Letter - July 2008





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The Leeward Shore

In the early days of circumnavigation, ships rounding Cape Horn into the Pacific often changed course and turned north too soon. The result could be disastrous. Westerly winds drove them relentlessly closer to the wild shores of Chile, the leeward shore. Unable to sail into the wind to escape the unkind gales, ships washed up on the unknown shores of what was then an inhospitable and frightening place. Often enough, the crew perished at the hands of the unwelcoming indigenous people. Yet, sailing too far west before turning north carried its own risk: running out of food and fresh water.

Having weathered the storms of the past year, we wonder whether our leaders in Washington have succeeded in keeping the economy from the leeward shore. Just as crews cheered the passage of Cape Horn with its treacherous channels, gales, and fog, we are relieved that the multiple crises of 2008 and early this year seem to be behind us. But it is not yet known whether we can be sure of making safe harbor at Valparaiso.

At the moment the powers in Washington choose to stay the course. Huge sums are being spent on fiscal stimulus. The Federal Reserve has loosened monetary policy in part by printing money and purchasing Treasury securities and mortgages. This has kept short-term interest and mortgage rates low. It will take time to tell whether actions taken have been the right ones and there are important decisions yet to be made.

A great debate is developing among politicians, the Fed, and market participants about when to change course. We are not alone in fearing that in a few years inflation will once again become public enemy number one. To defend the integrity of the dollar, the Fed will have to reverse course at some point, tightening money supply and driving up interest rates. Will the Fed get it right? Will the economy be strong enough to resist rising interest rates and avoid falling back into recession? Or will stagflation—inflation with no growth—reappear? A tricky bit of seamanship, this.

While the US economy stalls at ebb tide, many parts of the world are showing resilience due to effective stimulus programs. This is despite a dramatic slowdown in international trade flows. China, which expects 8% growth, and Brazil are notable pockets of strength. While welcome, overseas strength is unlikely to be enough to pull developed economies back to robust growth.

There remain other areas of concern for investors. Radical policy proposals by President Obama promise record deficits and higher taxes for years to come. The real estate markets are still struggling, foreclosures remain high and we expect more commercial bankruptcies over the coming year. Citigroup remains a ward of the state; taxpayers now own 35% of the company. However, recent failures have been well anticipated and should not ripple the pond too much. We note that the bankruptcy and reorganization of General Motors and Chrysler did not unsettle the markets unduly.

For now, the sense of crisis seems to have passed. It will be a year or two before we know whether Washington has successfully steered a course keeping the economy from the rocks of the leeward shore. In the meanwhile, winds have become more favorable, at least for the time being. Stock markets worldwide have rebounded sharply, though many remain down significantly from levels of a year and a half ago.

We find ourselves oddly bullish in the short term. We can envision another 10-15% rally as we enter the second half of 2009. The low interest rate policy of the Fed is forcing money into more risky assets, including common stocks. In the US alone, there is just under $4 trillion sitting in money funds earning next to nothing. As the sense of crisis abates, these low returns have become increasingly unacceptable to investors. We do not yet see a return to a long-term bull market; second quarter earnings largely exceeded very low expectations but valuations are not particularly low by historical standards. But we do sense that the weight of money searching for return will have a meaningful effect on the stock market.

Or strategy remains little changed. We have been accumulating stocks on weakness and will continue to do so. We like REITs, technology, good quality financials and industrials. However, clients should not be surprised if we take profits opportunistically. To get the bull convincingly started, greater certainty of having weathered the leeward shore is needed. That will take time. Like the 1970s, the market may well ebb and flow without any real overall progress for some time.

Tom Herzig


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