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Quarterly Letter to Clients

April, 2010

Indices at quarter-end (Mar. 30, 2010):

Dow Jones Industrials: 10,856.63 1Q'10 +4.11% YTD +4.11%

Standard & Poor's 500: 1,169.43 1Q'10 +4.87% YTD +4.87%

Last quarter I included a table showing long-term trends in interest rates. I have been thinking about how those trends might relate to stock market movement, and have found that there is not the tight correlation that I had expected.

Of course, there have been long-term trends to stocks, but it seems that they have not necessarily been caused by or been dependent upon interest-rate movement. This is surprising, because we were taught that PE ratios were (at least somewhat) dependent upon interest rates: when rates were high, PE’s were low, and vice-versa. There is, of course, more to the equation. Earnings, for example, the "E" in PE. The markets are rarely simple, but that doesn't stop us from always looking for ways to justify and predict prices.

So, while I maintain my long-held position that interest rates will rise, I must temper my attendant belief that such a movement will be bad for stocks. But there remains no question that movement in the prevailing level of interest rates affects bond prices. Bonds continued higher in the quarter, and are, in my opinion, a bit too high.

Speaking of trends, we've had a nice one develop in the stock market. January started off pretty good, but faded going into February, taking us into negative territory by 4.5-5%. By then, though, the jitters were gone and a very nice rally carried us from lows of around 9900 on the Dow up to 10,900. For the first quarter we ended up with gains in the neighborhood of 4% to 5% on the DJIA and the S&P.

I certainly hope that the move continues, but skepticism is probably warranted. It would be unusual for such a strong move not to falter. I have said on many occasions that I look for the market to move in a series of rolling peaks and valleys for the next few years, and that opinion remains unchanged. As always, I will look to buy stocks when we are at lower levels and to pare off the weaker holdings when we are in the upper ranges.

Recently, I was perusing some 6-year charts of things like Industrial Production, Foreign Exchange, Capacity Utilization, New Orders for Durable Goods, Leading Economic Indicators, Unemployment Rates, Construction Spending and Consumer Confidence. (My life is so exciting!)

They pretty much all looked just as you would expect. Starting in 2004 they all rose into 2007, where they peaked, then fell, sharply, through '07 and '08 and into early 2009, when a bounce occurred. That bounce carried most of these indicators back to just below their levels of 2004.

No surprises here; the charts approximately mimicked the move in stocks.

Money Supply, or M2, as you might remember, is the total of all physical currency in circulation plus checking accounts, savings accounts, money market accounts, and CDs. And that is the one chart that jumped out at me: growth in Money Supply (M2). This chart showed a gradually accelerating rise from '04 until a peak in very early '09, when it simply falls off the cliff, with no sign of a bounce. M2 growth, according to this chart, is now at the lowest point in the six years of these charts.

This led me to look at the 30-year chart of this volatile measure, where I found that the only other time we were at these levels was in 1995.

Don't misunderstand, the nation's money supply has continued to grow, and is currently expanding at a pace of 0.5%. But that growth has slowed from the 5% to 10% range that prevailed in the years 2004-2008, and from the more typical 6% over the last 30 years.

The slowing growth in M2 is counter-intuitive, given the stimulus spending and bailouts that we have seen over the last two or three years, and I ask: how can this be? Was the Fed really printing so much more money in the years 2004-08 than it is now?

While this makes me question my assumptions about inflation and interest rates, I strongly suspect that when M2 turns up stocks will rally. We probably will not have to wait very long to find out.

Spring is upon us, and things look brighter, not just outside your window; several indicators of economic activity are pointing in the right direction. Earnings for the quarter just ended will begin appearing in the next couple of weeks, and I expect them to continue to reflect recovery. Thus, if we do see a dip in the markets, I feel it may be an excellent buying opportunity.

Jim Pappas