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Quarterly Letter to Clients

July, 2009

Indices at quarter-end (June 30, 2009):

Dow Jones Industrials: 8,447.00 2Q'09 +11.01% YTD -3.75%

Standard & Poor's 500: 919.32 2Q'09 +15.22% YTD +1.79%

Now you can say you know what a relief rally is. By the middle of the first quarter it felt like the world was coming to an end. Then, like a swimmer underwater too long, we finally snapped back, and the sensation was like breaking the surface and gasping the air we desperately needed.

The rally continued, in a very powerful manner, rising 35% from its nadir. But even that wasn’t enough to bring the Dow into plus territory for the year-to-date (the S&P did manage a small YTD gain). And it should not have been unexpected for the market to sag a little after that run.

Still, we outperformed the averages smartly, and our accounts are nicely positive over the first six months of the year, a good feeling after that horrible 2008.

Basically, over the last year-and-a-half we have gone from 14,000+ on the Dow to 6500, or more than 50% down. The bounce off that bottom carried us to 8700, give-or-take, before yielding to a little selling pressure. We have to remember that if you go down by 50%, you have to go up by 100% to get even again. So even though we’ve had that very welcome 35% rise, we are still left with a lot of work to do. But then, even broken bones heal with time--I just hope we’re not left with a limp.

The economy has crumbled over the last 18 months, and steps needed to be taken. Still, I confess to being quite divided on the various government bailouts. On the one hand, it seems to me that it was certainly prudent to prevent the wholesale collapse of our banking system; on the other, if an institution really is “too big to fail”, perhaps we should not have permitted any institution to become that big in the first place. Further, my initial reaction to the bailout of AIG was that we should have let them go, but gradually I came to see that that would have meant additional failures in the banks that were counter-party to AIG.

Of course, rewarding the management of those companies that were collapsing and being bailed out just makes me shake my head. The idea that the people who inflicted the damage are the only ones who can get us out of it just boggles the mind.

Following every major financial debacle we write new laws to prevent a recurrence. The problem is that aggressive bankers then seek out new ways to skirt the spirit of the laws. So I suppose that, with the collapse of subprime lending, the banks are even now out scouting for new and better ways to lose money. There seems to be no end to the inventiveness of man.

I am guessing that the panic that followed the failure of Lehman is what has caused the government to be so adamant about not allowing any more large collapses. Which brings us to GM and Chrysler. While I own bonds in GM, and certainly do not want them to fail, if it had been up to me, I would have let them go, in a conventional bankruptcy. Perhaps it is my feeling that the bonds I own would have been worth more in that situation; but it is hard to see the rationale for the government’s involvement, other than an attempt to avoid panic. Then again, the bailout of AIG swamps that of GM and Chrysler. How can you justify saving AIG and not GM? One could further argue that a domestic automobile manufacturing infrastructure is a matter of national security.

I know that government bailouts are nothing new; I mentioned several in my letter of October, 2008. Sometimes, though, there is more popular support than there seems to be now. It is encouraging that several of the larger banks have been able to repay their bailouts.

I have heard people call this a failure of free-market capitalism. I do not feel that way. Rather, I believe that these economic convulsions are a normal and natural part of the free-market mechanism. While some people undoubtedly view a stock market crash as a catastrophe, others may view it as a rare opportunity. Your age and position in life will color your perception. But any way you look at it, today we certainly face a very difficult market environment.

Several signs point to a recovery, albeit a modest one: housing starts and sales have risen for the last couple of months (though prices continue lower); the banks are making significant progress in restoring their capital and repaying the government loans; consumer activity is showing some signs of picking up; and, of course, stock and bond prices have regained some ground.

We’re not out of the woods by any means, as oil prices have moved up by 100% from their lows, and mortgage delinquencies and foreclosures continue apace. It would also be nice to see some marked improvement in employment. Still, one cannot help but be encouraged.

We will tread cautiously going forward.

Jim Pappas