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Quarterly Letter to Clients

April, 2008

Indices at quarter-end (March 31, 2008):

Dow Jones Industrials: 12,262.89 1Q'08 -7.55% YTD -7.55%

Standard & Poor's 500: 1,322.70 1Q'08 -9.92% YTD -9.92%

The recent action in the markets has been fodder for humorists. A cartoon in the Wall Street Journal said it nicely: a TV market commentator stands in front of a jumbled chart and says, “today it did a reverse three-and-a-half somersault with a tuck”. Indeed, the market zig-zagged, see-sawed, rolled over and sat up during the quarter.

Another recent cartoon shows a bull, obviously panicky, with a sign that says, “The End is Near”. A Republican elephant and a Democratic donkey are saying, “We should toss him a couple bucks”.

Somewhere I read recently that volatility (meaning large downward swings in the market) was the price of admission to the game. Note that it is not considered “volatility” if the market is going up. Well, the price to play has certainly gone up lately. Triple-digit moves have become commonplace in our stock market.

The TV pundits have picked up a new phrase: “crisis in confidence”. They are using it to describe what is going on in our stock markets and in our nation’s credit system. Banks and brokerage firms are on shaky ground, with hallowed names seemingly on the brink of failure.

The collapse of Bear Stearns, long one of the Street’s most respected names, invited comparison with panics of yore, and led to the Fed breaking with it’s tradition of lending only to banks. The Fed, of course, is the lender of last resort, which has been its mandate since it’s founding.

In my opinion, given the fragile state of confidence in the markets, it was the right thing to do. And it wasn’t a bailout so much as it was a wipeout. Perhaps they should have “tossed him a couple of bucks” before we got into such dire straits.

The Fed also found it opportune to lower interest rates. In my opinion this was not the right thing to do, even though it had the immediate effect of pushing stocks significantly higher. Perhaps that is why I have not yet been invited to sit with the Board of Governors.

Let’s review; over the last eight years, since the turn of the century, the Dow Jones Industrial Average has given us an average annual gain in the range of 1%, and the S&P 500 did even worse, losing around 1% per annum over that span. Over the same period the ten-year Treasury bond has returned roughly 6.5% annually, and today yields in the area of 3.4%, not quite meeting inflation. What’s wrong with this picture, and is anything about to alter that miserable history?

It is an axiom on Wall Street that we don’t know we’ve had a recession until it’s over. Well, you may not know you’re in the hospital until you wake up, either, but all your relatives know.

I shouldn’t have to point this out, but there is a correlation between taxes, spending and the dollar. There is further a correlation between the dollar and the price of oil, gold and various other “hard” assets; and the correlation extends, ultimately, to the economy. I don’t know how many times I’ve said it: as long as the government continues to spend more than it brings in (taxes), the dollar will go down. And as long as the dollar is falling oil will continue to rise.

The bottom line: you may think you have had a tax cut, but because spending was not reduced, all you really had was a tax deferral -- plus a few unintended side effects.

The decline of the dollar has been a part of the “crisis in confidence” that we are experiencing lately, and the only cure for the dollar is a balanced budget. The looming threat of inflation would also be ameliorated with a firmer dollar.

Lately commodities, which have been on a tear in recent years, have come sharply off their record-setting highs, and this is one of the very few bright spots for our economy. I certainly hope more pop up in the near future.

Generally, in this business, you can do your homework, come up with good securities to buy, and feel confident that time will do the heavy lifting for you. Today it doesn’t feel that way; it feels like you have to struggle just to stay afloat. It feels different this time, ominous, even dangerous. We all have to change with the times, but usually the changes are subtle, small, incremental steps. As for me, while open, I resist dramatic change, and will continue my methods until I can prove another methodology better. But I do wish we had a friendlier stock market.

Jim Pappas