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Letter dated April 2009 reporting on the first quarter of 2009

Summary: We emphasized capital preservation during the extreme weakness in January and February, and gradually began to move assets back into the market in March. This resulted in both outperformance and much lower volatility. For the quarter, the total return on the S&P 500 Index was negative 11%. Our pure equity accounts lost 7.4%, while our balanced accounts declined about half as much and our bond accounts rose an average of 2.5%.

     The big question is:  is this a repeat of the 1930s with more downside to go, or is this the best buying opportunity since 1974?  There is persuasive, but hardly conclusive, evidence for the latter view. 

    The government is acting aggressively to shore up the banking system, both by injecting capital and by buying toxic assets.  Additionally, there is a broad stimulus program beyond the bank rescue that equates to about 5.5% of GDP.  Arguably, we are seeing the kind of aggressive government action now that wasn’t seen in the Depression until 1933  – and that action spurred a huge stock rally.

    While it is too soon to make a definitive conclusion, the price pattern seems to be straying from that of the 1930s.  Although the overlay is far from precise, the markets had similar percentage declines in 1931 and 2008.  The market fell an additional 50% in the first half of 1932.  Investors may have been spooked by that in early 2009, as the market fell 25% in two months.  We were very conservatively postured throughout that decline.  But as the attached chart suggests, the rally in March is at least an attempt to depart from any continuing similarity with the 1930s.   

    Even so, there is little room for error and thus our investment policy remains one of being ready to cut exposure quickly if policy errors seem apparent or if more shocks seem likely.  Certain dangers are arguably greater now than at the onset of the Depression.  Total credit outstanding was 160% of GDP in 1929;as we entered the Crash of 2008 it stood at 365%. [GDP ~ 14.3 trillion; credit market debt outstanding $52.6 trillion; http://www.economagic.com/em-cgi/data.exe/frbz1/FL894104005]

    The Treasury is spending $700 billion on TARP and another $700 billion on the stimulus package.  The Fed is expanding its balance sheet from about $1 trillion to $4.1 trillion by the end of this year, and buying up all kinds of outstanding debt.  The expectation is that this stimulus will return us to GDP growth of about 2.4% from a contraction of 6.2% in the fourth quarter of 2008. But particularly if growth lags, there is great risk to the dollar.  Since we are printing so much money, the federal government might be forced to defend the value of the currency at some point.  Doing so would likely require higher interest rates, which in turn would put a drag on economic growth.  In that sense, the Obama Administration may be in a race against time; if the stimulus does not get the job done, there may be no second act.

    That is why one of our biggest positions is in GLD, the gold ETF.  I think there is sufficient risk to the value of the dollar to make some exposure to gold very worthwhile.  Gold has done well even during a period in which the dollar has been fairly strong, mainly due to short term technical reasons.  It is poised to do even better if the dollar weakens.  Senior Chinese officials have suggested replacing the dollar as the world’s reserve currency with a basket of currencies. 

    Meanwhile, the immediate effects of this stimulus appear to be positive.  Thus, we have gone from underweighted to overweighted in the financial stocks as the most dire outcomes, including nationalization, seem less likely.  Bank of America has gone from $3.95 to $6.82 in March alone.  Barclays has passed its stress tests, has integrated the US part of Lehman well, and is profiting handsomely from market-making in fixed income.  General Electric has been clobbered due to concerns about its financial arm, which now seem overblown.  There was anxiety about the company’s ability to borrow, but the news from rating agencies was good and the company has already financed 90% of its needs for 2009.  GE has rallied from a March trough of $5.73 to $10.11.  We bought Berkshire Hathaway for the first time, now that the Buffet premium has melted.  After reading their latest 10-Q, I am convinced that Buffet has made some very shrewd bets that will have a big payoff for shareholders.  His letter opines that:  “The investment world has gone from underpricing risk to overpricing it.”

   Even the noted bear, Prof. Noriel Roubini of NYU, thinks that the risk of a total meltdown has been reversed and that the recession will last for another 18 months.  That is a major change from his dire commentaries of the past year.

   Consumer cyclical stocks may rally if people get the feeling that things have stabilized and it is safe to go to the mall.  I’ve started to nibble at some of these stocks after having avoided them for some time, but we are still underweighted in this sector.  Consumer staple stocks are normally good defensive holdings but many of them have been hit hard so far this year.  For instance, Proctor & Gamble was down 24% for the quarter, so something that I thought would be a good relative performer was not.  But it is still a great company and a fine long term holding. 

   Meanwhile, we have maintained a slight overexposure to the energy sector.  As noted in prior correspondence, oil prices have fallen further than we had expected.  However, oil prices are very sensitive to even modest changes in demand and we expect those prices to rebound sometime this year.  Many of our energy holdings have a high dividend yield, so we are getting paid something to wait. 

   The market remains below its 200 day moving average.  That has no predictive value, but is simply an indication to many that the market remains in a bear trend.  Thus risk management and capital preservation remain the paramount concerns.  If that means lagging a bit on the upside, as we did in March, I think that is OK for now.  The market has been exceptionally volatile.  It has moved as much in a week as it sometimes does in a year.  But we cannot turn over your account to reflect each week’s squiggle; instead we strive to balance appropriate exposure in up cycles and stringent risk controls in down periods.  Right now, you are about 70% invested in stocks.  Please let us know if you want any significant change in that exposure. 

   It is worth repeating a paragraph from my last quarterly letter:  “Bear markets have a way of sucking people in.  Every time there is a rally, there is a reason to believe that “this is it”.  But you never know where another grenade lurks – it could be the automakers, it could be instability in insurance, it could be weakness in the dollar; if there is to be another down leg, it is most likely something I haven’t thought of.”  Any signs of discord coming out of the G-20 meeting could unnerve markets.  Britain recently had a failed auction of government securities when there were fewer bids than bonds offered; that could happen here.  Weakness in commercial real estate could further weaken banks at a time when helping them is a tougher political lift; a recent poll says only 6% of Americans favor further rescue money for banks.  Congress could wreak havoc with the economy.  An editorial in the Financial Times said it well:  “The congressional response is a disaster. If enacted these ideas [on regulation of banks and compensation] would lead to an exodus of qualified employees from US banks, undermine willingness to expand credit, destroy confidence in deals struck with the government and threaten the rule of law.”  That refers to their role to date; things could get worse if they are asked for new money. 

   Earnings estimates for the S&P are expected to be somewhere between $40 and $60.  With the S&P 500 at 798, that translates into a P/E ratio of 16 with earnings of $50.  Although that is not bargain basement pricing, it is less meaningful than usual because there is huge volatility in the earnings of the financial stocks.