The Markets	6/30/10    Close	3/31/10   Close	2nd Qtr. Change	6/30/09 Close	12 Mo. Change	YTD       Change
Dow	9,774	10,857	-10.0%	8,447	+15.7%	-6.3%
NASDAQ	2,109	2,398	-12.1%	1,835	+14.9%	-7.1%
S&P 500	1,031	1,169	-11.8%	919	+12.2%	-7.5%
MSCI EAFE	1,348	1,584	-14.9%	1,307	+3.1%	-14.7%
10-yr Treas. yield	2.95%	3.83%	-0.88%	3.52%	-0.57%	-0.86%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)
The quarter began with considerable promise, with some nascent optimism of an economic recovery, progress on the financial crisis in Greece and stock markets solidifying their gains off the February lows. But then several government stimulus programs ended, questions about the strength of the economy returned, the May 6 “flash crash” damaged confidence in the markets yet again and frustrations mounted with the inability to contain the BP oil well disaster. The stock markets closed the quarter with seven down days out of the last eight and hit official “correction” territory of more than a 10% decline and took year-to-date performance negative. At the same time, just when consensus opinion was that investors were ready to flee Treasury bonds, Treasuries again became the safe haven of choice, yields went down dramatically and Treasury bond prices were one of the few bright spots.

Manufacturing has demonstrated some strength with 10 months of growth and May export orders at 17-month highs. While GM paid off its government loans early (the government invested over $45 billion in preferred stock which still has to be paid off through a GM stock offering) and auto sales were up significantly over the prior year, June auto sales were down over 12%. In April the Conference Board Leading Economic Indicators declined for the first time in over a year, and the FDIC’s list of “problem banks” tripled in size from 2008 to include 10% of all federally-chartered banks. The Fed acknowledged the European crisis and growing problems in commercial real estate but insisted that the recovery would “stick” and rates would still stay low for “an extended period”. In the meantime, Canada was the first major economy to raise rates, to a whopping 0.5%.

Jobless claims proved to be very stubborn, hovering at the same level for most of the quarter, and private sector job growth was disappointing. Unemployment actually decreased to 9.5%, but this was due to many job seekers leaving the job market rather than growth in jobs. Consumers appear to be acting more responsibly, slashing revolving credit (primarily credit cards) and cutting credit card delinquencies, but overall consumer spending growth is weak. After spiking to a two-year high in May, consumer confidence wilted 15% in June.

Home sales and pending sales both predictably plummeted over 30% in May with the expiration of the $8,000 tax credit and median new home prices were down nearly 10% from a year earlier. (Existing home sales, which account for the majority of activity, were only down 2.2% with prices actually up 2.7% from a year earlier, but new home activity creates more jobs and spending than existing homes.) Mortgage rates hit their lowest level since 1971 but financing activity was still anemic as credit-worthy borrowers have already refinanced and tighter lending standards disqualify many new borrowers.

The drama in Europe had many turns. A $40 billion rescue package for Greece was approved by the euro zone, only to be increased to $147 billion over three years from the euro zone and the International Monetary Fund as Greece’s deficit continued to grow and their debt rating, along with Portugal’s, was lowered to junk levels. The bailout will require cutting public sector wages and pensions, raising some taxes and increasing the retirement age for public workers, none of which was well-received by Greek public workers. Later, the euro zone and the IMF announced a $1 trillion “rescue fund” to address the market’s concerns that problems would spread quickly to other countries such as Spain. (Those fears didn’t seem so far-fetched when Hungary announced that the prior government had understated their deficits, but they insisted they could still come close to IMF debt targets through spending cuts.) Even though the UK is not part of the euro zone, elections in the UK left no clear winner and the conservatives took over with a coalition government.

Steady international pressure may have finally had some influence on the Chinese as they announced new “currency flexibility” for the yuan, which promptly reached a five-year high. The US and other countries have felt that the yuan was artificially cheap and should be allowed to float higher to a proper level, which would potentially make Chinese imports to the US more expensive and US exports to China less expensive.

The debate over financial regulation has replaced the rancorous health care debate, and it is only slightly less rancorous. At this writing financial stocks have had a minor rally, as the proposed legislation was watered down to gain crucial votes and markets were relieved that it was not as bad as it could have been. Still, a number of specific rules on credit card lending and bank fees have already kicked in and, as should be no surprise, banks are actively looking for ways to replace lost revenues. While dire Wall Street predictions of tighter capital markets and increased cost of capital due to regulation may actually be legitimate, it seems obvious that more fundamental problems like lax lending standards and excess leverage are bigger threats to the economy. So, for the average Joe who is most concerned with no-fee transaction services and convenience credit cards, it will be interesting to see whether those basic functions survive or whether the new fee letters we recently received for two credit cards that previously had no fee become the norm. (This is essentially an example of the truism that the consumer, who is at the bottom of the economic food chain, ultimately bears the cost of all taxes and increases in corporate costs, all of which are simply passed on.)

With the economy again appearing to slow, there is some call for another round of government stimulus. Indeed, just as European governments appear to finally be embracing some austerity and fiscal discipline, there are warnings that the US government shouldn’t “repeat the mistakes of Herbert Hoover” and tighten spending just at the wrong time. The opposing argument is that we can’t just keep adding to the debt and now is as good a time as any to start down the road to fiscal discipline; even a “double dip” recession may be preferable to postponing the inevitable reckoning of overspending and that reckoning will only get worse over time as the debt continues to grow. Of course, time and growth heal many wounds, and the mid-term elections are coming up this fall, so any further stimulus will unfortunately be driven by politics rather than economics.

It seems inconceivable that the BP oil spill won’t be contained during this coming quarter, but then again it seemed inconceivable that it could have gone on as long as it already has. The relief well is slated to be completed in August and additional resources and equipment from around the world have finally come on line. It is now hurricane season, though, and that could certainly complicate things. Despite rumblings from Congress, the White House and the public, it still remains to be seen whether BP will be held to the full cost of the disaster. The lasting impact could be the further damage to the public’s psyche and the government’s credibility in dealing with both the spill and BP, as witnessed by Pres. Obama’s declining approval ratings and growing discontent with any incumbent.

Our Portfolios

In last quarter’s review we noted the value of stop loss orders in a volatile market. The May 6 “flash crash”, in which a sudden absence of buy orders caused a number of large cap stocks and exchange-traded funds to temporarily plummet, exposed the unanticipated risk of stop loss orders. The rapid decline and just as rapid recovery of prices meant that many positions were unnecessarily sold and often at prices far below the stop price. We were not immune to this problem, as we had stop orders on certain positions and they were sold. As it turned out, the recent market decline allowed us to re-establish most of those positions at even lower prices, but we will be even less inclined to use stop loss orders in the future. As described below, if we want to hold a position, we will, and if we want to sell or reduce a position due to reasons of allocation or changing goals and risk management, we’ll just sell it.

In keeping with long-term perspective, the recent market declines also do not preclude continuing to invest for portfolios that are out of line with target allocations. In other words, we are still buying stocks where necessary, albeit cautiously. This environment also confirms the value of cash, however low-yielding, as a risk management tool. While there are other risk management techniques available, as the flash crash illustrated, sometimes the simplest tools are the best.

A View From the Trenches

There is certainly no shortage of challenging issues these days, nor is there any shortage of pundits of all stripes willing to give us their view and opinion 24 hours a day. So, here’s the take of an inconsequential financial advisor in Tucson on two current topics.

No Man’s Land – Since Wimbledon concluded this weekend, consider “no man’s land”, the area between the baseline and the service line that is the worst place on the court to be caught. You aren’t close enough to the net to make a winning volley, you aren’t far enough back in the court to run down deep shots and your opponent can easily hit a shot at your feet.

The “flash crash” of May 6 exposed the no-man’s land of investing, reinforcing the idea that an investor should commit to a strategy before the market takes its toll. It is important to choose whether to play the short trading game, knowing that the market can move unexpectedly and accepting the result, or to stay with the long investing game, basing decisions on goals, personal circumstances and overall allocation as much as on market prices. Managing risk in the short game involves drastic moves and exotic trading techniques while managing risk in the long game involves incremental adjustments over time, occasionally taking advantage of perceived opportunities. Just as with each point in tennis, you can choose which approach to take with different accounts or even different holdings in the same account, but getting stuck in the middle inevitably leads to more anxiety and frustration.

To protect and to serve – When I lived in Los Angeles in the late ’90’s, the LAPD announced they would no longer respond to home security alarm calls unless there was additional information to verify a break-in; the vast majority of those calls were false alarms and the LAPD simply did not have the resources to respond and still fulfill their other public safety responsibilities. Homeowners were understandably upset, but when the alarm companies were asked why they didn’t respond to the alarms themselves they said it was too costly. So there you have it – we’re not willing to pay for it ourselves, or ask our customers to pay for it, so let’s have the public pay for it.

That’s exactly where we are with the derivatives trading activities of banks. Government support of banks distorts the dynamics of those activities and makes them far less costly, and therefore far more profitable, than they should be. To make matters worse, non-bank participants in derivatives markets see no need for sufficient capital to absorb losses either due to the assumption of an eventual government bailout if the market blows up (the top 25 banks hold $293 trillion in derivatives, with 96% of that amount in the five biggest bank participants). Taxpayers are subsidizing derivatives rather than allowing the market to properly assign risk and return. Banks claim that the derivatives business will just go to European banks, but that would happen only if European governments are willing to indirectly subsidize derivatives, and they are in even a less charitable mood towards banks than is the US government.

Even the current watered down version of financial regulation would require banks to move most derivatives activities to affiliates that would expressly not have government support. This would in turn require the banks to raise more capital, making derivatives more costly, which is just as they should be. And if Europe wants the business and the public risk, let ’em have it.