Market Commentary

'Whoosh' and 'Whee'

April 2007

Sue's young daughter recently reminded us of some investing basics. Discussing the 416-point drop in the Dow Industrials back in late February, she likened the downs in the market to 'whoosh,' which she described with a downward cut of her hand through the air, and the ups in the market as 'whee,' which she described with raised eyebrows and a tone of delight. All of nine years old, when she was told that people tend to sell when the market is down and buy when the market is up, she quipped: "Mama, it makes no sense that they do that. What are they, drunk or something?" She then concluded, "Mama, I know: everyone should buy when it is 'whoosh', and sell when it is 'whee.'"

While it is tempting to say that even a fourth-grader can figure out how to invest in the stock market, Sue's daughter also asked the important follow-up question: "Mama, how do you know when it is done going 'whoosh' or 'whee'?" And that is what makes managing your investment portfolios both challenging and interesting.

Economic and capital market success eventually breeds economic and capital market failure – it is a fact of how market cycles work. Both success and failure tend to breed more of the same, especially in terms of investor sentiment. We are near the peak of a market cycle now. The economy has been terrific. Great returns on capital have driven yet more capital into the market where it seeks a nice home where it will be treated well. In search of that return, and in competition with lots of other capital, standards go lax, and investors and lenders make more aggressive and less prudent investments than they should. In addition, investor conviction that a trend will continue compounds the lack of attention to downside risks. Inevitably, inappropriate investments sour, investment returns go down, standards tighten, scrutiny of investments and loans goes up, and the whole cycle starts over again. This cyclicality is embedded in capitalist and stock market culture, and indeed this cycle mirrors cycles in nature.

Last fall, we concluded that while the economy and the market had been strong both here and internationally for many years, slipping economic fundamentals in the U.S. and years of unsustainably high returns on risk capital both inside and outside the U.S. were good reason for adopting a more conservative stance in your portfolios. After all, our aim for you is that you participate in the growth available in the economies of the world, while providing some protection from volatility in the markets when the markets move south. At a point in time when the markets appear to be vulnerable, as they do today, we don't want your portfolios to move so far down with the market that you are tempted to make decisions based on reducing pain and fear in the short-term rather than on what will achieve the best long-term financial outcome for you.

Certainly, the market is giving mixed signals. A period of downside volatility and uncertainty in late February has given way to a recent rally that has completely wiped out the late February and early March losses. While investors have been very concerned about the subprime mortgage market's meltdown, we have yet to see it impact the overall economy (although we expect it eventually will). The Federal Reserve may cut interest rates, but remains concerned about inflation, which may yet hold it back from cutting rates as is widely anticipated. While large-cap growth stocks have perked up lately, they still remain relative underperformers over the past year. The private equity boom, with even a private equity firm deciding to go public, could continue to help hold stock valuations aloft for now, but it could also accelerate negative market conditions. As is usually the case, the economic environment is somewhat of a mixed bag. At the moment, though, we think it will pay for you to be positioned more conservatively.

In doing so, we are balancing the opportunities with the risks in your portfolios. Could the market continue its rally for several more months or quarters? Certainly – and given the way you are positioned, you'll participate in that rally. Could the value of the stock market go down? Certainly, and make no mistake, when it does, the value of your portfolio could go down right along with it. At that time, it will be important to take the long view of the benefits of investing in the stock market. Our current positioning is intended to reduce the impact of a decline, but it is unlikely that one could be avoided altogether. No one can know exactly the moment that the market will go up or down, and even short term trends are rarely clear. We choose to tilt your portfolio more conservatively or aggressively depending on the environment, but we intend for you to always be materially exposed to the stock market. Only through remaining invested will you reap the long term returns the stock market has historically provided.

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

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