Market Commentary

Two Plus Two

May 2010

"Today is the tomorrow we worried about yesterday." - Author Unknown

"When speculation has done its worst, two and two still make four." - Samuel Johnson

We mailed out our last letter to you, 'Between Storms,' in late April, and soon thereafter the capital markets around the world ran straight into a doozy of a storm. We write with an update on recent events in the markets and the re-emergence of concerns about the health of the global economy. We feel that today is indeed the tomorrow that we were worried about yesterday.

It is not one thing that makes for a turn of the market as powerful as we have seen over the past several weeks, but an accumulation of things. Some of these things are material and some are more psychological (and therefore, we might argue, also material). First, and most importantly, the countries of Europe that took on too much debt during a time when too much cheap and easy credit was available to them are in danger of failing financially. In response to this, other countries who also share their currency who are financially more stable are going to put up funds to help them get through having taken on too much financial risk. This financial rescue is not unlike what the United States went through beginning in late 2008 when the government put up funds to prevent the failure of large financial institutions and certain parts of the capital markets and thus most likely prevented the failure of certain parts of our own financial system.

We have had a shallow economic recovery underway in the U.S. However, the worldwide economic picture continues to be fragile. The problems in Greece have highlighted a key fact of this recession - our global economic interdependence. As an example, if investors are worried that Portugal is going to default on its debt, and Spain owns Portugal's debt, and Germany owns Spain's debt, and we own Germany's debt...then really we all own Portugal's debt. So the problem of Greece, as it were, is as contained as, perhaps, the early failures of the mortgage derivatives market were back in mid-2007. As we surmised then, and as we surmise now, these problems wind up working their way through the whole system.

Overall, the news from Europe is part and parcel of what we have been writing to you about for some time: the economic slowdown is broad and deep enough that we expect to avert financial disaster through government support, but we do not expect that this will mean we will quickly inflate our way out of a worse-than-normal recession. Deflation is the economic phenomenon of greatest concern to us at this time. We expect continued slow economic activity, the price of things to be flat to down, and the elimination of debt (or worry about lack thereof) to be the order of the day for the coming one to two years.

Along with this fundamentally bad news from Europe, there has been a less noisy but we believe somewhat significant erosion of confidence in the functioning of our own stock markets following extreme volatility in the price of a large number of U.S. stocks on May 6. On a day full of bad news, inside of minutes, the prices of about 300 stocks dropped dramatically and then recovered, and industry regulators took a number of actions that alongside the price action made the market seem more arbitrary and unpredictable than even we would expect it to be in the near term on a volatile day. We remain cautious in this environment, as we have been for some time, and would not be surprised to see phenomena like this in the capital markets from time to time.

What this means for your portfolios is that we are glad we have continued to bulk up your bond positions which are invested in what we believe to be fundamentally sound investments with attractive yield and in some instances a possibility for price appreciation as well. We continue to de-emphasize your publicly traded commercial real estate investments, because in a deflationary environment we are not likely to see this asset class perform well and think we will see more down volatility there than we care to expose you to. We are rotating your investments gradually to more international investments on the stock and bond side, both. Where your bond and stock investments are exposed to foreign currency risk, we think that risk is appropriately and simply hedged so that your international investments are not completely exposed to the vagaries of foreign currency fluctuations around the globe. We are glad we did not put you back into commodity-oriented investments during the past year as those prices have recently turned down significantly. We continue to emphasize managers who will hold cash, bonds, or gold, even in stock-oriented funds, if they feel that the opportunities in the stock market are not available to them at this time. With this powerful rally over the course of the past year, stocks have become expensive again, and many managers have recently been adding to the cash in your funds. They and we stand ready to get more fully invested when there is a more opportune time to be so. Two plus two still equals four.

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

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