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Quarterly Newsletter
 
Newsletter 4th Quarter, 2009 
 
Year in Review
How different things are from a year ago.  As 2008 came to a close, many Americans were wondering if the United States was teetering on the precipice of the end of the world and whether or not just the slightest breeze of any further bad news would push the capital markets over the edge and all the world economies would plummet to their death.  
 
As 2009 got under way, it certainly did seem like the U.S. was headed into an abyss, especially as far as the equity markets were concerned.  At the beginning of 2009, the Dow was languishing at just under 8,700 after a grueling and harrowing drop of approximately 38% percent over a 15 month period. Once 2009 got rolling the Dow proceeded to plummet on March 9, 2009 to approximately 6,500 (that was another 25% drop).  
 
However, right in the throes of a crashing market, we stated in our newsletter dated February 2, 2009, that we forecast the equity markets would end the year 2009 in double-digit positive returns.  On the close of business on December 31, 2009, the Dow closed up 18.8%, the S&P 500 up 23.5%.  International developed stocks were also up around 30%, and emerging markets were up over 70% in 2009.
 
How did we know the markets were going to do that?  Partly intuition, mostly logic.  
 
In our estimation, most markets had dropped too fast too quickly, especially in light of what we thought many  underlying businesses in the markets were actually worth.  In our experience, we have seen there is a strong sense of gravity in the markets and that stock prices will, at some point, trade fairly in line with fundamentals.  It was our belief that things would move back toward fair value sooner rather than later.
 
To be fair, back in February 2009 we also thought there was a good change the Dow was going to go much lower than 6,500 before recovering.  We made this gloomy forecast based more on the history of crashes and how low things go once panic takes over.  Thankfully we didn't go that low.    
 
With the Dow peaking at over 14,000 in 2007 and now sitting around 10,500 and change, we are still nearly approximately 26% off the all time highs.  Much better than the 53.8% drop we had experienced, but nonetheless the markets are far from even.
 
Where do we go from here?  We don't think the markets are as a good a deal as they were earlier in 2009, but things are not nearly as scary in the economy in general as they were either.  We could see the Dow go as high as 11,500 early on into February 2010, but that also could be a good time to rebalance and/or cash in on profits as the markets may start to feel the impact of rising mortgage defaults, continued unemployment, a decrease in consumer spending and the wearing off of the euphoria from the stimulus.  We'll keep you posted as to the opportunities as they unfold.
 
As investors try to claw back lost ground, it might be tempting to drift towards certain investments, theories or fantasies based on a perceived hope for a quick fix to bad investment decisions.  And it seems, usually the way this works is that investors start to look around for what's been doing well recently and then jump on that bandwagon.  In professional and personal circles, we're hearing a lot of discussion about some magic bullet solutions to investing, like gold.  We believe we have a slightly different view on gold and that there is another way to look at gold than what is commonly discussed.
 
 
Another Way to Look at Gold
No one knows for sure when a particular asset or market is in a bubble until after the bubble has burst.  As we outlined in our previous newsletter, bubbles can be used to an investor's advantage so long as investors do not get tricked into thinking a trend or bubble is permanent.  There are some factors about gold right now that may give some perspective on the nature of the current run up in gold prices.
 
First of all one must be cautious as to whether or not asset prices globally are in somewhat of a bubble due to the liquidity that's been injected in the world economies to prevent a global economic wipeout.  If it's true that many asset prices have been soaring on the wings of easy money and low interest rates, then one must consider what will happen when governments, in particular the U.S., start to raise interest rates again.  The reality is interest rates can't stay at near zero forever and if money contracts, so might asset prices, including gold.  
 
Second, something that gold proponents seem to promote when you hear them on the radio or read their advertisements is that a rise in gold prices is essentially an attack on a fiat (government backed) money system.  Since gold is a recognized global currency, it may seem like the rise in gold prices is due to a lack of confidence in government supported monetary systems, especially the U.S., since the dollar is still the reigning currency. 
 
But as Nicholas Taleb in his rather timely work Fooled by Randomness has rightly cautioned us, it's important not to confuse correlation with causation.  Just because gold is rising at a time when the dollar is sinking doesn't mean the demand for gold is the driving force pushing down the strength of the dollar.  
 
For example, it's pretty clear there is no run on the dollar.  As Nouriel Roubini points out on his website on December 2009, the velocity of money is not speeding up at the moment, which you might expect if people were cashing in or ditching their dollars in favor of other currencies.  
 
In addition, we find it very significant that when the world markets were crashing in 2008, people flooded to put their money with the U.S. government.  Even as recent as with Dubai's credit crisis last month, money flowed to the U.S. government.  One conclusion that can be drawn from this is that the U.S. government, the same government that backs up the weakening dollar, is still considered to be a good place to park cash.  
 
Nonetheless, the juicy returns of gold can be mouthwatering, especially for those who have been hammered by bad investing decisions.  However, before investors dive into gold, consider the cold hard data of returns in gold.
 
Thanks to Kenneth French we have some longer-term data on gold that goes back to 1963.  From 1963 to December 2004, gold did about 9.21% (inflation did 4.51% and stocks did 10.74%).  
 
Seems like a great run, right?  Well the ride to earn those returns was anything but fun.  During that time, precious metals lost more than 35% on 5 separate occasions and on one occasion, lost nearly 70%.  Also, between 1980 and 1998 gold lost more than 53%.  From an inflation standpoint that's almost a quarter century of zero returns!
 
So, one of the questions that has to be asked, who is willing to stay the course for an entire generation to get some positive returns in an asset class?  Think about that, an entire generation!  
 
Because gold goes through periods of such wide manic swings, we agree with William Bernstein who suggests instead of being a gold bug, an investor interested in gold should be an "anti-gold bug" ("The Longest Discipline," Efficient Frontier, 12/05).  Bernstein says investors should be losing interest in gold when gold is raving and coming out of the woodwork when no one gives a flying leap about it.  Right now, gold is clearly raving.
 
There are still some serious lingering concerns about the U.S.'s long-term economic leadership, but the fact remains we are still a strong nation.  And right at the moment, it's hard to tell exactly just how things are going to pan out in the currency markets because some things just don't add up.  For example, the fact that the dollar is trading at such a discount to the Euro is pretty inconsistent and contradictory because Europe has many of the same economic, credit and demographic problems that we do.  However, there are other countries that could be success stories of the 21st century as we have pointed out in earlier newsletters, such as China or India, that could push U.S. out of it's position of leadership.
 
The point being in the above discussion is that gold's main value, if at all, is as a hedge, not a primary investment.  This is where we feel we are different.  Instead of being "all or nothing" investors in gold, we think hedging a portfolio with gold makes sense.  Where we are also different is that we think when a person hedges and at what price is also very important to keep in mind.    
 
As French's data show, gold is extremely volatile.  However, the point remains, if and when the U.S. takes some even more serious blows, some gold may come in handy.  But gold would not be the only thing to hedge with.  Other international investments and U.S. government bonds that are inflation hedged could come in handy if the U.S. loses its position of global economic leadership.
 
But gold investors beware, if the US reasserts itself either by strength or by default (i.e., other countries tank and the U.S. remains on top), this could cause the dollar to go up, which could very easily do some serious damage to the price of gold.
 
And yes, you're hearing us right, we do think the dollar could very likely go up and that at some point the hated dollar is going to be a buying opportunity.  Economists at Deutsche bank say the dollar is 20% too cheap against the Euro.  In fact, after heading towards it's imminent destruction, the dollar has rebounded and finished the year heading strongly up.  Stay tuned.  
 
 
A Few Words on Real Estate
Home sales are picking up.  The Associated Press reported that home sales surged by 7.4% in November.  The S&P/Case Shiller real esate index reported prices were flat in October 2009 for the second month in row after several months of steady gains.  Our best guess as to the reason for this surge in sales and momentary leveling off in prices is that the stimulus, low interest rates and tax credits are working for the time being.  
 
This is a national number. The Case-Shiller index did show Los Angeles was up for a 5th month in a row.  So what about California then, aren't things recovering even more?   Perhaps, but the overbuilding and bubble in the inland empire are a threat to any real recovery in California real estate.  In August of 2009, the Wall Street Journal reported that office vacancies were around 26% in San Bernardino, and around 20% in Orange Country.  Also, Deutsche bank forecasts that nearly 48% of homeowners nationwide will be underwater in with negative equity (they owe more than than home is worth) and that 87% of homeowners will be underwater in Riverside-San Bernardino.  This can't be good for California real estate!
 
Add that to the fact that there are still some long term problems in real estate such as a massive inventory of homes for sale, the backlog of inventory of homes currently in delinquency or foreclosure, unemployment, the next wave of defaults due to adjustable rate mortgage resets and a pending disaster in commercial real estate due to rising vacancies and problems with refinancing.  So while there may be some short-term opportunities in real estate, we see long-term difficulties that will continue to haunt the banks and wipe out individuals.  If investors are looking to invest in real estate right now we think it makes more sense to invest in mutual fund type investments because they are liquid and don't require a mortgage to get in.
 
 
2010 Roth Conversion
Taxes are almost certain to rise to pay for the bailout and government entitlement programs like Social Security.  It's projected that the next generation will be in twice as high a tax bracket to pay for Social Security and Medicare for the Baby Boomers.  This year is a special opportunity for those who were previously ineligible to convert traditional IRA funds to Roth IRAs to do so.  If a person follows all the rules, a Roth provides tax-free income, which would be nice to have during a time of soaring tax rates.  Expect a letter from us in the coming months explaining in more detail some important factors about this.