thousands were forced into liquidation. The collapse in the money supply lead to huge unemployment and deflation, which in turn overwhelmed debtors and drove the economy down. Second: the process was worsened by the Smoot Hawley tariff, which helped spread the deflation world wide. The U.S. deflation was also violently radiated around the world by the monetary contraction forced by the gold standard. It was only when Roosevelt came in and immediately devalued the dollar against gold, thus expanding the money supply and aiming explicitly at reflation, that the deflation was countered and recovery started. Thus: two gigantic policy errors, neither of which is being made now and both of which the government is aware of and is determined to avoid. (The above summary of the depression is from a paper by economist Christina Romer, current head of the Council of Economic Advisors. We have it if anyone wishes more details.)

The recent actions by the Fed, in which they announced a policy of quantitative easing, using newly created money – money not borrowed but freshly created –to buy both mortgage debt and long term government bonds, are very aggressive actions. They are aimed at reflation; designed to increase the base money supply (cash plus bank reserves) and thus raise both spending and prices. The Fed wishes to change expectations – to replace deflationary expectations with inflationary ones. They are trying to find a middle way, a soft landing with some inflation and some recovery of spending and employment. But if the choice is only between the deflation of the 1930’s and the inflation of the 1970’s, the Fed will take the inflation – and they have plenty of fire power to do that. They could, for example, explicitly state that they have moderate inflation as a policy goal – and that they will do whatever they have to do to get it.

Which way will things go? Again, we really don’t know – but as always there are two primary risks investors face – volatility and inflation. We do know that these two risks will always exist. Bear markets happen. Our emotions cause us to focus on the volatility (losses) but logic tells us that the short term volatility must, in an efficient market, produce higher long term gains. Logic also shows us that for the long term investor, which you are, inflation is the bigger risk. Don’t let your emotions distract you from the risk that your portfolio will not keep up with the rising costs of goods and services – that risk is paramount. The conundrum is that the investment solutions for these two risks are diametrically opposed – bonds for stability and stocks for inflation. Your portfolio is a compromise between these two choices, as determined by your financial plan and risk tolerance. Our rebalancing method is designed to maintain the chosen balance, and so to take advantage of the emotional swings of the markets.

Dalbar, an organization that studies the consequences of emotional investing, has released their most recent study on investor performance. They estimate total returns for the average mutual fund investor and compare these to the returns of the market. According to Dalbar the average equity fund investor had average annual returns of 1.87% per year over the past twenty years, thus underperforming the S&P 500 by 7% a year. This is an amazing number. Seven percent per year, compounded over twenty years, is a lot of dollars. And these dollars were left on the table by investors who had to do no more than simply buy and hold an S&P index fund for the entire time – no fancy stock picking – no market timing – avoid the avoidable errors – just sit and sit and sit. Instead they did the opposite, selling on fear and buying on greed.

The past 17 months have been a test of us and our methods. The markets have been falling and we have been adopting the optimistic view that one day the market will turn. This optimism is forced on us by our method. You hire us to behave well – on your behalf – in the stock market – and that is what we do. We avoid the avoidable errors. We do not panic. We rebalance. We sell what does well and buy what does badly. Basically this has meant selling bonds and buying stocks. At a time when pessimism is the word for the day we are the optimists. Our single bet is that market capitalism will survive this and the markets will recover. At a time when most market participants are nearly paralyzed by fear and are therefore selling stocks to buy bonds, or just holding cash, we are buyers. This is our method and discipline. We have done many rebalancing trades in the last 18 months, many more than at any other time in our experience. The bet is that the markets will recover one day. When it does these trades will pay off. We are living these big events with you. We are making history together.

Jim & Dean