Second Quarter 2009 Letter to Clients

During the relentless selloff in the market that occurred in the first two-plus months of this year, we raised the point that historic market declines are usually accompanied by historic market gains on the other side. Those rebounds typically come quickly and unexpectedly, and are completely out of synch with the day’s conventional wisdom. Investors who miss those early gains coming out of a market downturn typically miss out on fully one-third of the gains a new bull market has to offer.

Those words are scant comfort when you are in the midst of a market that seems to be stuck in a downward spiral. But as we look back on the three-month rally that began on March 9, we can see that this pattern emerged again in full force. Below are the returns for the equity funds we use to construct our portfolio strategies from the March 9 low to the high the Dow Jones Industrial Average reached on June 12:

Many of those funds experienced gains never before seen in a three-month period of time, let alone a full year. And it happened almost before any of us even realized it.

It is true that those gains are relative in the bigger picture of the long bear market that began in October 2007. It is also true that no one knows if the spring rally was truly the beginning of a new bull market, or if it was a “bear market rally” as the media loves to assert. Indeed, since that dramatic sprint, stocks have pulled back considerably from their highs a month ago.

But that is also the point: We can’t know when the market bottom occurs, so we have to be invested to be sure we participate in the recovery once it commences. There are often one or more false starts before a new bull market begins (like we saw in November and December) and it is only in retrospect that we can tell a false start from the beginning of the real recovery. And by then it is too late.

Now imagine the plight of all those folks who are swimming in the pool of $4 trillion invested in money-market funds, most of which was pulled from the stock market in the past nine months. No doubt those investors were kicking themselves all the while stocks were soaring in the spring, wishing they had a chance to get back in.

Well, here we are. Now is their chance. As of this writing (July11) the S&P 500 is down nearly 10% from its high in June, and midcap, small cap and REIT funds are down even more than that. But do you think the environment is one that a person sitting in cash, trying to get back in the market but desperately wanting to avoid even more losses, finds comforting? All the talk in the press is focused on the idea that stocks “got ahead of the recovery” and are now due for further declines. One talking head after another parades through the media with dire predictions about the economy and the stock market’s reaction to it. It is not exactly a feel-good time for an investor who has already locked in huge losses to get back in the market.

These are the two alternatives. Stay the course even when things seem bleak, or flee the market and sit paralyzed while gains that ordinarily take years to occur happen in only weeks, and you are reduced to watching CNBC nine hours a day trying to decide if those gains are “real” or not. 
                                                         * * * * *
The near-term health of the economy remains murky, and the stock market continues to be volatile. But in the grander scheme it is encouraging to look back at the mess we had on our hands last fall and see that the turmoil in the financial system today has calmed considerably.

Two key indicators of how the credit markets are working reveal both that return to normalcy and also just how extreme the financial meltdown was last fall. The first indicator is the “Ted Spread” – the difference between the interest rate on interbank loans and short-term Treasury bills. It is an indication of how willing banks are to lend to each other – in essence, a reflection of banks’ confidence in each other and the financial system in general. Here is a look at the Ted Spread over the past two years:

The second indicator is the “Libor/OIS spread.” It would take us about three paragraphs to properly explain what the Libor/OIS spread is, so we will direct you to Google for that definition, but suffice it to say it is a widely followed measure of liquidity in the financial system. Here’s the chart for the LIBOR/OIS spread over the past two years:

In looking at these charts, it is interesting to note that the volatility in the credit markets has diminished to levels not seen in two years. While the financial crisis reached a full-scale meltdown last September, the real turmoil actually began suddenly and dramatically in the summer of 2007, when the first dominos in the subprime crisis began to fall. So from that perspective, it is a very good thing for the global free enterprise system that the financial system has calmed, because it would be impossible for an economic recovery to begin without that all-important foundation in place.