July 10, 2008
“I see the next year or so being a very volatile period as the market continues to sort out the effects of the housing and credit bubbles and adjusts to a more inflationary environment. However, I think that three to five years from now, investors will be mostly pleased with returns because I expect the economy to recover and I think the market will see it coming first.” – Chuck Royce, the manager of Royce Total Return fund, made this statement in his July 2008 newsletter. This quotation reminds me of the theme from our last quarter-end letter: stay diversified, look to the long-term and do not try to time this market – better times are ahead.
As you have probably read in the newspapers or heard during financial reports, the second quarter started with a positive month in April, but then as oil and other commodity prices continued to climb and investment banks continued to waver under the stress of shoddy mortgage deals, the market began to fall in mid-May. This past month was the worst June for the Dow Industrials since the Great Depression. As I write this, the Dow and the NASDAQ have slipped into bear market territory in the first few days of July. A bear market is defined as a 20% drop from its peak, which in this case was last October. As of today, the S&P 500 is down 19.4% from its October record close.
During this past quarter, the dollar has begun to establish a floor against other currencies. The latest statement from the Federal Reserve indicated that “uncertainty about the inflation outlook remains high.” This essentially means that their focus is now on making sure that inflation does not reach epidemic levels. In the early 1980’s Paul Volcker fought inflation by significantly raising the target Federal Funds rate. The economy suffered during these increases, but he set the table for several years of growth during the mid and latter half of the 1980’s. The dollar will most likely appreciate against other currencies once the Federal Reserve begins increasing rates again. Not only will the dollar appreciate, but the price of oil will probably come down since oil is traded in dollars around the world. We all know that cheaper fuel means more money in all of our pockets. Look to see the Federal Reserve start to increase rates late this year or early next year.
Hang in there! The market will recover – we just have to give it some time. I can assure you that our managers are “licking their chops” at some of the bargains that are out there right now – particularly in the financial sector. For those of you who wish you would have converted your entire portfolio to fixed income – including CDs – one year ago (by the way, I have not heard of anyone wanting to do this): keep in mind that inflation will pick up some steam in the months ahead. In order to keep up with rising consumer prices over the long-term, inflation protection is a necessity. We have some inflation protection with the inflation protected bond funds (Vanguard Inflation Protected Securities and PIMCO Real Return funds); however, most of our protection comes in the form of good ol’ common stocks that are held in your equity mutual funds. Remember, corporations have the ability to pass on the increased costs of their products to consumers as soon as they incur them. Conversely, many fixed income portfolios made up of a few long-term bonds or CDs will lose to rising inflation. In my opinion, stocks are an important component in any diversified portfolio.
By the way, please note that Katie’s e-mail address has changed to katie@aiai.biz and my e-mail has changed to bill@aiai.biz – thank you!
If you have not stopped in to see us lately, please do not hesitate to contact Katie or me to schedule an appointment. Enclosed you will find your Portfolio Performance Summaries, Portfolio Holdings Statement as of June 30, and a quarterly Account Management Fee Statement. Please call us should you desire the most recent copy of our Form ADV, Part II. In addition, do not forget to notify us should your investment objectives or personal financial situation change.
Best regards,
William A. Bullock