The Markets	06/30/09   Close	3/31/09      Close	2nd Qtr.  Change	06/30/08   Close	12 Mo. Change	YTD       Change
Dow	8,447	7,609	+11.01%	11,350	-25.58%	-3.75%
NASDAQ	1,835	1,529	+20.01%	2,293	-19.97%	+16.36%
S&P 500	919	798	+15.16%	1,280	-28.20%	+1.77%
MSCI EAFE	1,307	1,056	+23.76%	1,967	-33.55%	+5.64%
10-yr Treas. yield	3.52%	2.69%	+0.83%	3.98%	-0.46%	+1.28%
Fed funds rate	0 to.25%	0 to .25%	n/a	2.00%	-1.75%	n/a

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

The market recovery that began at the end of the first quarter continued in the second quarter, with the market solidifying its gains. The Dow gained as much as 40% from its March lows before settling down for one of its best quarterly gains in years. While the Dow did not quite make it, the broader S&P 500 finished positive for the year to date. Technology stocks fared even better, as reflected in the NASDAQ gain, and the dollar generally weakened, boosting international stocks as indicated by the MSCI Europe, Australasia and Far East (EAFE) index.

The benchmark Treasury yield was up considerably as more bonds are sold to finance the growing government debt. S&P retained its highest rating for US government debt, at least temporarily allaying fears of a downgrade. China and Japan signaled that they planned to reduce their Treasury holdings, and Russia plans to use bonds from the BRIC countries (Brazil, Russia, India and China) for some of its currency reserves, adding to concerns that the dollar will weaken further. Ten large banks have been given the approval to repay bailout funds to the government, indicating some stabilization in the financial markets.

The big concern is unemployment, which reached a 25-year high of 9.4% (and hit 9.5% on the July 2 announcement). Initial weekly jobless claims have dropped a bit but are still consistently above 600,000 and over 1.3 million jobs were lost during the quarter. Pending home sales were up slightly for four months in a row, but prices continue to soften. Despite oil rising back to $70, the trade deficit has shown improvement as other imports have dropped sharply.

There are, to be sure, some glimmers of hope. First quarter GDP was revised to be down “only” 5.5% from the previous 6.2%. Inventories have declined, leading to the possibility of an accelerating recovery once it begins. Leading economic indicators have shown increases (although part of that increase is attributed to increased stock prices) and consumer confidence has rebounded from cataclysmic lows. Inflation is nil, and the Fed has signaled its intention to keep rates low as long as it takes. The rate of decline in many economic indicators has slowed or even flattened out, but that does not necessarily mean an uptick is imminent.

Two big government initiatives could have broad impact but are far from final. Health care reform retains private insurance and does not include the government as a “single payer” but there will be a battle over whether there should be a direct government insurance option at all. There will also be a debate on how to incorporate incentives for healthy lifestyle choices, which have been lacking in the current system. A much-needed overhaul of the financial regulatory structure will address cracks in the system which contributed to the financial crisis. The Fed’s powers will be expanded and broad powers will rest with a new regulator to oversee consumer protection, including banks, nonbanks and mortgage brokers. More murky is the issue of what to do with firms that are so interconnected with the overall financial system that they become “too big to fail” and whether the government should have the power to seize them.

The odyssey of GM and Chrysler, both now in bankruptcy, makes history at every step. GM looks to have found buyers for Hummer, Saab, Saturn and Opel, even though all the buyers are not traditional automakers. Creditors of the automakers have objected as the proposed bankruptcy settlement leaves them with far less than in typical bankruptcies, in favor of labor unions and the government ownership stakes. The silver lining is that the whole episode has been so convoluted and contentious that it will hopefully make the government think twice before becoming so directly involved with any other industries or firms.

And in a small victory, Bernie Madoff was sentenced to the maximum 150 years in prison. There is still $13.5 billion in net funds (money invested less money withdrawn over the years) unaccounted for.

Looking Forward

There are still plenty of unanswered questions about the economy and the financial markets, both in the short and long run. One of the immediate unknowns is the timing and extent of improvements in corporate earnings. The recent market run-up has taken the US market from relatively cheap, based on earnings, to fairly richly valued. Even when adjusting for the huge losses in the financial sector, the market really can’t be considered cheap. Earnings are ultimately the true foundation of market value, and with the consumer still holding back, unemployment still rising and cost cutting reaching its limit, the market will suffer if earnings do not begin to improve.

In the intermediate term there is still the conundrum of inflation. Not much has really changed at this point other than the extent and the volume of the rhetoric. With recent consumer prices down 1.3%, the economy still contracting and plenty of excess capacity, some economists feel inflation is as much as five years out. Any sustained inflation will mean higher interest rates and a weaker dollar. On the other hand, some inflation is probably the best way to work down the massive debt being incurred by the government. Balance will be the key, and we do not anticipate inflation anywhere near the levels of the late ’70’s and early 80’s.

Still the lion’s share of the overall economy, consumer spending will have to work out over the long term. Part of that recovery may be a shift in employment trends. General Electric’s chairman recently opined that the future is in making things here in the US, and the promise of jobs related to a “green revolution” is still unfulfilled. Bill Gross, the highly-esteemed fixed income leader of PIMCO, noted that greed will eventually return for consumers and investors but that fear continues to be the motivating factor, perhaps persisting for a generation. He also referred to John Maynard Keynes’ observation during the Depression that much of individual economic behavior is due to “animal sprits” rather than long-term rational calculations and economic theorists. Human behavior is the wildest of cards.

Our Portfolios

Despite the uncertainty of inflation, we have maintained positions that will hedge inflation, typically through inflation-protected Treasuries. TIP’s have had solid performance, driven more by the flight to safety and inflation fears in the market than from inflation itself. The risk is twofold: investors may lose patience if inflation does not return and opportunities elsewhere become more attractive or the “flight to quality” reverses as investors become more comfortable with risk and sell all types of Treasuries. In either case, we feel the risk is less than in other asset classes and are therefore comfortable with TIP’s.

We are also nearing the point where equity positions that were trimmed over the last year can be re-established, again to varying degrees. This is not an exercise in market timing, but rather a judgment regarding relative risk. Having said that, we would certainly prefer to buy below current market levels. In the meantime, we try not to be discouraged that relatively large cash positions are earning next to nothing and rely on the role of cash in reducing risk and stabilizing portfolios in volatile and uncertain times.

End of an Era?

Tens of millions of homeowners are “underwater” on their homes, owing more than the homes are worth, to say nothing of outright foreclosures. Unemployment is at 9.5% and likely heading to 10%. Savings rates are at levels not seen for years, and increasing. Consumers are de-leveraging by paying down debt, new credit is still very hard to get, and existing credit is being cut. Total household debt is estimated to be nearly 100% of GDP. Consumer incomes are barely increasing. US consumers suffered a decline of an estimated $15 trillion in wealth since early 2007. The number of millionaires in the US (net worth not including primary residences) declined by over 27% in 2008 to around 6.7 million, according to a study by the Spectrem Group. Those with investible assets of $1 million fell 26% to 4.4 million.

It is hard to see how or when consumer spending will be the salvation of the economy.

Aside from statistics, just looking around vividly illustrates how consumer spending has gotten out of hand. Go to any vacation or ski area and look at the number and cost of vacation homes and condos. Go to any beach area or marina and look at the number and size of the boats. Drive down the freeway (especially here in southern Arizona) and look at the luxurious RV’s towing cars. Give a quick thought to all the auxiliary expenses associated with those activities. Then try to imagine all the vacation homes, boats and RV’s at all the other beach and vacation spots around the country and ask yourself who can afford all this and where the money comes from. The only conclusion is that we are up to our eyeballs in debt and relying on the “greater fool” theory of future buyers to bail us out at even higher prices.

(Here is just a sample of data in these areas. In the 2000 US census of housing, the latest complete survey available, there were 3.6 million “seasonal, recreational and occasional use” homes. In 2006 alone, 1.07 million vacation homes, including resales, were sold at what was probably the top of the market. As of 2005, there were 600,000 power boats of 26 feet long or more registered in the US , not to mention large sailboats.)

Extend the critical, common sense approach to most homes, which are filled with what can generously be called useless stuff This is officially known as discretionary spending, but seldom does it really influence quality of life other than satisfying a spontaneous urge.

There is nothing inherently wrong with any of these things; it is still, for the most part, an economically free country. It’s just that the massive bill is now coming due. The sobering reality is that we can live incredibly rich, comfortable lives spending far less than we have been, and the adjustment could be hard for the economy to digest.

Or we could wake up in six months and decide to replace our entire wardrobe, dine out four nights a week, upgrade all our electronic devices to the latest models, book a last-minute trip to a luxury resort and completely gut the five-year old kitchen.