Market Commentary

Knowing

October 2010

"There are those who don't know, and those who don't know they don't know" – John Kenneth Galbraith

We have recently spent time focused on the effort of defining what we do not know, and making sure your portfolios are positioned for a wide range of potential outcomes in the coming years. At more than any point in our careers, we think these potential outcomes - and their impact on your portfolios - have never been so varied. We don't know the exact path of the economy or the markets, so we want to be both careful and flexible.

Since we last wrote, it continues to be apparent that we are in a second-stage economic slowdown in the U.S. We are glad the economy stabilized after such a sharp plunge across 2008-2009, however we are not sanguine about the prospects for steady economic growth here in the U.S. In fact we think that corporate profits, which rebounded on cost-cutting measures, have peaked for awhile and aren't likely to reach higher for some time. However, the policy of the Federal Reserve in the U.S. and indeed of central reserve banks around the world has become increasingly clear: they will take truly extraordinary measures to stop the specter of deflation. This is a force that has clearly been at work in our economy and in other developed economies around the world. This means that while we expect the fundamental performance of the economy to be weak, we could see our economy in continued deflation, stagflation, or inflation. The picture is simply not clear.

The market has rallied substantially from its bottom. This rally and fragile economic recovery has given whole swaths of investors confidence that stock market investing is fine again. Stocks don't seem so very expensive, but they don't seem so very cheap, either. We are reminded now of the year 2007, when the market looked healthy enough on its surface, but there were significant fundamental economic problems underneath. So, as happened in 2007, the market could go materially higher. However we think the bear market is still out there, and likely to show itself clearly again. We think the overall trend of both up and down volatility will continue for the next several years. Because of this, we have prepared your portfolios to be as stable as possible in a continuing bear market, while retaining exposure to longer-term upside.

Your portfolios have been built to be flexible and to withstand a number of potential shocks. During the past five years, we have continuously researched and gradually placed your capital with managers who are philosophically aligned with our thinking, and who are experienced and disciplined at investing in more than one kind of investment - more than one asset class. This shift has been accomplished one investment at a time, really picked up steam in the fall of 2008 as we realized the world and the markets were shifting dramatically, and is now essentially complete.

Why do we structure portfolios with so much internal flexibility? Think of it as a team working to get you to your destination. All the managers we choose deeply share an investment philosophy that is like that of North Berkeley Investment Partners. Each is making different specific decisions in their portfolios. The result is a set of managers who are working in different parts of the stock, bond, currency and commodity markets across the globe with flexibility to go where they think the opportunity and the defense is, both. We think this team, all working for you, has and will lead you to opportunity, while they proceed with caution when they think it is warranted. To this end, we note that when prices fell in the stock markets here and around the globe during the summer, your managers were somewhat opportunistically buying stocks, while they have recently begun to sell as some of their holdings have hit price targets.

We have made a meaningful shift overseas in your portfolios over the course of the last two years. Non-U.S. stocks now are about half of the stocks in your portfolio. Moreover, the U.S. stocks in your portfolio are tilted towards large global franchises that sell overseas to growing markets - a global opportunity with a US base. This year, importantly, we re-established a significant international bond allocation in your portfolios. Another issue knit into your portfolios is that of the weakening of the U.S. dollar, and the impact of inflationary economic policy on the U.S. investor: direct investments in gold and foreign currency are held across many of the funds you own, and many of your international investments have been made with a point of view on the value of their related currencies, as well. We expect to continue to shift you incrementally overseas.

Three years ago on October 12th the market reached its all-time high. From that point until now, the performance of the great majority of our client portfolios is flat to down by single digit percentages. The S&P 500, however, remains off 25%. There is a quip around the investment world: "Flat is the new up." While this is good for a laugh, we continue to focus not on performance of a general basket of stocks but on positive performance over time regardless of the market: we think UP is the old and the new up. We consider our efforts for you a success only if we get you to your long term positive return target. We remain focused on this, and confident of the long-term investment goals we have set for you, even though there are some important things that we know we don't know.

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