Market Commentary

Up and Down

January 2008

"The way up and the way down are one and the same." - Heraclitus

We have had extensive conversations with you over the years about risk in the investment world, and the fact that we take risk in order to gain greater long-term growth in your assets. We also work to design portfolios with different types of assets, and with managers who deliberately work to reduce declines in value during down markets. However, we also know that at times, any portfolio invested in predominantly risk-based assets is going to go down, even if it doesn't go down as much as the overall stock or real estate markets. We think we are in one of those time periods right now, which is why we more recently tilted many of your portfolios more heavily towards more stable value assets and towards the mutual funds of managers with excellent track records of preserving capital during a downturn.

We think at least the first two quarters of 2008 will be an uncertain time for stocks and real estate. The market is trying to price in the uncertainties of probable recession and the timing of a recovery, a much more expensive and less liquid debt market for everyone from major corporations to homebuyers, ongoing price inflation, a fall in the U.S. dollar, and a presidential election. We think it is entirely possible that in the first six months of this year, the stock and real estate markets move lower instead of higher. Of course, as we wrote about last quarter, while we think the market could go down, we advise clients to stay invested. It would be imprudent to leave the market in the short-term, only to need to time it on the way back in – a feat that we don't think can be managed successfully. The way to benefit from the higher long-term returns in stocks and real estate is to stay invested over the course of an entire cycle, while tilting the mix of assets in portfolio somewhat to balance risk and opportunity.

Along the way, of course, a down market is anything but pleasant. This is particularly true if you sold investments with hefty embedded taxable capital gains only to reinvest the money into investments where you are now looking at short-term capital losses. Year-end taxable mutual fund distributions aggravate as well, despite the fact that position values stay the same as distributions are reinvested, and tend to increase in size at the end of a bull market just as returns begin to turn negative.

A good example of this dynamic in 2007 was in the real estate portion of many client portfolios. In most cases, the most heavily weighted real estate investment is with a manager with an excellent track record for preserving capital. This fund was down on the full year less than half what the major real estate index was. We consider this a strength of the manager that they could in 2007 deliver significantly reduced downside. Yet, the manager re-opened to new investors in 2007, so many of you purchased it recently and can see only short-term losses on an investment. At year-end, they made a large taxable distribution – based mostly on earlier years of gains.

Is this a time to get of real estate entirely? No, we believe that it is prudent in this case to keep real estate in the portfolio for the long term. We still think real estate is a solid long-term investment that reduces overall portfolio volatility. While we are reducing some clients' real estate allocations somewhat, we believe a material position in real estate will enhance overall portfolio value. We therefore remain committed to core real estate holdings, even during a downturn.

On the stock side, continued relative strength in international investments has been fueled by investor enthusiasm for growth around the world, and the devaluation of the U.S. dollar. We too are enthusiastic about the robust global investment environment over the long term, and expect further decline in the dollar over the coming decades. However, we feel that the dollar may be at or near an intermediate term low, and many foreign stock prices may be nearing their peak, and so we are looking more for growth at reasonable values in the U.S., not internationally, for the coming intermediate period of one to three years. U.S.-based large-cap multinational defensive growth companies particularly appear to offer good relative value in stock prices, as well as benefits from selling into overseas growth with a weak dollar in play. The international part of client portfolios has been positioned more defensively for the last year, with a heavier emphasis on more capital preservation-oriented international managers. While this has led to near-term underperformance, we are comfortable that over the intermediate-term these international investments will be less volatile than many available, and will also produce good long-term returns.

Finally, in many client portfolios we are taking gains in commodity positions where clients have become overweighted.

Overall, we think your portfolios are well positioned for negative near-term market surprises and for positive long-term returns. The way up is the same as the way down; when it comes we want to be sure you are there to participate.

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

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