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Quarterly Letter to Clients

April, 2007

Indices at quarter-end (March 30, 2007):

Dow Jones Industrials: 12,354.35 1Q'07 -0.87% YTD -0.87%

Standard & Poor's 500: 1,420.86 1Q'07 +0.18% YTD +0.18%

January was excellent, February not so much. And March was, shall we say, “unsettled”. The year started out strong, with gains across the board. But February saw a pullback that pushed the averages into negative territory, and the rebound in March was short lived.

Everyone said the correction was “overdue”, but no one was saying that before the event. And it doesn’t soften the blow to just say that the market “needed to pull back”, or that the market had “gotten ahead of itself”. You get comfortable with your gains and you do not like to see them evaporate.

I have commented before on oil prices, when they were rising and of concern, and it is only fitting that I revisit the subject in light of the current volatility. I wrote earlier that oil prices would rise as long as the government was filling the Strategic Petroleum Reserve. The fall from the mid-70’s to the upper 50’s can be laid to the ending of that program.

Then, in the President’s January State of the Union address, he called for a doubling of the SPR. Are you surprised that oil has rallied from that date on? Even if the program has not yet begun, the market recognizes the potential demand and sets prices accordingly. When the government stops sopping up every extra barrel available, oil will find it’s true supply-and-demand level.

Doubtless the continuing problems in the Middle East have exacerbated the situation. When we invaded Iraq four years ago, oil hovered in the $30 per barrel range; as I write this, it is trading at $66. Higher levels will start to affect the economy.

The buzz this past quarter has been primarily about problems in housing and sub-prime mortgage lending. Homebuilders, banks and other lenders actively sought out questionable borrowers, packaged those loans, and sold them to willing buyers. They are now finding those loans coming back to haunt them. Foreclosures are sharply higher and real estate prices are softening. The fear is that the problem spills over into the prime area, and further that it affects all of the industries ancillary to homebuilding.

My personal feeling is that the market always looks for something to be nervous about, and that this will eventually fade into history just as other seemingly catastrophic situations have. I’m more concerned about oil prices than about sub-prime lending.

“Don’t fight the Fed” is an old market axiom. But it has been nearly three years now since the Fed began raising rates, and today the 10-year Treasury yields less than it did when the Fed began tightening. This shows that even if the Fed changes course, it is the market that will ultimately dictate rates.

I believe that rates should go up, for several reasons, not just because it has been the desire of the Fed. If rates do go up, bonds will go down, so to remain true to my belief, I am avoiding buying longer bonds. Keynes said, “Markets can remain irrational longer than you can remain solvent”, but I still find it impossible to go against my instinct.

Thus I have a problem: Over the next twelve months or so bonds will be called faster than I can find good places to deploy the money. So I ask your patience in the fixed-income area, as you will see cash levels building up. It is my feeling that we have entered a long-term bear market for bonds, and my direction will be toward shorter maturities and higher quality. However, barring some dramatic change, we will have to get used to lower yields. At the moment, money markets are as good a vehicle as any.

As for equities, it looks like stocks will remain unsettled for the next couple of quarters. While cautious, I have not turned negative and am looking to be a buyer on the dips. Long-term participants know that market pullbacks are very often buying opportunities. While we cannot know in advance the depth of a pullback, or it’s duration, we can show that historically they have been relatively short-term events. Stay diversified, buy reasonable valuations, watch the balance sheets, look for growth, and time will heal all wounds. I will, as always, apply my conservative precepts to all purchases, stocks and bonds, and will continue to do my utmost to protect and preserve our capital and to make it grow.

Jim Pappas