Letter - April 2008





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The Hunger Time

For the prehistoric ancestors of many of us, springtime was the hunger time. Stores of food gathered the previous autumn were depleted and new growth to replenish them had yet to appear. Early spring was particularly stingy with its offerings. It was a perilous time especially for the young and old; starvation was an ever-present possibility.

For many, now is the hunger time. Over the past two years, the shocking decline in housing prices and the stock market has depleted reserves and undermined the real economy. Unemployment is rising and will continue to do so for some time. Opportunities are scarce for student summer jobs or more permanent ones for new college graduates. Those who are retired worry that they have the resources left to live out their lives in comfort.

Life is cyclical, something our most ancient ancestors understood well though we moderns often forget. No matter how bleak the early spring, they knew that warmer weather and its abundance would return. Hope and expectation of better times sustained them.

The dramatic rally of the stock market over the last six weeks reminds us of the cyclicality of economic life. Hope and expectation of better times seem to be hard-wired into us by evolutionary forces to ensure survival. Investors are feeling better though it is a sign of the ferocity of the stock market decline that the recent rally still leaves the S&P 500 Index somewhat shy of where it started the year!

Despite the stock market rise, it is still the hunger time on Main Street for the working-man. The economy continues to decline, though it is no longer in a free fall; it is declining at a slower rate. This de-acceleration of decline is typically a sign that the fall in economic activity is approaching a bottom. There is some hope that the economy will start growing by year-end. Positives include lean business inventories, which will lead to an increase in production when demand revives and pent-up demand from consumers who have sharply curtailed consumption in the face of looming unemployment, uncertainty and the fall in household wealth.

There remain many obstacles to a vigorous rebound in economic growth and corporate profits which drive the stock market over the long term. As the year progresses, we expect multiple bankruptcies. The automakers are in a perilous state and may well choose reorganization under Chapter 11. Recently, we witnessed the largest commercial real estate bankruptcy in history by a well-respected operator of shopping malls. Expect more failures as loans come due and lenders refuse to refinance them.

And then there is Washington. Federal efforts to stem panic in the credit markets have succeeded so far but the system remains fragile and banks are reluctant to extend loans to any but the highest quality borrowers. The federal budget, which was passed by Congress almost unnoticed, is a fiscal nightmare of trillion dollar deficits containing a wish list of programs that the country cannot now afford. By borrowing today, we limit the prosperity of tomorrow. There is no free lunch. It is ironic that the President talks of a new age of responsibility and accountability when his budget, from an economic point-of-view, seems highly irresponsibile. We read in the media that consumers must exercise frugality, pay down debt and repair their personal balance sheets, but the same rules do not seem to apply to the government.

The recovery when it comes is likely to be anemic. Consumers will need to curb consumption to pay down debt and replenish household savings. At some point when the crisis in the banking system has passed, the Fed will have to raise interest rates to drain the flood of money they have injected into the economy or risk resurgent inflation. This could cause higher interest rates, an additional drag on economic growth.

Despite all the economic uncertainties, we are cautiously optimistic about the stock market. In the short term, the market likely has rallied too far too fast and we may well see declines from current levels. Yet it “feels” like the low of last March was a bottom. We see many stocks that look attractive and advise that positions should be built on weakness. Sentiment has become extremely negative. We think that the market has probably over discounted yesterday’s fears. We would point out that two years ago nobody listened to the small group of bears who “ got it right.” Today, everybody listens to those same bearish forecasters and is scared out of their wits.

Clients should consider a scenario where the market doubles from its March low over a period of 10 years. This would result in a 7% compounded annual rate of return unadjusted for inflation. This is in line with long-term historical experience and we find it conservatively plausible. Furthermore, as an investment, stocks are likely to beat bonds, which would suffer from rising interest rates and/or resurgent inflation.

We remain acutely aware of our responsibilities to clients and are sensitive to their concerns. We want to make sure that everyone makes it intact through the hunger time.

Tom Herzig


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