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Quarterly Letter to Clients

October, 2012

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

Dow Jones Industrials: 13,437.13 3Q'12 +4.32% YTD +9.98%

Standard & Poor's 500: 1,440.67 3Q'12 +5.76% YTD +14.56%

As always, we have bright spots in the economic news, and we have dark clouds. Among the positives: another round of quantitative easing; a nascent recovery in housing; rising consumer confidence; and decent auto sales. On the opposite pole, manufacturing and corporate earnings have become subdued, and international turmoil continues unabated. Finally, interest rates still seem highly resistant to any move higher, a factor which both helps and hurts the economy.

The positives have outweighed the negatives of late. The stock market, which has been in a nice uptrend for the last three-and-a-half years, was particularly ebullient in the third quarter. Bond prices have also been strong. You would think that this would make me very happy, and you would be right. But the flip side is that I am painfully aware of how tough a market it is.

When we think of a "tough" market we are generally describing a declining market. But a sharply rising market is an equally difficult market. The question is whether you are buying into a market that will keep on rising, or are you buying at the top? No one ever said this business was easy.

A friend recently asked me if I was fearful of the prospect of a sharp correction in the market. I answered that I prayed for just such a move, because that is where and when you can really make money. (Just to be clear, I do not anticipate any such correction, and my outlook on the markets remains positive. But other people may not be quite so sanguine, and part of my job is to address their fears.)

Often I will show people a 100-year chart of the Dow Industrials and ask them where they would like to have bought in. They invariably point first to the 1932 low, so dramatic as to be everyone's choice. "Where else," I ask, and they point to each successive panic bottom.

Think of the panic lows in modern market history: 1987, say, or 2008, or even a couple of recent "flash crashes." In bonds, the rate acme around 1980 and the break in 1994 stand out. Basically, for my entire lifetime it has paid--handsomely--to buy on panics. But it has never been easy.

Now, you cannot spend your investing lifetime waiting around for crashes. The reality is that you must be invested in something at all times, even if you choose cash. And while I regard cash as a legitimate investment option, it is generally the least rewarding holding, especially so today, and thus cash is likely to be only a small part of our holdings at any given time. So when it is that we are at last presented with the extraordinary situation, the panic low, all the cash we are likely to have available is a nominal few percentage points of our total portfolios.

Still, it is the employment of that amount at that time that boosts portfolio performance in the ensuing years. It is very hard to be a buyer in a panic, harder even than holding on through the event, which, of course, has proven to be the correct strategy every time (so far).

Of course, in a panic market you could shift assets from bonds into stocks. This, though, is an action almost unimaginably difficult to implement, since you are moving relatively safe assets into a class that is under severe pressure. Not to mention that by the time in our lives when we have become bond investors, we have shunned the assumption of risk, and have no taste for trying to catch the proverbial falling knife.

When we think back to the important crashes in market history, we are often left asking what the cause was. Take 1987 for example: what caused that fall other than the fact that stocks had simply gotten too high? As for the Great Crash of 1929, the cause is still being debated, but again one could make a cogent argument that it began because prices had just gotten way out of line.

While I did not live through the Great Depression, my investing world was indeed shaped by the 1973-74 decline, and the moribund years before and after that period. That phase in the market was highly instructive to me, although I didn't know it at the time. By the time 1987 rolled around, I was a 20-year veteran, but still unprepared for what was to unfold. It turned out there were more lessons to be learned and new mistakes to be made. You may think you know how you will react to a cataclysmic break in the market, but it is impossible for you to tell until it actually happens.

Thus we can infer that in any market, a modicum of worry and a dollop of caution is always appropriate. Caution seems to be an inherent part of my investment character, and an undercurrent of worry is my normal condition.

But, no, I am not afraid that the market will suddenly collapse. I do confess to a permanent fear of the slow, relentless, extended decline. That is much harder to deal with than cataclysm. I must reiterate that I do not anticipate either cataclysm or the long slow decline. I have seen and lived through a lot of different markets, and still I know with certainty that there will be things to come that will surprise and try me. With patience, logic, and a steady hand, we will weather any storms.

Jim Pappas