Market Commentary

Beating the Bear

July 2010

"You can beat the bear once, but never the same way twice." – John McKay

We write well into what we think is a long bear market that started ten years ago and is likely to last for several more years. What is a bear market and why is it called that? In the financial world, a bear market is defined as an extended period of price declines. The term 'bear market' references the way a bear attacks its opponent: a bear swipes down from high to attack (a bull, by contrast, moves its horns up from below). Bears are clever, and are skilled at getting what they want. As an example, bears in Yosemite National Park have over time favored a specific profile of car to break into as they search for food.i

So, it is hard to beat a bear, who is big and focused and clever and attacks from above, and we do think it's likely that you can't beat a bear the same way twice. What does this have to do with your investments?

Last fall as the market rallied, statistics that measure economic activity indicated an economic recovery. Many thought the crisis was over. We noted talk of inflation and worries that we were off to the races and possibly needed to become more fully invested in the stock market. We thought and wrote to you then: not so fast.

In the past few months, it has become more apparent that we continue in a period of slow economic activity. Government stimulus, some of which is coming to an end, hasn't been able to completely compensate for deflationary forces at work in the economy. Loose credit at the federal level hasn't translated into banks getting looser with their tight standards in the private sector. Hiring of census workers dampened the severity of the unemployment numbers for a period of time; as that time comes to an end, unemployment forecasts are worsening. The "cash for clunkers" program didn't lead to a sustained recovery in auto sales, and the first time home buyer tax credit has not led to a more sustained recovery in the housing market. Retail sales are down the last two months running. The price of things is in fact now going down: the Consumer Price Index, what it costs folks to buy things, and the Producer Price Index, what it costs companies to make things, has gone down two and three of the last months respectively. The continued slow economy and deflation are now measureable. What some people have called a 'double dip' recession is in our opinion an actuality.

After a market rally like the one we saw over the past year and an increasingly negative economic outlook in the cards, we anticipate continued volatility. The market is down about 10% since its peak in April, and we wouldn't be surprised to see further erosion in prices and a return of the bear.

What does this mean for your investments? We have you positioned somewhat conservatively but also somewhat opportunistically. At this point, stocks for most clients don't make up even half of the portfolio: the majority of your investments are in bonds, cash, and gold. Yet you are also positioned somewhat opportunistically because a significant portion of those bond, cash, and gold investments are held in the funds of managers who can, will, and do have good track records of shifting investments from one type of asset to another when they see opportunity at the right price. As an example, many of your managers right now are more defensively positioned than they have been in the past eighteen months: they have let cash build in their portfolios, or have decided to own bonds for yield rather than be more fully invested in stocks, or they have allowed their gold positions to drift up in value.

How to beat the bear when it returns? Partly by being less invested in higher volatility assets such as stocks after they have risen, despite the fact that the specific stocks you own may represent solid businesses that will survive and thrive through this time. When opportunity comes, it may be cheaper prices on those same companies or cheap enough prices on other quality businesses, or it may be another period when market sentiment drives down the prices of bonds, making them a more interesting risk-adjusted investment than common stocks. In early 2009, in the midst of the period of panic selling, some of the managers you were invested with bought bonds at very steep discounts (as an example, one manager was able to buy bonds yielding over 20% for the bonds' years to maturity; when the market returned to normal the same bonds paid around 8% to maturity).

Last year you benefited from investments made opportunistically in the period of panic. What will beat the bear the next time? We don't know. We are nevertheless confident that the management teams running your assets have the discipline, patience, and experience to make prudent decisions with your money as we all move forward.

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

i"Selective Foraging for Anthropogenic Resources by Black Bears: Minivans in Yosemite National Park," Journal of Mammology 90 (5): 1041-1044, 2009

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