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Quarterly Letter to Clients

January, 2009

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

Dow Jones Industrials: 8,776.39 4Q'08 -19.12% YTD -33.78%

Standard & Poor's 500: 903.25 4Q'08 -22.45% YTD -38.49%

I do not have to tell you what has transpired in the markets this year. As a buyer you hope for lower prices. They have arrived with a vengeance. But as someone who already owns assets you will not be so sanguine about the damage done to your portfolio.

It has not just been the latest year that has proven so uncomfortable. The Dow Jones closed at 10,786 on December 31, 2000 and eight years later has finished at 8,776. The figures for the S&P are 1320 and 903. I have commented before on this type of long-term, grinding market, and now we are living through one. It is the second one of my career, the first being the period 1967-1982, which indelibly shaped my opinions, outlook and character.

Stocks were not alone in their misery: corporate bonds also had one of their worst years ever. In the real estate market the malaise is now three years old. Oil has tumbled to one-third of it’s former high. All asset classes have declined, and volatility has spiked to unprecedented levels. A wide range of businesses are lined up for Federal relief.

We are in an economic funk. In recent years our National Debt has doubled; GDP growth has slowed by almost half; our Federal Budget remains stubbornly in deficit; unemployment is up by 50%; and consumer credit debt has spiraled upward by a factor of two-thirds.

Into this miasma we throw Bernie Madoff with one of the largest financial scams in history. Mix in the death-by-a-thousand-cuts of General Motors and Chrysler. Season with hedge-fund losses. Serve over the apparent failure of our entire banking system. Cover all with a TARP and allow to simmer.

It is not a diet to relish, and it has not been a fun time to be sitting in my chair.

A generation that sought careers in finance is now looking for other forms of employment. They learned only to buy the dips, but this is more than a dip. Like an animal caught in the headlights we fear moving. Our fears are that earnings will plummet, that dividends will be cut and that if we buy—anything—we will lose money. These are legitimate fears, and a normal and natural part of our human makeup. The life cycle also affects the psychology: youth has less money invested and a longer time to recoup, while age often has no ready method of recovering losses. Thus, at my point in life, it is much harder to rebound.

Which leads me to the quandary of trying to discern what sort of bear market we have. For example, whether the markets will behave like the U.S. in 1973-74 or like Japan in 1989-90. In the U. S. downturn, we hit bottom 45% down and after roughly 18 months. The market didn’t really get its legs back under it until 1982, so it was a long and difficult time, but at least the worst was past by the time 1974 came to an end. In the Japanese meltdown their market initially fell from roughly 40,000 to 16,000, a 60% break. But that wasn’t the end. Two decades later we find the Japanese market in the area of 8,600, a 20-year bear market loss that is approaching a whopping 80%. (How do you think that generation is feeling about their retirement funds?)

There are similarities and differences with both. Perhaps the greatest difference is that today our government is flooding the system with money, unlike either of the two examples. While we hope that this will break the fever, there is no guarantee. I am afraid that the debt that we will incur for the “stimulus” will add to our enormous existing debt to such an extent as to undermine the dollar, something we have already begun to see. It is certainly an inflationary move, though that outcome seems on a further horizon.

I have been saying for several years now that bonds should come down and yields should go up. This was the year for that call to come true, at least in the corporate bond market. With the tumble in bonds we arrive at very attractive yields, and I have come to the opinion that, for the next few years, corporate bonds may well be the category that provides the best performance.

If our situation is akin to that of Japan, then bond investments will prove their worth. Similarly, if we find ourselves in a scenario like that in the U. S. described above, bonds will again be the right place to be. It is only in the event of a sharp reversal, resulting in a strong, sustained bull market that you would benefit from being in stocks, and that is indeed a difficult prognostication to make today.

We are three years into the housing decline and a year-and-a-quarter into the stock market decline. I would hope that one more quarter, or perhaps two, will wring all of the selling out. In any event, it is a buyer’s market in bonds, and a good time to divert additional funds into those securities.

Jim Pappas