The Markets	3/31/09      Close	12/31/08    Close	1st  Qtr.  Change	3/31/08    Close	12 Mo. Change	YTD       Change
Dow	7609	8,776	-13.30%	12,263	-37.95%	-13.30%
NASDAQ	1529	1,577	-3.04%	2,279	-32.91%	-3.04%
S&P 500	798	903	-11.63%	1,323	-39.68%	-11.63%
10-yr Treas. yield	2.69	2.24%	+0.45%	3.43%	-0.74%	+0.45%
Fed funds rate	0 to 25%	0 to .25%	n/a	2.25%	-2.00%	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

Our prior review concluded with the hope that reduced volatility at the end of 2008 may indicate a return to sanity in the markets. That turned out not to be the case. In January the Dow was down almost 9%, the worst January ever. For believers in the idea that as January goes so goes the whole year, this is bad news; the January indicator is correct 75% of the time and 26 of the last 30 years. February was even worse, with the S&P 500 posting an earnings loss in the prior quarter for the first time in 80 years and the Dow falling another 12%, for the sixth straight month of decline. March started out the same, as the Dow reached levels not seen in 12 years. And then a sharp turnaround on a few reports of positive earnings news, as the Dow recovered over 20% from its lows and ended March with an increase of 8.5%, the best month in six years.

Fourth quarter GDP was revised to a decline of 6.2%, the worst since 1982, from an initial estimate of a drop of 3.8%. The Fed pledged to keep rates at low levels as long as it takes to spur the economy, and the Bank of England cut rates to the lowest level in 315 (that is not a typo) years. Inflation is barely registering and manufacturing continues to contract, while durable goods orders were down 5.7% for all of 2008. After sliding to $35 a barrel, oil bounced back over $50. The SEC alleged that an $8 billion fraud occurred at the Sanford banking empire, which would have been major news if not for the Madoff scandal.

Consumer data was particularly bleak as consumer confidence hit yet another low. Weekly jobless claims were consistently over 600,000 and unemployment reached 8.1%, the highest in 25 years. Over 71,000 layoffs were announced on January 26 alone. Home prices were down 19% from a year ago, and despite signs that declines in home sales are beginning to level off, the market for both new and existing homes is extremely weak. (Ironically, the declines in home prices and low mortgage rates have driven home affordability to record highs.) Consumer spending for all of 2008 was up 3.6%, the least since 1961, while incomes rose 3.7%. Rather than spending, consumers responded to their feelings of misery by tightening and increasing their savings rate to 5%.

Through it all the government expanded its efforts to restart the economy, all the while denying that banks would be nationalized. A $750 billion stimulus package was passed after much debate, and a mortgage bailout package for stressed homeowners was finally defined. Not only did the Fed announce plans to buy Treasuries and mortgage-backed securities to drive lending rates down, but the administration also announced its plan to partner with private investors to buy “toxic assets” from banks to restore confidence. Finally, the White House rejected turnaround plans from GM and Chrysler and ousted GM chairman Rick Waggoner. At the same time, new incentives for buying new cars were announced and the government stepped in to guarantee car warranties. Chrysler now has 30 days, and GM 60 days, to somehow pull off a miracle and avoid being forced into bankruptcy.

Looking Forward

As government interventions in the economy grow in number, scope and dollars, the specter of inflation has returned. Despite record low interest rates and miniscule increases in price indices, these government programs will greatly inflate the money supply. In the past year alone, a common measure of the money supply increased 10%, and that is before the effect of recent government intervention. Conventional wisdom holds that too much money chasing too few goods will lead to inflation, a declining dollar and increases in commodity prices.

But all that new money is not being spent, at least not yet. The personal savings rate has spiked from zero to nearly 5% and it is clear that consumers are hunkering down in fears of job losses and further loss of value in homes and investments. Another indicator is the velocity of money, or the speed at which money is spent, measured by comparing gross domestic product to the money supply. The decline in the GDP means that this velocity fell to its lowest level since 1991 in the fourth quarter of 2008, and could be even lower for the first quarter of 2009.

So where is the money? In addition to personal savings, bank reserves of cash have increased over $600 billion in just the last seven months. The banks are faced with a dilemma, with the government begging them to lend but the market looking for a stronger capital structure (that is, more reserves) after the huge losses suffered by banks.

In the past, increases in bank reserves have been followed by increased lending and fast economic growth a few quarters later. But once the prospect of recovery starts to become clear, the Fed could reverse course and begin to tighten the money supply, soaking up the surplus reserves. And consumers, still weighed down by heavy debt loads and decreased asset values, may not be willing to spend and resume borrowing. Finally, the banks have to be more willing to lend, which won’t happen until the banking system is more healthy.

The opposing view claims that deflation is the more likely and bigger problem, as the process of “deleveraging” or debt reduction causes assets to be sold at fire sale prices. This would cause more assets to be dumped at even lower prices, creating a downward spiral in prices that would not stop until everyone who had to sell had done so. Widespread declines in prices have not been seen since the Depression, and there are few monetary tools to deal with it once it begins.

So far the economy has absorbed an historic decline in both real estate and stock prices without falling into deflation. The question, then, is if, when and to what extent either deflation or inflation will take hold.

Our Portfolios

The deep recession and steep market decline have created a chorus of proclamations that “all the traditional investment approaches failed” and “there are new rules for investing”. On further examination, these proclamations are mostly opportunistic hindsight and really reveal a lack of appreciation for and understanding of the traditional approaches in the first place.

So, what to do now? Depending on the individual circumstances, here is what we are doing.

• First and foremost, do not react out of panic. Throwing in the towel and selling everything will provide some temporary relief from anxiety, but it probably won’t meet the financial objectives and will only postpone necessary hard decisions.
• Take the time to re-evaluate goals and objectives as objectively as possible given the difficult circumstances and develop an investment strategy accordingly. If that evaluation leads to a more conservative approach, it is okay to sell some holdings to implement that new strategy, even at depressed prices. (And while we do not advocate market timing, the volatility of the market will provide opportunities to sell at “less bad” levels.
• Consider “reverse dollar-cost averaging”, which involves a series of sales over time.)
• Do not take a “head in the sand” approach. Confirm whether spending levels and the timing of larger goals are still realistic, and if some adjustments are necessary. In many cases this assessment has shown that things are not really as bad as they seem.
• As important as avoiding panic is to avoid greed. Many asset classes are at very low prices, but do not base a purchase decision on price alone. Some things are cheap for a very good reason, and only buy after making an assessment of prospects for recovery. We are evaluating commodities, for example, but are still wary of high yield bonds.
• If a large amount of cash is available, this is an excellent time to construct a well-diversified long-term portfolio. Yes, there are still many important unanswered questions, and plenty of risk, but that is precisely what creates opportunities for growth. And by all means, continue payroll deductions to retirement plans and other dollar-cost averaging purchases.

An Excess of Fear

In early March, as the stock market was hitting new lows, Lawrence Summers, director of the White House’s National Economic Council, suggested that among our many problems was an “excess of fear”. A true economic recovery would require the elimination of that excess and a return to a rational examination of risks and opportunities.

As an example of what an “excess of fear” means, I offer this edited summary of an actual exchange with a caller who wanted to buy some gold.

Me: Do you want to buy gold as a short-term trade, a long-term investment or as a hedge against inflation?

Caller (recalling pictures of people pushing wheelbarrows filled with paper money to buy a loaf of bread): I want to use gold to pay my bills when hyper-inflation hits.

Me: Do you want to take possession of the gold or do you want to have it held elsewhere for you?

Caller: I want to take possession because all the institutions could fail and I could lose access to my gold.

Me: Do you want to buy gold bullion or gold coins?

Caller: I want to buy gold coins because the government could confiscate gold bullion from private citizens. (Note: When President Roosevelt issued his 1933 executive order calling in gold, he exempted “gold coins having a recognized special value to collectors”. In 1977 Congress removed the president’s authority to regulate gold transactions during a period of national emergency other than war. Who knows if, when or under what conditions the government will call gold in again.)

Me: Do you have a safe in your home?

Caller: Yes, we have a safe but I don’t want to store my gold in it because someone could force us at gunpoint to open it.

Me (in an attempt to illustrate the folly of where the conversation was going): A local coin dealer told me the story of a widow in Green Valley who was having some work done in her house. The workman found some gold coins that her late husband had apparently hidden in the wall and never told anyone. They checked around the walls of the house and found $30,000 worth of coins.

Caller: So, you think that as long as I tell someone, the wall is a good place to store my gold coins?

The only response I could muster was that if we reach that point I will just have to rely on my wits to survive. While it is often a good idea to plan for the worst and hope for the best, this scenario just seems a bit much.