Market Commentary

What's Visible from Here

July 2011

"I learned more about the economy from one South Dakota dust storm than I did in all my years of college." – Hubert Humphrey

We write as a hot sunny week in Berkeley has receded into a more typical summer fog. The immediate view is somewhat unclear; however, a larger pattern is visible.

We don't think that the two-year old rally in the global stock market is ultimately sustainable. Here and overseas, governments and their regulators have pulled out the stops to ensure a restoration of confidence in the financial system and in the markets. What we haven't seen is a commitment to fixing some of the things that got us into so much trouble in the first place. Money is very cheap - after accounting for mild inflation, short-term interest rates are below zero. Risk has not only been tolerated by authorities in this environment, it's been flat-out encouraged. Certain technology-driven companies are undergoing hot IPOs. Wall Street is back to speculative excess; in a way, it never really stopped such excess. A massive slowdown in government spending is now coming on the heels of the massive slowdown in corporate spending. Jobs are still scarce. National debt is piling up here and in Europe.

Why is it that we are back to the future, with the same set of problems we had before? As bad as the market and economic collapse was during 2008 and into the first months of 2009, many of the problems that led to it have not yet been removed from the system, and many of the financial imbalances not yet completely stabilized.

We find a useful analogy for this view in the history of forest management. The national parks service learned that to fight wildfires at all costs across any parkland that burned was not the right policy. After many decades of effort in the first half of the twentieth century, they found that fighting fires at all costs led to more fuel coming along for an even bigger fire later. This of course was potentially much more damaging to the ecosystem, and also made it problematic for the park service to fulfill its mission. As a consequence the decision was made to, in part, let burns that started from natural causes such as lightning actually course through the forests to a certain extent. In other cases where humans had settled closer in, the preventive measure was taken to physically remove the fuel for the future fire - the detritus from the forest - through a painstaking process of pruning and collection. Neither of these sensible control methods - pruning or controlled burning - has come about in our financial system in the aftermath of the "wildfire" that burned through our market and our economy in 2008-2009. This increases our concern about future downside volatility in the markets.

We have been talking with you about the continued caution we think is needed in this environment for some time. We feel that on balance of all the evidence to date, this caution is more warranted than ever. Europe is in grave danger of becoming economically unstable in the coming few years, and the way it may do so may once again threaten the American economy as well. Much of our ability to resolve economic problems and thus to move forward with a more healthy outlook rests with a political situation that has become increasingly dysfunctional, particularly on issues related to taxes, spending and the deficit. Several generations of financial analysis have been predicated on the existence of a 'risk-free rate' of return, that is, the return received on a longer-term U.S. debt security. At this moment in economic history, however, we wonder if analysts may not justifiably shift their attention from the question of 'what is the risk-free rate,' to 'is there a risk-free rate', thus raising the thorny issue of intrinsic risk in the largest and strongest economy globally. These are not problems that make us sanguine about the potential for intermediate-term capital appreciation.

Of course, we don't know at which exact moment our caution will be most warranted. Since around August of 2010 the market has moved blithely up on news of easy monetary policy and on a human predilection for drawing a straight line forward from our most recent experience - not on fundamentals. Historically we have observed that this could go on for awhile. We don't think it is a good idea, though, even as your portfolios lag the overall stock market this year to date, to chase the storm.

We continue to tilt your portfolios away from the U.S. dollar, and instead are emphasizing non-U.S. government bonds of high quality and short duration, stocks of high quality companies globally with strong balance sheets, opportunistic corporate debt securities, and gold. In the U.S., we are more focused on investments that emphasize income - yield and dividends - than on capital appreciation. We think this is appropriate pursuit of opportunity, even as we expect trouble ahead. As an Italian proverb points out, "since the house is on fire, let us warm ourselves." We continue to seek positive return for you in this environment, even as we ramp up the caution.

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