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Quarterly Letter to Clients 

July, 2010

Indices at quarter-end (June 30, 2010):

    Dow Jones Industrials:             9,774.02       2Q'10        -9.97%          YTD      -6.27%

    Standard & Poor's 500:            1,030.71       2Q'10        -11.86%         YTD      -7.57%

This last decade has certainly been a difficult one in which to be an investor.  Because markets tend to repeat moves, I have been reviewing the period 1968-1982 looking for clues as to how the market might behave.  History is interesting.  We tend to think that things are so very different today than they were in the past.  That may not be an accurate assumption.

For example, it is easy for us to think that market volatility is higher than ever, with markets alternating between jubilation and despair; it seems like almost every day there is a triple-digit swing in the Dow Jones.  But if you think of volatility in terms of the difference between the highs and lows of a given year, you will see that the past decade parallels the market of 1968-1982.

Of course, back then the Dow languished in the range of 750-1000, so a ten-point move in the average was, percentage-wise, equivalent to a move of 100-plus points today.  Still, the annual lows from 1968 to 1982 averaged 21% below the highs, while over the last ten years that measure was 23%, a difference that can only be called marginal.

“Ah”, some might say, “but look at the difference in volume”.  And it is certainly a noteworthy difference:  when I started in 1967 volume was typically 2 to 3 million shares daily.  I well remember the first day that volume rose to over 5 million shares; it was a landmark, because that was the share volume reached on the day of the 1929 crash, and it had not been matched since.  Now we measure daily volume in the billions of shares.

So there is no question that there are more participants, and vastly more money, in the markets currently.  But do the markets behave differently today than they did in the past?  I do not believe so, and my review of the 1968-82 period has served to reinforce that belief.

There are people who will argue that it is different today, and they would point to things like hedge funds, high-frequency trading, dark pools, and private equity.  I would answer that while the tools are admittedly much more sophisticated, none of these things are really new.

The Gulf oil spill, they may retort, is unprecedented.  In response I refer you to Chernobyl, Bhopal, Three-Mile Island.  Industrial catastrophes, abhorrent as they may be, are nothing new.

Nine years ago (see my website for the letter of July, 2001), I wrote in this forum that we could possibly be facing an extended period that might mirror the years 1968 to 1982.  I pointed out then that the market seemed to move in long cycles alternating between generally rising prices for 15-20 years and then running flat-to-down for another 15-20 years.

If you think about it, you can easily rationalize such moves.  Expansion is accompanied by rising stock prices; in turn followed by the “digestion” of the expansion and flat or lower prices.  Then the cycle repeats.  (Witness:  rising prices from 1942 to 1966; flat to lower from 1967 to 1982; rising again from 1982 to 2000, flat to lower from 2000 to ?)

In each of the flat-to-lower time frames stock investors spent a decade-and-a-half struggling for annual returns that ranged a point or two to either side of zero.

Makes you rethink dividends and bonds, doesn't it?

Speaking of bonds, they have their “long cycles”, too.  It has been my belief for some five years now that the downtrend in interest rates that began around 1982 will reverse course.  If—or rather when—that happens we may well see bonds under the same pressure that stocks are under today.  We know that there is precedent for rates to remain abnormally and artificially low for decades longer than market forces would seem to warrant; think of Japan over the last thirty years.  So a reversal may not be as imminent as I suspect.  Still, we must guard against it, and we do that by keeping bond maturities short.

Can we thus conclude that we are doomed to another 5 or 10 years of difficult markets?  The good news is that we already have seen a decade of stagnation, so most of the misery may well be behind us.  The bad news is that we probably will see a pretty flat market for at least a few more years.  It is admittedly hard to foresee conditions that would change that course in much less time.

The sun will come up again, of course.  After each down cycle comes the up cycle; that is normal and it’s just a matter of time.  So we do have the next bull market to look forward to, whenever it may finally arise.  In the interim we must do our best to protect what we have.

Jim Pappas

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