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Quarterly Letter to Clients

July, 2012

Indices at quarter-end (June 30, 2012):

Dow Jones Industrials: 12,880.09 2Q'12 -2.51% YTD +5.42%

Standard & Poor's 500: 1,362.17 2Q'12 -3.29% YTD +8.32%

The stock market was constrained during all of 2011 by the turmoil in the Euro zone caused by Greece. By the start of the first quarter it seemed that that problem was over. The feeling of relief led to a very robust move, topping right at the end of March with double-digit gains in the Dow.

Of course, everyone knew that the solution wasn’t permanent. It turned out that they hadn’t bought nearly as much time as they expected. When it became apparent that the troubles in the Euro zone had not been solved, but were actually spreading, the market stumbled. The ensuing decline in April and May wiped out that whole first quarter gain before greed returned to the markets and a brief rebound recovered some of the loss.

The swings were dramatic, 8 to 10 percentage points or more in both directions. Ultimately, we closed the second quarter with a loss of 2.51% in the Dow and 3.29% in the S&P 500. For the year-to-date we are up 5.42% in the Dow and up 8.32% in the S&P.

But we grow tired of old news: the real story of the second quarter was the initial public offering of FaceBook. Widely hyped, it turned out to be a dud, and all those folks complaining that they were unable to buy on the offering turned out to be rather lucky.

The FaceBook debacle yields a lesson. Widely seen as a “sure thing” before the offering, it reaffirms common sense: it is hard to make money if you pay 100 times earnings. Even renowned investment managers got caught up in the hype. Many appeared on TV and in print, crowing about how they had bought the stock in private transactions before the offering. Here is the lesson: if you fail to do your homework you are likely to flunk the class.

Speaking of renowned investment managers, another bit of news this quarter had to do with J. P. Morgan Chase losing some $2 billion in it’s trading operations—later estimated to be as much as $8-9 billion. While Morgan’s loss was apparently easily absorbed by the bank’s capital cushion, it’s sheer size pointed out the potential threat to our banking system, which is locked into a global web of banking speculation. What if that loss had been a multiple larger? This is not the first bank to report trading losses in 10 digits. Is it not obvious that we need to regulate these institutions along the lines of our utility companies?

The ratings agencies have recently lowered their ratings on many large U.S. banks, implying that they are less safe than previously thought. Morgan’s plight may well have been the impetus, though in my opinion, the major banks have long been much less credit-worthy than their ratings would have one believe.

When to invest, where to invest, and what to invest in: these are the perpetual questions.

If you think about when to invest, you have to look at history, which shows long periods of bull and bear markets in both stocks and bonds. The decade just past, for example, was not a particularly good time to be in stocks, while 1980 to 2000 was a wonderful time for equities. As for bonds, the past 30 years has been a very rewarding period, while the 40 years prior to that was not so enticing. (You see that I think in terms of decades.)

Let me expand a little on bonds: interest rates bottomed in the 1940’s, then began a long upward move (meaning bonds went down in value) that lasted until an outrageous peak in 1980-81. Since then, rates have generally declined and are now at levels so low as to be unthinkable. Bonds responded by staging a bull market of more than a generation in duration.

It would be folly to predict anything other than a rise in rates going forward, although we may well get stuck in a flattish low-rate environment (a la Japan) for some extended period. Indeed, we have been in such an environment for the better part of a decade already, and I have harped on this subject too many times in the recent past to give it much more ink today.

Still I must comment: The ten-year Treasury Bond now yields 1.6%. That is below the rate of inflation. Thus, an investment there is guaranteed to lose you money, at least in "constant" dollars.

Why should investors settle for a security that will certainly lose them money? Safety. With the major banks and currencies of the world seemingly at risk, dollar-denominated assets, and the bonds issued by the U.S. government in particular, are viewed as a “safe haven”, and attract investment from all over the globe. Thus, when pondering where to invest, you realize that the U.S. is prime territory.

Finally, what to invest in: As for me, I continue to prefer investments in major domestic and international businesses, either through their bonds or their common stocks. No matter what happens to currencies, these companies are likely to continue to find markets for their goods and services, and to generate healthy profits. I fully expect investments of this sort to generate satisfying returns, but remember that I think in decades.

Jim Pappas