Market Commentary

The Pull of History

October 2011

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." – Alan Greenspan

We are through a bumpy summer and now into what will likely be a bumpy fall. Telescoping in on our current market situation, a mass of very contradictory data doesn't offer illumination other than to allow us to predict continued volatility. U.S. and international authorities' open encouragement of elevated risk-taking has been followed by many investors over the past few years, yet many investors are also quick to move yo-yo like between perceived risk and perceived safety.

Interest rates are as low as they have been in three generations. However, the money supply has grown so dramatically, particularly in the last six months, that significant inflation inside the U.S. looks inevitable, following significant inflation hotspots outside Europe and the U.S., even as the timing is quite uncertain. The U.S. economy has weakened significantly and we think will continue to slow. Yet, corporate cash levels and profits are at record highs. We wrote during the past two quarters that the market seemed vulnerable and ripe for correction. While we have been right on that count, stocks in general still seem reasonably priced, especially following the recent decline. What to do?

What the pull of monetary and fiscal policy makers has produced in collaboration with the markets in the U.S. during the past few years is a kind of neap tide. In the oceans, a neap tide is the especially weak tide that produces the smallest difference between low and high tide. It occurs because the gravitational pull of the moon and the sun counteract each other. It is not that the tides are not there, but they are held in check by one another.

The neap tide is contrasted by a spring tide. A spring tide is when the gravitational pull of the moon and the sun are aligned, and together they produce both very high and very low tides. Taking a step back from more current economic readings that represent neap tides, we see reasons to continue to be cautious and to be on the lookout for an environment that we think will be likely to produce spring tide-like extremes.

Europe is a big problem. Sue met recently in New York with some of your fund managers and she was struck by how seriously they take the developing monetary and financial crisis. They expect Europe to move in a somewhat orderly path similar to U.S. actions taken in fiscal crisis during 2008-2009, but are also hedged against the possibility that European monetary and economic union fails.

Here in the U.S., we are faced with significant erosion of all public finance, and bipartisan agreement on large cuts in federal spending - the opposite of two years ago. The long-term viability of Social Security and Medicare is under threat, and there is significant underfunding of corporate and state pensions, just as our population skews older. Developed world currencies and bonds are full of risks that become clearer every day, even as they are seen, to a certain extent, as the safest alternative in a world that feels less safe than it did just a short time ago.

We are eleven years into a long-term bear market that we think will continue for some time. Looking both short- and longer-term, we anticipate spring tides to come. There is a kind of spring tide that is particularly strong when the moon is unusually close to the earth. These tides are quite dramatic, even as they are predictable. As with the natural cycle of tides, we anticipate more dramatic upcoming parts of this bear market cycle in the coming few years. We realize that as this occurs, even as we anticipate their potential arrival, their volatility can still feel surprising to you. We have and continue to shape and monitor your portfolios with an expectation of these types of market moves, and think that they are well prepared for this type of environment.

Overall, we continue to emphasize a balance of dollar and non-dollar assets, with sensible hedges in place. You are invested in stocks for long-term growth and inflation protection; but not overly so. Portfolio stock exposure has been carefully selected for quality of financial situation and cash flow, and leans heavily towards defensive industries that weather economic downturns well. Your bond investments are short-term and a mix of opportunity and quality that we think will produce real yield. This is important because in an environment with just modest inflation and very low interest rates, standing still can mean you are falling behind in terms of your overall purchasing power. We are emphasizing gold more than ever in your portfolios, as a general hedge but also as a counter to currency debasement around the world. We are particularly interested in developing market investments in both the bond and stock markets, when they can be acquired at the right price.

While the near-term readings for the economy and the markets are never clear, we continue to pursue longer-term opportunity with an abundance of caution, and expect to do so for the coming few years. We are still playing offense but ever more defense as the economic and market situations evolve, so we can work to preserve as well as grow your capital during these confusing and difficult times.

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

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