Letter - April 2011





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Here We go Again

The recent disaster in Japan, partly an act of nature partly a failure of man, has gotten us thinking again about the nature of risk and subsequent financial turmoil. Low probability, high impact events often referred to as Black Swans, are individually unique. But the probability of some sort of event with a major financial impact is more likely than we are inclined to believe. We tend to focus on a particular possibility such as an earthquake in California rather than the possibility of any number of low probability, high impact events. As I look back over the last 25 years, disasters have occurred with startling frequency:

• 1987 stock market crash
• 1989 Savings and Loan collapse
• 1991 Gulf War
• 1998 Asian debt crisis
• 2000 stock market bubble
• 2001 World Trade Center
• 2008 financial meltdown

In each of the above cases, financial markets suffered a substantial decline. In time, however, the system stabilized and prices rebounded to new highs (with the exception of 2008, but we are close.) The take-away for investors is that low probability, high impact events happen with surprising regularity. We should be less unsettled by them than we actually are. Losses tend to be relatively short-term. Over time, financial markets produce a return. My father, Philip, was fond of saying that the end of the world happens only once.

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In light of the events in Japan, global stock markets have been surprisingly resilient though Japan's has been understandably weak. Short term, the tsunami will probably be a drag on growth and corporate profits as essential supplies of Japanese parts have been disrupted. No question, wealth has been destroyed by the disaster and Japan is poorer for it. But rebuilding should act as a stimulus to global growth in the second half of the year.

Of more concern to the US market is the ending in June of quantitative easing by the Federal Reserve that has kept US interest rates artificially low. What impact will higher interest rates have? Inflation is a related concern. We fear that gas at $4/gallon and escalating food prices will act as a tax on consumers, too many of whom remain unemployed.

Please see our disclosures on page 2 and on our website

Member FINRA/SIPC We know clients have been watching with concern developments in Washington as both ends of the political spectrum debate the future of the entitlement society we have constructed over the past 75 years. It is becoming increasingly clear to all that we cannot afford future commitments made without impoverishing the next generation. However, there are sharp disagreements about what to do. This is sure to be a long struggle but the fact that there is a genuine debate is refreshing and fascinating to watch. Surprisingly, the US stock market has been rising in the face of this debate, climbing a “wall of worry.” Expectations of strong corporate earnings seem to be more important in the short term. The stock market has almost doubled off its 2009 low. We remain concerned that such momentum cannot be sustained.

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The future of nuclear power has suffered a setback as a disabled Japanese nuclear power plant leaks radiation. Despite encouragement from President Obama, the cause of nuclear power has likely been delayed substantially. Re-engineering designs to enhance safety will be costly and time consuming. It is uncertain whether investors will require higher returns in order to finance nuclear power, adding to costs. This development is creating opportunity for natural gas as a bridge fuel between an oil and coal powered economy and one powered by nuclear and renewable energy.

Recent technological advances have opened up tremendous domestic reserves of gas (and oil too) that were previously uneconomic to develop. Daniel Yergen, an industry expert, has estimated that these new reserves could supply US demand for 100 years. Strategically, developing domestic sources of energy is attractive. It would make us less reliant on foreign sources. Gas is particularly relevant in light of the numerous rebellions in the Mid-East and North Africa. Gas is less polluting than oil or coal. And, at current prices, it is competitive with coal, historically the low cost fuel, while supplying an equivalent unit of energy at one third the cost of oil.

Investors should be aware of risks. Infrastructure needs to be built to move gas to consumers. There are obstacles to overcome pertaining to safety, contamination of groundwater while drilling and disposal of polluted wastewater. Finally, as resurgent supply reaches the market perhaps overwhelming demand, natural gas prices may remain depressed in the near to mid-term. The future is bright but it will take time, making natural gas an investment for the patient.

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As an SEC registered investment adviser, we recently updated our Form ADV Part 2 brochure to comply with new rules. We have posted the new brochure on our website at www. prherzig.com and will send hardcopies upon request. We encourage clients to read the brochure, which describes our business practices and code of ethics.

Tom Herzig


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