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Third Quarter, 2010


We begin this letter with a list of bullet points presenting some of our current observations regarding investment markets.

As the third quarter began, the stock market was reeling from a number of growing economic concerns, particularly centered around growing indications of deflationary trends coupled with overleveraging in developed markets.  Indications of a growing “soft spot” in the U.S. economy and Western Europe further contributed to stock market unease.  As a result of these concerns we modestly reduced investor exposure to stocks across all investor risk categories early in the third quarter and initiated various equity hedging activities in those accounts which allowed for the strategy.  Funds generated from equity sales were reinvested in various fixed income instruments which we believed would perform well in an environment of declining inflation with possible deflationary risk.


Equity markets drifted very modestly higher during the first two months of the quarter and then began to rise sharply in September when the Fed began to hint at starting a second round of quantitative easing (QE2).  Fed Chairman Bernanke has stated that the inflation rate is below desired levels and the recovery in GDP growth and employment is too weak, hence the need for another round of monetary easing.  September’s 9% stock market return represents one of the highest monthly gains on record and illustrates the point we have often made that investors should never completely abandon the stock market. 


With trillions of dollars around the world looking for investment returns, it’s expected that this flood of new Federal Reserve money will further fuel investment returns in already hot markets: emerging market stocks and bonds; agricultural commodities; precious metals, and base metals such as copper, lead and aluminum.  Your portfolio has investments in all of these areas. 


Oil deserves special mention because it has lagged the gains in other commodity markets.  When the U.S. and Europe finally begin to show signs of self sustaining economic growth without the need for further government stimulus, energy markets could experience brisk price increases due to the constantly shrinking spread between the global quantity of oil produced and oil consumed.  For the present, the global economic outlook has been revised downward for 2011 by the International Monetary Fund (IMF) from current 2010 growth projections.  Should modestly slower growth occur in 2011, oil prices may continue to fluctuate in a narrow trading range.


What are investment markets saying about government deficit strategies?


Western Europe and the U.S. are currently pursuing almost diametrically opposite courses of action regarding government deficits.  The U.S. has taken the stimulus road without regard today for the consequences tomorrow of a growing Federal debt burden.  The Administration takes solace in the fact that our growing debt burden is occurring in the face of declining global and domestic interest rates together with strong global demand for treasury securities.  The Administration and Congress have been adhering to Keynesian economic theory, which posits that high unemployment and excess manufacturing capacity call for governmental stimulus spending until the private sector once again is on a robust growth track.  If this approach creates inflationary financial problems and a lack of faith in government debt tomorrow, the Administration and the Fed will deal with these problems when the time comes.  That day of reckoning is still somewhere out there in the future.


The European Union (EU), backed by the forceful leadership of Germany, believes EU member governments should be putting their fiscal houses in order now despite weak, or even negative, economic growth by cutting spending to levels which bring country debt-to-GDP ratios back in line with levels agreed upon when the EU was created (60% debt to GDP).  Their economic theory states that serious corrective actions taken now, although painful, will lead to financial market expectations of future economic growth that will quickly encourage new investment in the affected countries.  The message is to take the pain today through high unemployment, possible deflation and reduced public benefits, in return for a stable currency and stronger economies tomorrow.  The European Central Bank is responsible for currency stability while our Congress has given the Federal Reserve responsibility for the dual objectives of a stable currency and full employment.


Europe’s very tough measures of fiscal restraint to reduce budget deficits now and over the next five years or so has created widespread public anger and violent reactions as unaffordable entitlements are cut.  Protests continue to take their toll on local and national economies.  Today, France is the media focus with strikes across a variety of industries which threaten to shut down the entire country.


So, which approach offers greater investor confidence?  As you might expect, economists disagree.  As our focus is on the investment implications of government actions, and not the morality of their actions, we look to investment markets for reaction to these divergent government policy philosophies.  We have performed two very simple analyses by looking at this year’s performance of the euro vs. the dollar and the major stock markets.

Consider first the price of each currency in terms of gold.  This analysis is indicative of the degree of investor confidence in these varying government approaches.  The greater the increase in the price of gold, the less the confidence in the currency



Second, equity markets are forward looking barometers of investor confidence.  Here’s how European and U.S. investors have fared in their own domestic markets this year using the Euro Stoxx 50 Index and the S&P 500 Index as stock market proxies: 

From this admittedly simplistic analysis the message seems clear enough: stock and currency markets are not overly concerned with U.S. fiscal and monetary policy at the present time vis-à-vis the approach being taken by European monetary authorities.  In fact, currency and equity traders and investors have strongly favored the U.S. strategy over Europe’s during 2010.  One caveat: markets move in a continuum and nine months

of history may, with hindsight, prove to be only an anomaly masking a longer term trend.  Time will tell all.


We have taken the investment position that the U.S. continues to head down a path of long-term financial decline due to the present combination of increasing entitlements to an ageing population and lack of political will to curb the associated increasing spending which will eventually lead to financial market revolt.  Neither individuals nor companies nor countries can continue to leverage up indefinitely.  For the time being however, global financial markets remain complacent regarding domestic leveraging risk. 


As a consequence of current U.S. policies we have employed a strategy of diversification of client investment assets away from the dollar.  Our target in this regard is to bring your portfolio to approximately 50% foreign investments.  This strategy is, of course, open to discussion with you.


Equity Performance


The third quarter ended strongly for the equity portion of your portfolio.  Domestically, the broad Russell 3000 stock index had a total quarterly return of 11.5%.  Client stock portfolios generally outperformed the domestic stock market during the third quarter due to 1) investment in various international equities and 2) the significant outperformance of holdings in the Basic Materials and Industrial sectors of the market.


The cost of our hedging activities had a minor negative impact on equity return during the quarter.  As mentioned near the beginning of this letter, we believe global equity markets currently offer the best risk/reward trade off compared to cash, bonds and commodities.  However, due to all the significant uncertainties associated with economic recovery in the developed markets we are maintaining client equity exposure around the midpoint of the range for each risk category.


Fixed Income


Since our last quarterly letter, and in fact for the entire year, interest rates have continued to fall resulting in attractive returns to bond holders.  The bond portion of client portfolios has helped to reduce portfolio volatility for the year and, as the numbers show, has generated higher 9 month returns than our stock portfolios.


Declining interest rates over the course of the year are attributable in large part to the Fed’s efforts to manipulate down the yield curve.  Markets now anticipate that the Fed will soon begin anew its efforts to push longer term treasury yields down even further.  There is a saying on Wall Street: Don’t fight the Fed!


The Fed’s successful efforts to manipulate the yield curve are just that: manipulations.  Artificialities.  Presently the consequences of these actions are booming emerging market returns, rising commodities prices and a falling dollar.  Prevailing wisdom is that eventually, when the manipulations end, interest rates will rise and bond prices will fall.  As clients know from our past letters, we place little or no faith in any prevailing wisdom.  Stay tuned.


Other Assets


The principal investments in this category are our commodity funds.  We have been long term owners of GLD, the gold bullion ETF.  Towards the end of the quarter, we added an agricultural commodity fund to client portfolios and reduced client gold holdings somewhat to cover the cost of the new purchase.


A number of developments have spurred our interest in agricultural commodities.  Briefly summarized, the most important of these are: 1) a rapidly growing global water crises as the world’s potable water and agriculturally suitable water is diminishing at a stunning rate; 2) ongoing rapid destruction of the world’s top soil; 3) hundreds of millions of people each year in countries around the world seeking to improve their diets as they move out of abject poverty and into the “middle classes” and 4) recent years of prolonged droughts and extreme heat which have destroyed many millions of acres of croplands.


The Latest Residential Mortgage Fiasco


In a stunning development, Bank of America recently announced that it was suspending all mortgage foreclosure activity across the country.  Other large mortgage servicing companies including JP Morgan, Wells Fargo, Ally Financial and Citicorp are reviewing their foreclosure activities as well.  It’s not out of a sense of goodhearted benevolence towards suffering homeowners that these actions are being taken, but rather from a growing realization that in many instances, the foreclosure process is so deeply flawed that the banks or other investors can’t prove they own the debt on the homes going through the foreclosure process.  Frequently the notes which represent the debt are missing or fail to reflect all previous purchase and sale activity on a property.  Evidence is also coming to light that many notes have been fraudulently altered.  We are in the early days of discovery in this mess, but already Attorneys General of all fifty states are starting to launch criminal investigations.  Spokespeople for various banks say the matter will be corrected with minor financial consequences to the banks and the mortgage market.  We are reminded however of Fed Chairman Bernanke’s comments regarding defaulting subprime loans before that situation precipitated the worst global economic crisis since the Great Depression.  He said: “The subprime problem will be contained”.


We don’t know what the end result of this latest fiasco will be although bank stocks have already taken a hit and their bad debt reserves will be increasing.  It’s a new caution flag in the otherwise ongoing tepid recovery.


As you know, we typically follow up with a telephone call after you have had an opportunity to think about our comments.  We attach great importance to follow-up client discussions as they frequently enable us to gain new insights into your own investment views.  The better we understand your views, or changes in your views, the better able we will be to align your portfolio structure to those views.



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