Market Commentary

Twice as Fast as That

July 2007

"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else — if you run very fast for a long time, as we've been doing."

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
- From Lewis Carroll, Through the Looking Glass and What Alice Found There

Sometimes it takes a lot of effort to stay in the same place. At other times, seemingly smaller efforts provide great velocity and lift, whether in our lives or in the capital markets. In evolutionary biology, scientists like to use the story of the Red Queen's Race, the culmination of which is quoted above, to explain how species need to continue to develop in order to just maintain their fitness relative to all of the systems and other species that surround them.

Economic and capital market cycles mirror cycles in nature. We have for the last several years been in an environment, happily, where prudent risk-taking has been very rewarding for your portfolios. Looking forward, we still think it is appropriate for you to continue to take risk in your portfolios. However, as part of the natural evolutionary cycle of risk and reward in the capital markets, we are entering a point in the market cycle where you may feel like you and your investments are running even harder and not moving as far along as you have gotten used to in the last several years. This is normal, and to be expected after a period of above-normal returns across many asset classes. We are here to help you navigate what may wind up feeling like a Red Queen's Race, on a course that may be a little trickier in the coming few years than it's been at any point since the early 2000s. We know the Red Queen's Race left Alice feeling breathless and dizzy; our approach aims to let you feel comfortable and confident in the way that your assets are invested.

Overall, we see risks outweighing opportunity in the markets right now. We see plenty of reason for a continued cautious stance in your portfolios. While the U.S. and international stock markets have continued steady overall, we note that volatility in these markets has continued to increase. Valuations in stock markets across the globe remain fairly high and historical studies show that it would be extremely unusual to experience above-average returns in the coming years given where market valuations are today. We wrote three months ago that the subprime mortgage debacle had not yet affected credit markets but that we thought it eventually would; the effect has begun to be seen in both the corporate and consumer credit markets, and the terms of the massive loans that are financing the big private equity deals are getting tighter. We think that eventually the leverage used to magnify the returns on subprime debt will create a magnified effect on the economy as much of this debt is eventually downgraded. Our overall conclusion is that a period of time in which investors and borrowers had access to cheap and easy money is coming to an end. This means that risk assets, including stocks and real estate, are somewhat vulnerable as this stage of the credit cycle comes to an end. We have therefore continued to encourage you to think long-term about achieving real returns in your portfolios by being invested predominantly in stocks and real estate, but we also currently have you placed predominantly with managers in those assets who are focused on the twin goals of market return and capital preservation.

We have noted that interest rates have spiked up on the long end. The yield curve looks normal again, and not because the Federal Reserve cut interest rates. The Fed has refrained from cutting short-term rates due to its goal of making sure inflation does not become more of a problem than it already is in the economy, even as the economy has slowed. The reason the yield curve looks normal again is because bond investors decided they wanted to get paid more for investing in long-term debt than in short-term debt. This of course has resulted in price declines in long-term bonds and has vindicated our decision to focus your fixed income investments on the short end of the interest rate spectrum. However, we now feel more firmly that we could be in a rising interest rate environment for some time. Going forward, the fixed income allocation in your portfolios will therefore focus even more on asset stability. This emerging higher interest rate environment will also impact the planning work we do for you.

Real estate as an asset class has corrected in price recently. While this decline impacted your portfolios this quarter, we think it is prudent that you stay the course and continue to hold your current positions. While commercial real estate valuations have gone down as a result of this market correction, the fundamentals remain strong for high quality diversified commercial real estate. We have weighted your real estate positions, as in other asset classes, with a manager who has a solid track record at preserving capital as well as generating return, so we are satisfied that your real estate allocations and specific investments are appropriate at this time.

Overall, we are running hard for you, perhaps to stay in place for now. And when the balance of risk and opportunity shifts in the markets back to a focus on opportunity, we will take advantage of that too.

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

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