Letter - July 2008





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Biding our Time

It has been a year now since the current economic mess began to first unfold. There has been ebb and flow, rallies and sell-offs, as the tide of prosperity has receded. It remains uncertain as to how low the tide will go. Investors have been left to wonder after each decline whether the worst has passed. So, we have been biding our time.

Since our last letter there have been continued financial fires. IndyMac, a California based thrift recently declared bankruptcy, sunk by (what else?) bad mortgages. Media coverage of depositors lined up outside the bank’s offices to withdraw their money prompted a number of phone calls from our clients asking whether their banks are any good.

In the housing sector, Fannie Mae and Freddie Mac, tireless promoters of home ownership (at any cost?), are in danger of insolvency and subject to a possible federal takeover. Although the debt of Fannie and Freddie is backed by real assets, the vast majority of which is sound, a complete takeover could add $5 trillion to the national debt and federal guarantees. One wonders how long Uncle Sam would hold onto his AAA credit rating!

What began as a problem for housing and the mortgage industry has now begun to inflict pain on Main Street. With the collapse of housing prices and the stock market, a weak dollar, $4 gas, soaring food prices, it is hard to believe that the economy is not in recession. The trouble on Main Street is affecting retailers, some tech companies and the auto industry. Credit card delinquencies are on the rise.

Shades of the Great Depression? We don’t think so. There will be additional bankruptcies, perhaps large ones. But Treasury and the Fed have made bold policy decisions to hold the system together. So far, so good. We do share the concern, however, that a new administration will make major policy mistakes like raising taxes or increasing barriers to trade.

Nobody likes a bear market. The market has fallen approximately 20% since its peak last October. An investor’s fantasy is to sell at the top and buy at the bottom. The reality is that one has to expect setbacks. Over the long term, clients have experienced substantial growth. A year from now, the world is likely to look better.

Stocks have been unusually volatile. A 250-point decline in the Dow one day is followed by a 250-point rally the next, with 10% swings in individual stocks during the course of a day not uncommon. Much of this volatility results from wild swings in sentiment fed by uncertainty about the value of assets on bank balance sheets. We note that volatility does not necessarily indicate a bottom for the market but market bottoms are typically accompanied by high volatility.

We don’t know when things will settle down. Our experience tells us that the bad news will subside and the economy will right itself. The shrill tone in the media suggests we are approaching a turn of the tide. When it turns, fundamentals will still look terrible. The rise off the bottom will be met with skepticism and disbelief. Investors trying to “time the market” (stay out for now and buy before it goes up) will be left holding their hats in their hands.

As to stock market strategy, we know what we should do: lighten up on energy and metals, and buy depressed financials and technology. Lightening up on energy makes sense, as it has grown to be the largest position in many accounts. But we are hesitant to commit more to financials and tech just yet. Previous attempts to find the bottom have left us chastened.

So, we will continue to bide our time.

Tom Herzig


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