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
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
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.
Please read our important notice
about these letters and the securities they mention.