Market Commentary

Be Prepared

January 2013

"You see, but you do not observe." – Sherlock Holmes to Dr. Watson

Opinion has caused more trouble on this little earth than plagues or earthquakes." - Voltaire

The year in the U.S. stock markets started with a surge - because we didn't go over the fiscal cliff. Reports generally indicate that last quarter's earnings should be okay, and immediate employment and economic readings indicate that things are fair-to-middling.^[i] We're glad that a sense of calm has returned to the surface after the cliffhanger that was year-end 2012. But, like a sunny day before an earthquake, we aren't so sure how relevant today's headlines are to the problems we sense deeper beneath the headlines' surface.

We live in an investment world that is predominantly oriented to the short-term. When you go to an online finance page to look up a stock quote, the first chart that appears is how the stock traded minute-by-minute, today. In a world where value can be reasonably estimated and stands out as the only way to actively invest that stands the test of time, does today's trading range matter? While we look at prices every day, the more immediate information that happens to be available is not always the important thing on which to focus.

Here are a few things we are focused on: Unprecedented money-printing is being done around the globe. Economic and social policymaking have always been and continue to be key inputs into the health of the economy, and Washington, D.C. is more broken than it's been in a century. We are now thirteen years into the kind of long-term bear market that tends to last at least twelve but usually no more than twenty years, so even as things seem benign on the surface, we think there's more trouble ahead. High-frequency trading now comprises, according to a recent study out of Yale, over 70 percent of the daily volume of the U.S. stock markets^[ii] – meaning that 'flash-crash'-like volatility continues to be likely in the event of a more emotion-driven market. We think the doors have mostly closed to disruptive deflation – but the way this has been accomplished makes disruptive inflation much more likely down the road.

We don't know the timing of events that more immediately show these fault lines, but we know these fault lines are there under the surface. Your portfolios have therefore been built with a strong degree of something akin to seismic engineering upgrades to a house. Even if the big one is years off, those of us in the Bay Area can especially appreciate that even on a sunny day it is prudent to have our houses bolted to their foundations, and to have shear walls in place as well. We obviously can't guarantee that the earth won't shake or that our house might not need some repair if the big one comes, but we know we've proactively done what we can to avoid the worst. We think of your short-duration, high-quality bond positions, along with your carefully selected balanced global stock managers, as your seismic bolts and your shear walls. While they all won't outperform bond or many stock indices in a good market, we think they'll weather today's unseen crisis better in the end.

Your portfolios did well on an absolute basis in 2012. Heavy weightings in international bonds in countries where the managers saw long-term currency value performed quite strongly. As this value has become recognized, your international bonds did better than many stock investments. In another area of focus, your gold and gold-based holdings, investment performance was more mixed. However, we are maintaining or slightly adding to these positions as we see this as important insurance for your portfolios. Your global stock managers continue to invest prudently and either stayed competitive with global benchmarks or underperformed them. Longer-term, we think their strategy and execution remain solid, and we are not surprised by underperformance at this late stage of this rally inside a longer-term bear. We do continue to think that ownership of longer-term bonds and being more fully invested in stocks pose intermediate-term risks that today's headlines may not mention, but are quite real. Today, we still patiently watch for that to shift, and watch for an environment with more compelling asset prices that will allow us to invest your portfolio more fully without undue risk.

Happy new year, and we look forward to our continued work together in 2013!

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

i 'Stock Bulls Place Bets on Earnings Growth – Some Investors See Pickup in Profits for Fourth Quarter on Improved Economic Front; Questions About Revenue Worry Others,' Wall Street Journal, January 8, 2013

ii Frank Zhang, Yale School of Management, "High-Frequency Trading, Stock Volatility, and Price Discovery," December 2010, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1691679, and referenced in a broader article on high-frequency trading available at http://spectrum.ieee.org/computing/networks/the-microsecond-market/ 0