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Quarterly Letter to Clients

October, 2011

Indices at quarter-end (September 30, 2011):

Dow Jones Industrials: 10,913.38 3Q'11 -12.01% YTD -5.73%

Standard & Poor's 500: 1,131.42 3Q'11 -14.33% YTD -10.04%

Volatile: tending to vary often or widely; inconstant; fickle; ephemeral; fleeting; tending to violence. The term seems perfectly descriptive of today's stock market. It has made my work a little more, um, interesting.

The human trait is to celebrate when prices soar, and when that happens there is rarely much talk of volatility. It is when prices move sharply lower that volatility, with it's negative connotation, becomes the buzzword. Higher prices good, lower prices bad. Seems pretty natural to me.

It is further the human condition to try to find a guilty party when we are perceived to have been damaged. After all, no one ever looked to find a culprit during the period when housing prices were soaring beyond rationality, or when we had bubbles in stocks. No one questioned Madoff as long as the numbers he invented seemed rosy. Only when these assets come crashing down to reality do we try to find someone or something to blame. The fault, dear Brutus, lies not in the stars.... We are all guilty of greed.

What has spooked people of late has been the degree with which the markets can move in a single session. Daily moves of 100 or 200 points on the Dow are commonplace, and moves of double and even triple that amount seem to be happening more frequently than ever. The moves are in both directions, up and down, and often a sharply down day is followed by an equally sharp up day. What drives these moves? It seems to make no sense.

But is that degree of movement unprecedented? Yes and no: compare the 1970's with today, and you will see that 40 years ago we had many more swings of 2% or more than we do today. (As I write this, a 2% move is equal to 225 Dow points.) If you count days with moves of 4% or more, though, the current period is unique.

On closer inspection you will see that the current level of volatility has occurred primarily during the summer of 2011. Does this tell us anything about the market going forward? If it does, I am at a loss to discern what it might be. In previous times of extreme volatility the fire seemed to burn down and trading returned to more subdued levels, leaving no permanent damage. I expect that this is what will happen again.

The correlation with the 1970's seems apt. During that era (say, 1968 to 1982) stocks behaved very much as they have behaved over the last dozen years; a series of rolling tops, followed by often-violent corrections, then a gradual recovery, but never seeming to definitively surpass the old highs. And yet, history shows us that the proper course of action was to buy on the extreme dips and to hold our positions through the storm. The big dips can indeed offer us attractive buying opportunities, for which we must be alert. And brave.

The bond market, meanwhile, seems to be immune to the disease affecting stocks. It has continued its gradual, steady upward trend, (meaning that interest rates continue going down). Please be aware that this condition cannot persist. There is a top to the bond market; it is at zero percent, and we are very close to that now.

There is a lot of negative news roiling the markets today. In my opinion a lot of it is just noise. Will Greece default? Will housing ever bounce back? Will the jobless numbers improve? Will our debt situation ever improve? All of this is fodder for journalists, pundits and politicians. We are a robust, diversified nation, and we will overcome all of these problems, and all of the myriad problems that I do not have room to mention. I cannot tell you how these things will be resolved, or, more importantly, when, but I do have faith that they ultimately will become only memories, historical talking points. In the interim, when we get large moves to the downside in stocks, we will look to use it as a buying opportunity. Given lemons, we will try to make lemonade.

Jim Pappas