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Quarterly Letter to Clients

April, 2013

Indices at quarter-end (March 31, 2013):

Dow Jones Industrials: 14,585.10 1Q'13 +11.25% YTD +11.25%

Standard & Poor's 500: 1,570.28 1Q'13 +10.03% YTD +10.03%

It is widely viewed as sacrosanct that money in a bank will be there when the depositor asks for it. This has not always been true: in fact, such a guarantee has existed in the U.S. only for about the last 80 years. Banks fail all the time, and it is not necessary to the system that any specific banking institution be protected from failure. What is imperative is that depositors are assured that their funds will be safe, even should their bank not survive. This trust is the foundation upon which the global economy is built.

We may be only slightly less sanguine about our funds that are held in brokerage accounts. It was not until 1970 that those accounts received protection similar to what our commercial banks have enjoyed since 1933, and in both instances it took a tremendous blow to the system--and serious losses--to bring about those reforms.

Today the situation in Cyprus is disturbing our serenity in the banking system. Under the latest deal by the EU to bail out Cyprus, two of that island nation's banks will compromise deposits. Smaller depositors are to be made whole, but depositors above €100,000 will not be protected, and stand to lose a significant portion of their assets. Therein lies the reason why the tiny nation's troubles have had any effect at all on the world's financial markets: if it can happen in one Euro-zone country (even such a very small one), it forces us to ask if it can happen in another.

When faced with a similar threat five years ago, the U.S. raised the insurance level for depositors from $100,000 to $250,000. That storm has passed, and we can rest assured that our funds in FDIC insured banks remain safe. (By the way, here is a bit of history: in 1960 only five banks were publicly traded. FDIC insurance covered only $10,000 in deposits.)

Modern business is international, even global, in scope, and ripples in remote places may cause our collective boat to rock. My guess is that these multiple Euro-zone crises are the growing pains of the still-new union, and will eventually be overcome. In the interim, why their common currency, the euro, hasn't declined remains an unanswered question.

The general nature of all markets is that they go up and then they go down. This past quarter has been one of the "ups." In fact, the gains of the past three months would make me very happy if they applied to an entire year. New all-time high levels were recorded. The alacrity of the move has sown the seeds of doubt in people's minds; skeptics abound. Some of that doubt should be eased by the knowledge that volatility was much less this past quarter than during the whole of 2012. The quarter's rise was calm and orderly.

All-time record highs in the stock market used to bring elation and a sense of well-being. But with today's new high levels I keep getting the same question: when will the stock market reverse course and take a tumble? No one knows, of course, though everybody has their opinion.

My opinion is that you should just take pleasure in the ride. After all, if you can't enjoy it while it is going up, how do you think you will feel when it inevitably goes down?

We have been going up for four full years, and only recently has it become the general feeling that the economy is improving. Two big drivers, housing and employment, are experiencing a welcome rebound, and a third support, corporate earnings, looks to continue to be solid.

The bond market has not yet imploded, and seems unlikely to do so in the immediate future. Still, there is very little upside, and quite a lot of potential downside in fixed income. We remain in a position of holding shorter-term bonds for their yield and their resistance to fluctuations due to rates. A more attractive choice lately is high-quality stocks, whose dividends exceed the yield on their bonds. I have been gradually moving in that direction, and am likely to continue that program, but you should know that I prefer to buy on dips, and can be very patient in waiting for the right price. It is uncomfortable to me to be a buyer at prices that are 10% or more higher than the level that prevailed only eight or ten weeks earlier. Seeing cash build up in the accounts I oversee is not uncomfortable at all.

Over the past decade, when we have had a strong first quarter the second quarter has tended to be much more muted. There is room for the market to move up, but it should come as no surprise to anyone if the market gives back a few percentage points over the next few months. It is then that we will deploy some of our cash reserves.

One characteristic of our stock market is that it tends to trend upward, relentlessly, over time. Yes, history shows us that the market can go down for painfully long stretches. We also know that it took a full six years to re-attain its previous all-time high. But history also shows us that if you are patient, and view the declines as buying opportunities, you will be pleased with your results.

Jim Pappas