Market Commentary

Finding the Top; Finding the Bottom

April 2008

"Then as now, people lost their heads at the top of a cycle and their nerve at the bottom." - James Grant

We write from our quiet offices here at Colusa and Solano with the sense that we prepared as intended for the turbulence the world is experiencing in the U.S. and foreign stock markets, and in the U.S. credit markets. We have expected volatility for some time, although we couldn't predict what it would look like or when it would come. And when economic and investment headlines move from the front page of the business section of the local paper to the front page – as they have in recent months - we know people begin to worry about the viability of their portfolios, as we have heard from some of you in the past month or two.

To put the current economic and market situation into context, what has happened in the credit markets is severe. After a period of time in which lending standards practically evaporated and money was lent to borrowers who wouldn't be able to service loans, the over-reaction in the credit markets is drastic enough that highly qualified people and businesses are finding it harder than it probably should be, and clearly more expensive than it was before, to borrow money. This has the impact of slowing economic growth and putting a damper on corporate and personal profitability. The Federal Reserve has responded to the end of this cycle with swift and strong measures to try to slow down the impact of such a rapid rate of change in the credit markets and keep liquidity in the borrowing markets, including taking some unprecedented actions with regard to lending directly to non-commercial banks as well as the more common and this time quite dramatic short-term interest rate cuts.

It will be some time before we can tell how the Federal Reserve's actions will contribute to changing the economic environment. Overall, the preponderance of your bond investments is in high quality, short- to intermediate-term fixed income funds, and we have a high degree of confidence that they should provide an adequate bond return and stability of asset value over the remainder of this credit market cycle. In the meantime, floating-rate debt has been hit much harder than anticipated; nonetheless, we think at this point it makes sense to continue to hold these positions in your portfolios. High quality credit analysis backs your core position in this type of debt, and it should respond well both to eventual economic recovery and to an inflationary environment. Municipal debt has also suffered from uncertainty and illiquidity in the credit markets.

On the stock side, as we have written about frequently during the past year and a half, we have thought that the U.S. and international stock markets were exposed to a fair degree of risk given overly optimistic viewpoints about company earnings. Risk has increased as a burgeoning amount of bad mortgage debt began to affect the housing market, the U.S. economy, and U.S. credit markets by the middle of last year. One old adage on Wall Street is that 'no one ever rings a bell at the top.' In retrospect, we now know the stock market rallies here and overseas in September and October 2007 marked a top in stocks.

And what of the ride down? Having located the market top, we are now spending time working to understand where the bottom will be, and we candidly report that we are not sure. However, as we wrote last quarter, we think that the next couple of quarters will see continued high volatility and uncertainty in the U.S. and international stock markets, and we think that the real estate markets will continue weak as operating performance is impacted in all these asset classes by a slowing economy and higher borrowing costs.

Commodity markets have not yet clearly reached their own top, but we are concerned that upward price action has reached a speculative pitch. We have now limited or eliminated this exposure in client portfolios as we are as averse to participating in buying panics. Where opportunity will lie in the long run is after many, many people have given up on stocks and real estate, and lose their nerve. When this happens, we know it will be time to increase our client's stock and real estate allocations, but until then we will continue to run your portfolios with the same degree of conservatism as we have during the past year. We do, however look for the day we will be able to seize more opportunity out there in the market; we don't believe that day is here yet.

As always, please call to get in touch as needed about planning or investment issues.

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