Market Commentary

A Polar Bear Market

January 2010

"The art of being wise is the art of knowing what to overlook."
- William James

Why, how, and when does great change happen and what accompanies it? We have been thinking about this a lot as we've stewarded your portfolios through the recent extremely volatile market environment. In our thinking on this issue, we have been influenced by studies of the natural world – of earthquakes and avalanches – as well as those of the social world – of political transformation and rapid changes of fortune in the financial markets.i

Volatility accompanies change. A growing blanket of snow or pile of sand that appears stable nonetheless contains core pockets of instability that shift and grow until at times a last small shift occurs and a great change is effected. This is true in nature, in politics, and in social realms. When these shifts occur they are unpredictable, and the subsequent impacts and reactions can also be dramatic, going significantly in one direction before shifting and moving in an opposite direction.

We find it interesting that in lay discussions of 'global warming' a more comprehensive linguistic term has recently been adopted, that of 'climate change.' This is the result of a growing recognition that changes in global climate systems could lead not just to an increase in temperature, but to volatility and uncertainty of all kinds in the weather and in temperature. This includes the possibility, paradoxically, for global cooling as well as global warming. Somewhat surprisingly, potential outcomes of climate change could in fact favor polar bears, reversing the common expectation.

And so it goes in the financial markets. We have had an unusually volatile few years, both down and up. This volatility came because there was a fundamental instability underlying the world's financial markets – too much capital was allocated irrationally and in a riskier manner than was acknowledged in markets across the globe. This continued incrementally, and over many years built to a crisis point in 2008. At that moment there was a great shift in perception of risk, and a lot of volatility was the result.

In the context of that volatility, we were able to limit clients to significantly reduced portfolio losses during downward market movements, but capture a majority of the upside as the market rebounded. It is the most stressful part of the full market cycle to live through, but as Bruce Berkowitz, the manager of the Fairholme Fund has said, "we make our best money in bear markets. We just don't know it at the time." ii

What next? About two and a half years past the first shocks of subprime mortgage failures, volatility levels in the U.S. stock market recently declined back to their pre-crash levels.iii It makes sense to us, therefore, to ask if the volatility has diminished to the point that it makes sense to rebalance a heftier part of your portfolios back over to stocks. We don't think so – because we feel that we are still in the process of dramatic changes and the possible reversals that follow such change. In financial terms, we believe we are in a long-term bear market that over history has commonly followed a great end-of-bull market shift.

Philosopher Søren Kierkegaard noted that "life can only be understood backwards but it must be lived forwards." We realize that many investors may be more cautious than they were before because they are indeed looking backwards. English economist Arthur Pigou rightly pointed out that following a crisis such like the one we have had, an important change occurs: "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant."iv

Looking forwards, we think that the long-term bear market will continue for some time. It has been born of significant "global financial climate change" that is connected to, more than anything, the deleveraging of the consumer and the corporation and the leveraging of governments all over the developed world. This does not mean, however, that we are pessimistic about investment opportunities available to you during this time. We cannot predict immediate outcomes, either positive or negative, but we have positioned portfolios to take advantage of opportunities that arise for investors who remain focused on value, cash flow, absolute return and not necessarily going with the crowd, especially when the crowd is in a panic. We see today's market as not only a bear market but as a polar bear market.

Your portfolios maintain a high degree of flexibility to seize opportunity as it becomes available. Recently in your portfolios, many mutual fund managers have been increasing their cash holdings, as well as shortening the time horizon of their bond positions and maintaining or upping their stakes in gold. When the time is right, they will take opportunities that arise in markets where they too anticipate dislocations in response to the dramatic changes financial markets have been through. We will also continue to tilt your investments more internationally across the stock, bond, and real estate asset classes - a process that began in 2008. We will at the right time look to expose you increasingly to investments that will do better in an inflationary environment, but think that the necessity of doing so is still at least a year off.

We remain focused on helping you achieve your long-term investment and financial goals, and look forward to being in touch.

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

iA good review of the cross-currents in both the physical and social worlds is Mark Buchanan's Ubiquity: Why Catastrophes Happen (New York: Three Rivers Press, 2000).

iiSeptember 30, 2009 conference call; transcript available at

iii See a recent price history of ^VIX, the measure of the S&P 500's expectations for near-term volatility in S&P 500 stocks, 2007-2010, available on Yahoo! Finance.

ivCited in James Grant's essay in the Wall Street Journal, "From Bear to Bull," September 19, 2009.

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