Quarterly Newsletter – October 2005

As your asset class performance report shows, the markets have done well over the past twelve months. Indeed, they have done well since the recovery began in March 2003. Since that date, your account is up substantially.

At the same time, there is this tone of weakness, and even of fear. Right now things feel very negative. Iraq, budget deficits, global warming and terrorism all loom. While strong over the past twelve months, the markets have weakened considerably in calendar 2005. It is the perennial question of investing. Are the markets strong or weak right now – and will they go up or down?

We, of course, remain silent as the Sphinx on this issue. The headlines have been gloomy for more than two years. Investors have been waiting for long-term interest rates to rise, and for the market to fall, ever since the Fed began raising rates more than a year ago. Anyone who waited to invest until the news improved is still waiting, and has missed a very big bull market. We did not miss it, and neither did you.

But the emotions – the headlines. This is the hard part. It is so hard to absorb, to really absorb, the idea that the press is not a good guide to investing. No matter how often the press is wrong, we all read it and simply cannot ignore what it says. The press is not a good guide when it is pessimistic, like now, nor when it is optimistic, as it was in the 90s.

The markets are a contest between the bear case and the bull case. The problems we face are the bear case. The opportunities are the bull case. When the headlines are full of only one side of the contest it is difficult to remember that there is another side. In the 1990s the headlines were full of technological breakthroughs, internet triumphs and a brave new world. It was hard to remember that the internet might not provide huge productivity gains or that there would almost certainly be a consolidation with fierce cost cutting and consequently falling stock prices.
The opposite is true now. With all the problems of the world presented to us, one has to work hard to state the bull case. It is there however. In the broadest terms, the bull case is the gradual rise of democracy and free markets all around the world. Nations go to these institutions not because they necessarily like them, but because no other institutions can manage modern and complex economies and societies. Japan is successfully reforming. The E.U. will reform. The U.S. will eventually face and deal with its financial difficulties. China and others are being dragged along.

Many investors fail to take the long-term view. They follow the latest headline or the latest performance statistic. No matter how often investors are told to not chase returns, they go right on doing it. The fund service Morningstar ranks funds based on performance. Money floods into the funds with highest ranking in the face of persuasive research that this method does not work. Excess returns (returns due to a manager’s skill or luck) do not persist – but the most common question asked prior to investing is – how well have you done lately? The manager, fund or asset class that has done well lately gets the bulk of the money. It is an unstoppable force of nature. Excess returns do not persist. It seems a simple idea. It only takes five words to say it. But it is not understood or believed.

Our method benefits from the above mentioned irrationality of investors. We thrive on it. We trim what the return chasers are buying and buy what they are selling. We, and you, represent the opposite point of view (bull or bear) from the general tone of the media. We are on the other side of the trades of irrational and emotional investors.

In the past year, the assets that have done the best have been the international small stocks and the emerging markets. These are the riskiest areas of the markets. Bonds have done the worst. In other words, despite the gloomy headlines, markets have been risk seeking – looking to move money into more risky areas and out of safer areas. And as usual we have been going the other way. We have been trimming emerging markets and international small stocks and buying bonds. This is the rebalancing method in action.

But we are not betting. We are just rebalancing.

The markets have been strong since March 2003, in the face of persistently worrisome data and headlines. Listening to the headlines since 2003 would have kept you out of the market, and you would have much less money than you do now. The markets are always the balanced stand-off between the bull and the bear case, and it is impossible to consistently predict if they will continue to do well or will fall. Doubtless they will do both. Listening to the headlines, or to your own emotions, is a mistake either way.

Dean & Jim