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Quarterly Letter to Clients

January, 2007

Indices at quarter-end (December 31, 2006):

Dow Jones Industrials: 12,463.15 4Q'06 +6.71% YTD +16.31%

Standard & Poor's 500: 1,418.30 4Q'06 +6.17% YTD +13.63%

For the first six months of the year the markets marked time. By the end of the second quarter the Dow was up about 4% and the S&P had gained less than 2%. But the second half of the year really lit up, both indices tacked on another 10 percentage points or so, and the Dow hit all-time highs.

In my opinion, the start of this move can be directly traced to public announcements that our policy in Iraq was in need of drastic overhaul. The possibility of a cessation of the conflict was just the psychological boost that the markets needed. Adding to the euphoria was the Fed’s action of halting its policy of raising rates.

Thus were we able to overcome the sharp drop-off in housing and our continuing problems in the domestic automobile manufacturing sector. Corporate profits outside these industries have been robust; without that, there would have been no foundation to build a rally on.

It was a welcome rally, too, following two rather unremarkable years. So, at least in the stock sector of our accounts, life has been a little more fun this year. While the market isn’t cheap by various valuation metrics, it isn’t that expensive either. It may, of course, just be the bull market talking but I have found a few attractive companies at reasonable prices, and it looks to me like I will be able to continue to find good investments in equities.

I would caution though, that if you got used to the stock and bond markets of the 1990’s, where almost every year was up, and often by a handsome double-digit figure, well, get ready for reality. The future is not likely to be quite like that, and the year just ended should not be viewed as a harbinger for 2007.

People have been asking my opinion on the dollar recently, and I have described the situation as something akin to a kid with a credit card but no job. He can spend, and even look prosperous, at least for a while, but the bottom line is that he is in serious trouble. The dollar looks to me like it’s in a long-term decline that will probably not stop until we are able to balance our budget.

On a related note, I’d like to talk about bonds and interest rates for a moment. For quite some time now we have had an inverted rate curve. This means that longer-dated bonds yield less than shorter-dated bonds; you can earn more on a 2-year Treasury than you can on a 10-year.

This is an unusual situation, and one that has never, historically, lasted very long. There are a few ways that the market can resolve. Here are some potential scenarios: first, short rates could go down and long rates stay where they are or move slightly higher. The implication for the bond market would be relatively neutral; short bonds would rise, but they also would mature quickly, so the investor would not reap any extra benefit from owning them. Long bonds would stay flat, or decline slightly, also no benefit to the investor. The implication for the stock market would be mildly positive.

Second, long rates could go up and short rates stay where they are, or decline slightly. In this scenario long bonds would go down in value and short bonds would stay essentially the same. Both stocks and bonds would be likely to suffer under this condition.

Finally, it is possible, though unlikely in my view, that the inversion could persist for a much longer period than normal. This would have a neutral effect on all markets, but would leave investors with an unsettled feeling that might lead to increased volatility.

If you are a percentage player you can see that there is no real benefit to buying intermediate-to-long bonds at this point; your most favorable outcome is neutral. The reward seems to come if we buy short-term paper, say two years and less, as we would garner more yield at less risk. Right now, though, money market funds are yielding as much as two-year paper, so we maximize our return and minimize our risk in money markets. This is why I have allowed cash to build up.

This whole situation is caused by there being so very much money chasing returns. When the kid with the credit card finally has to stop spending things will change, probably dramatically.

There are times when your best investment action is to take no action at all. For bond investors, this is just such a time. Our best course of action is to let existing bond holdings ripen, that is, to continue to collect our coupons, allow calls and maturities to add to our cash balances, and await attractive options for reinvestment. We’ve used utility stocks for the last couple of years, and that segment has performed very nicely. Nevertheless, the money market is today’s best investment for the bond buyer. Remember that cash is an investment option, and sometimes the best one.

Jim Pappas