Letter - October 2010





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Big Dogs

I have always been a fan of small dogs: Jack Russell and Norwich terriers, corgis. For me, big dogs make big messes. Their wagging tails knock things off the coffee table; their digestion requires constant clean-up patrol in the backyard.

So too, with business and government: the bigger the size, it seems, the bigger the mess. Large banks and financial institutions contributed to the explosion of private debt and the consequent financial meltdown of recent years. BP polluted our off-shore waters. Government has exploded in size, producing unprecedented trillion dollar deficits and a debt load nearing 14 trillion dollars, almost as large as the annual output of the economy.

A sorry record. At least business, despite its occasional failures, has a record of producing wealth and prosperity over a long period of time. Government by contrast produces no wealth and the bigger it gets, the more it consumes private sector wealth, inhibits economic growth and compromises individual liberty. Along the way, it promotes a culture of dependency. It comes as no surprise that the best real estate market in the country surrounds Washington D.C. Government has become the ultimate big dog, the one that walks its owner rather than the other way around.

Only days away, mid-term elections are expected to upset the status quo of the last two years. Citizens are angry and disillusioned. Incumbent Democrats are widely expected to lose control of the House and several Senate seats. The President is increasingly being abandoned by his own party and looks weak. The mood seems to be, “What we’re doing isn’t working, let’s try something else.” Animal spirits, so crucial to confidence and economic prosperity are subdued. We sense a sorrowful cynicism that regardless of what party calls the shots, the big dog never changes its habits.

We wrote last quarter that the stock market could rally even if the economy did not, and so it has. We interpret anticipation of change in Washington and state capitals as a contributing factor to improved market sentiment. Non-financial corporate profits are solid due to cost cutting and strong balance sheets though growth is slowing. Meanwhile, strength in emerging and developing economies bolsters profits of those US companies that have meaningful international businesses. But revenue growth, a better sign of domestic economic activity, remains sluggish. All in all, stock valuations do not seem excessive so there appears to be room for prices to advance without much help from the domestic economy.

To be candid, however, it is hard to argue that we are entering a new bull market. Anyone who reads the daily papers is aware of how many problems there are. The Fed fights unemployment

and the weak economy with a policy of artificially low interest rates funded by newly printed dollars, a tactic that historically has presaged inflation. The White House has left the burden of repairing the economy largely to the Fed by pursuing policies that are unusually hostile to business.

The economic recovery continues at a slow pace as predicted by many. In the last month or so, it hit another speed bump. Mortgage processors allegedly cut corners in registering mortgage papers during the housing boom, leaving questions as to who owns the mortgage liens on foreclosable houses. Without an adequate paper trail to show who owns what, some homeowners who have not paid their mortgages for up to two years are contesting foreclosure. This affects owners of mortgage-backed securities who want to claim on their collateral, title companies who insured the titles of the properties and mortgage servicers who must deal with the homeowners. The result has been a partial moratorium on foreclosures by the big banks that own the servicers. This has set back the nascent housing recovery. It’s a mess. We find it impossible to know how this will play out. As a result we have lowered our exposure to the housing sector.

As clients may have noticed, we have begun to liquidate holdings in fixed income securities. These provided reliable income during the bad times and capital gains as the recovery took hold. The Fed's beleaguered attempt to spur recovery with easy money has driven interest rates to levels we feel are unsustainable over time. As we mentioned above, such a policy is likely to result in future inflation and a spike in interest rates. We are probably early in making this call but it is increasingly likely that in a few years fixed income prices will be down 15%-20%.

We continue to hold positions in natural resources and other businesses we think can benefit from recovery of world-wide demand. In addition we watch political and economic developments closely trying to find stocks with a compelling narrative that will protect them in this era of austerity and uncertainty. But most of all, when it comes to man's best friend, we recommend small dogs.

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The SEC requires us each year to offer to clients our Form ADV II, which discloses important information in plain English 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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