Letter - January 2010





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The Noughties

Tongue-in-cheek, the Financial Times has dubbed the decade just ended the "Noughties", an appropriate moniker not only because of the preponderance of the digit zero in the years of the 2000s (nought means zero in the Queen's English) but also because of the zero positive total return (actually a loss of 9.1%) of the S&P 500 during the decade.

The decade was also a period of naughtiness from Enron to Madoff. Politicians indulged in an orgy of misguided social policy, businessmen in deceit and individual citizens in greed-induced speculation. In the end, the decade came to nought.

Nonetheless, 2009 was a pretty good year. After hitting a crushing low in March, the S&P 500 rose 67% from there to end the year up about 26%. Emerging markets, having hit their lows in 2008, did the best. Some rose 70% or more over the course of the year. However, if one looks at the two-year period, 2008-09, many markets around the world, including the US, are still under water.

As portfolio managers, the experience of the last two years reminds us of an important lesson learned over the years. If we can do better than the market on the way down, the way back up is not nearly so difficult. The math is simple. After a 50% decline, a portfolio must increase 100% to get back to its previous level. A 25% decline requires only a 33% rise get you back to even.

Although individual experiences vary, fully managed portfolios of our clients in the aggregate declined about 16% over the last two years vs. just over 20% for the S&P 500 with dividends included. (Past performance does not indicate nor guarantee future results. All results are net of expenses). This was largely due to a substantially smaller loss in 2008 than the market. We do not congratulate ourselves for we feel the losses to-date acutely as we know our clients do. We prosper only if our clients do. Investing is a difficult business. We have no control over the market nor do we believe that market timing can produce superior returns. But we do take some comfort in the fact that as professionals we have been able to mitigate losses in a period of extreme turbulence.

Looking forward there are a few things about the economy that we know with some certainty. Corporate earnings will increase compared to a dismal 2009; taxes will be rising; interest rates are likely to be higher by year-end; government budget deficits will go to record levels.

But this is also a period of an unusually high degree of uncertainty. What will increased financial regulation mean and how will it affect the banks' willingness to lend? What will be the unintended consequences of any healthcare program that passes? Will business begin to invest and hire more workers? When will housing bottom and stabilize?

The outlook for the stock market is particularly hard to assess. After a 26% gain for the year, our instinct tells us to be cautious. Yet after similarly strong gains in 2003 following the dot-com meltdown, the market rose another 49.1% by October 2007, registering double-digit gains in every year but 2005. Could it happen again? You bet. Will it happen again? We don't know.

Corporations are now in the process of announcing fourth quarter 2009 earnings. The short-term direction of the market will depend upon whether earnings exceed already high expectations. It is plausible that they might. Q4 2008 was so dismal that Q4 2009 is bound to look good. Also, when the severity of the recession hit in Q4 2008, companies were unusually quick to cut costs, lay off workers and cut production. Now that the economy has stabilized and begun to grow, they are lean and profitable. Productivity is high and revenues are in many cases growing. The hope is that companies will begin hiring workers once again.

Though the stock market has risen sharply in the last nine months, it has been a market of unbelievers. Daily trading volume on US exchanges has been noticeably low. This could change. There remains a lot of liquidity on the sidelines earning low returns. Real estate is less competitive as an investment alternative to the stock market. This suggests that should money begin to flow into stock markets performance could surprise to the upside.

So, here's to the next ten years. Be it noughty, naughty or nice, we will be slugging it out in the trenches for our clients.

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The SEC requires us each year to offer to clients our Form ADV II, which discloses important information on how we manage client funds and run our business. You can find the form (technically a "replacement brochure") in the "Disclosures" section on our website at www.prherzig.com. Let us know if you would like us to mail you a hardcopy. Also FINRA requires us to ask clients periodically to advise of any changes in address, financial circumstances, or financial objectives. Please let us know if we need to update any information.

Tom Herzig


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