Market Commentary

In All Things Moderation

October 2007

"Whatever you do, do it in moderation" - Proverb

Over the course of our lives, we all bear witness to occasional extreme situations in our world. We grapple with understanding the magnitude of them, what they mean, and what to do about them. A terrific contemporary example of this which much of the world shares is the phenomenon of climate change – the situation seems extreme, and we are struggling with assessing the import of this phenomenon and determining what we can do about it. Other extremes are more particular - each of us may have faced an extreme situation in our lives in the past year or two, and in similar fashion, we have struggled with interpreting its meaning and what to do in the face of it.

In our work in the capital markets and in your portfolios, the dynamic is similar. We have seen some unusual things in the markets over the past several months, and we have worked hard to interpret their meaning and act appropriately for your investment portfolios.

Just three months ago we were writing that we thought that money had been too cheap for too long, and that the subprime mortgage issues would ultimately have a meaningful impact on the economy. We thought there was a needed cyclical correction coming in that too much money was chasing too little return – and that this extreme situation would ultimately revert back to a more regular situation. Little did we know that just a week after sending out this assessment, a swift credit market correction would occur over just a few weeks. While we were directionally on target, we (and the world) were surprised at the speed with which the correction occurred. Banks, central bankers, and credit portfolio managers (including the ones managing your fixed income positions) around the world have responded responsibly and thoughtfully to the speed and depth of this correction, and to the partial rebound which has also occurred in the credit markets. Stocks have recovered more than lower quality bonds generally, and in early October in fact surpassed earlier highs.

Our thinking now remains the same as it was three months ago, which is that we will have a major slowdown in the U.S. economy as a result of a significant bolus of bad debt having to work its way through the economy. This will in turn most likely affect the valuation of your stock and real estate investments, as well as the earnings of the companies in which you are invested. This is why we continue to have you exposed to more shorter-term, high-quality fixed income positions than you have previously been in your portfolios. This is also why we continue to have you meaningfully exposed to stocks and real estate, but weighted towards managers who focus on capital preservation at the same time as capital appreciation. While we sense that the market may become unsettled, we don't want to market-time you out of the market.

Some interesting analytic work has been done around market timing. Switching your assets from one asset class to another, or never changing your mix of assets, have been shown over time to not work as well as a moderate amount of market-timing, or tilting your assets in one direction or another.² That is the advice we consistently offer in our management of your assets. Weight fixed income a little more heavily now, and wait until a later time when opportunity is better to move more solidly back into U.S. or internationally-based stocks, depending on how this next period unfolds. As with many things, market-timing in moderation is healthy.

In October 1987, twenty years ago this month, the S&P 500 corrected 21% in a single day. This was an unanticipated and unprecedented event that has since been the subject of much hindsight analysis. The often-overlooked fact alongside this analysis is that over the course of the entire year 1987, the performance of the S&P 500 was basically flat. We see a few important lessons to glean from these two facts put side by side: Don't react to what happens in a day, but to what unfolds over a period of time. Don't try to time the market based on short-term movements but be willing to tilt asset allocation from time to time based on what you think could unfold in the intermediate term. Do stay invested because you don't know what day the market will be up or down. Expect the value of stock-based portfolios to go down meaningfully and up meaningfully from time to time over a short period of time.

The most interesting fact to us is one of measurement twenty years later. Even from its 1987 peak, in the past twenty years the very same market benchmark has gone up 357%. While we don't know what will happen in the market over the next many days, and while we know the value of your portfolios could certainly go down over a short-term period, we are convinced that over the next many years stocks and real estate will remain excellent long-term investment vehicles.

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

² "In all things moderation, including market timing," New York Times, July 29, 2007