2009 Report to Clients*

About this report…

Our friend and noted economist, Woody Brock, PhD, likes to quote poet T.S. Elliot’s “Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?”  How prescient. T.S. Elliot could not have been writing about the difference between hard copy and the digital age, since there was little concept of the digital age during his lifetime (1888-1965). Yet digital communication has exponentially increased the data at our fingertips, both in quantity and timeliness. To the extent this data is “information,” it would be impossible for it to be conveyed via hard copy; it is outdated the instant it materializes in cyberspace. In like vein, there is no “information” in this report.

Because of the digital age, there exist many rich data sources that can be accessed by almost anyone. We try to interpret these data with economic and financial analysis to pick out investments for your portfolios.

This report depicts how we find the markets we work in to find investments. Not necessarily a forecast of future prices, but what are the conditions (safety, danger, etc) of the markets. Where might there be opportunities.

Note that even more pages are devoted to Level I, Conservative Income. As we wrote last year at this time, these markets were dysfunctional: for all intents and purposes, the only liquid instrument was a U.S. Government bond. There were no markets for high-quality residential mortgage-backed securities, commercial real estate pools or even corporate bonds. Without primary and secondary markets for these instruments, commerce grinds to a halt, and this was happening at the time. Reflecting these conditions, equities were in free fall.

In last year’s Annual Report, we noted that opportunities in Level I investments would need to be realized before investors would be willing to venture out on the risk curve to Levels II, III and IV, Aggressive Income, Conservative Growth and Aggressive Growth, respectively. In other words, as long as the bond market wasn’t working, neither would the stock market or the economy.

Our analysis was correct. Yield spreads collapsed from record levels, over $1.0 trillion of new corporate debt came to market as interest rates fell, and equities soared. But our time frame could never have comprehended the speed with which this recovery took place. As will be said again in this report, what we thought would take years happened in just a few short months. Capital poured into bonds and overflowed into stocks. By yearend, not only were equities higher, but the riskiest, most unhealthy companies saw their stock prices soaring.

But how healthy is the bond market? Will secondary mortgages continue to be traded after the Federal Reserve discontinues its acquisition program? Have equities gotten ahead of economic reality?  A return to conditions present a year ago (or even a whiff of them) could result in a lot of damage to stocks whose prices contain much-raised expectations. Level I is still the most important investment category, and there are strong forces buffeting this market segment.

Here’s something else we’d like you to know. In response to the crash of 2008-Q1, 2009, it appears that investors and managers are taking one of three courses of action.

  1. Some in the investment community continue to practice denial. Whatever happened, happened to them. They were, and are, correct. Sooner or later, their investment strategies and tactics will deliver superior results; and their accounts will get back to where they were at the end of 2007. These are the mutual funds that remain fully invested, in their respective style boxes, regardless of market conditions and ignorant of fundamentals in other markets. These are some of the nation’s large college endowment funds, pension funds and local government benefit funds who support their—incorrect—decisions to own “alternative investments” and esoteric holdings that lack a mechanism for price discovery.
  1. Other participants, having provided some degree of protection from the market crash (better relative returns) with diversification, are redoubling their efforts to make their pie charts more effective. In this endeavor, they are trying to do a better job of preparing for what they don’t know: the cause of the next storm.
  1. Finally, there are a few who are looking outside the box. This is the category we belong to. Yes, in relative terms, your diversified portfolios may have delivered better returns (less losses) than a host of indices; but we understand you live in the real (not relative) world, can stand some volatility, but are not in the position to live another 100 years to overcome a 37% whack out of your investment capital. As a result, we identified four specific areas in last year’s Annual Report that needed to change. We are happy to report that we believe our efforts in this regard are bearing fruit. They are continuing, and we will have more to report in future periods.

Entering the second half of 2008, we began to think about some type of activity to celebrate the firm’s 15th year in business, which landmark we passed in September 2009. As the remainder of 2008 unfolded, and the markets crashed, it became apparent that it would be an accomplishment just to survive the period. The objective was to get to 16. This year, we will achieve that goal in September, and we like to think the services we provide to you are partially responsible. However, unequivocally, we know that we survived because of you. Tom, Louise and I want to thank you for being our clients. Rest assured that we will be here for you in the future.

*Complete reports available to clients and subscribers in Client Area.