April 11, 2008

Dear Client:

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Q1 2008 Market Update

The U.S. stock market lost 9.4% in the first quarter of 2008, following a gain of 5.5% in 2007. The normal relationship of stock and bond performance is an inverse one: bonds often have positive returns at times when equities decline, particularly during periods of sharp declines.

Although we are barraged by news of the stock market "meltdown", the fact is that equity markets have not experienced a calendar year loss for five years, including 2007, in which U.S. large-cap equities gained 5.5% and foreign equities gained 11.2% in U.S. dollar terms. (One minor exception: U.S. small-cap equities lost 1.6% in 2007, bringing their five-year annualized return from 2003 through 2007 down to 16.3%.)

The losses of the first quarter have reduced the five-year annualized returns to:

Clients who have been working with us for several years have been through a number of market declines, and realize that losses are an unavoidable circumstance of investing. The pervasiveness of the effects of subprime credit crises and the recent collapse of Bear Stearns has caused a particularly steep and swift contraction of market values.

Periods of market decline have occurred regularly for as long as financial markets have existed. There have been ten periods since World War II in which the U.S. stock market declined more than 20%, which is the accepted definition of a bear market. (A correction is defined as a 10% decline, which has happened much more frequently.)

On October 19, 1987 the stock market declined 23% in one day. Markets around the world fell in response; Hong Kong lost 46% by the end of October, and the U.K. lost 26%. I remember that day and the panic that investors felt when they could not place sell orders.

Many of these declines were initiated by political crises such as 9/11, the start of World War II, and the start of the Gulf War. Others have been economic in origin, such as the 45% decline in 1973 and 1974 following the 1973 oil embargo, the Russian default and credit squeeze suffered by Long Term Capital Management in 1998, and the collapse of the technology sector from 2000 to 2002.

While it is tempting to dream about buying and selling in anticipation of political and economic forces, it is not possible to capitalize on such timing because:

• the vast majority of investors are not able to predict market movements,
• the minority of investors who have predicted a single market movement have not been able to repeat their performance, and
• the fantastic few who can reliably predict market movement are billionaires not available for hire.

Actual Portfolios vs. Market Returns

During first quarter portfolio update meetings, several clients expressed surprise that their portfolios have lost far less than they expected. The portfolios we manage lost less than the equity indices, with the exception of two client portfolios, both of which had large concentrated positions in employer stock. (See the paragraph below: "...the benefit of diversification...") Our median portfolio declined 5.0% in the first quarter, net of fees.

The discrepancy between investors' actual performance and their perception of that performance is created by eye-catching media headlines, reporting peak-to-trough market results. Disciplined investors' portfolios are less affected by sudden, large changes in the market because we're not purchasing at peaks and selling at troughs. To the contrary, disciplined investors purchase regularly as savings accrue, and manage their cash requirements to avoid having to sell at market troughs. In 1987, when the stock market declined 23% on October 19th, the market actually gained for the entire year. An investor who bought the Vanguard 500 Index fund on January 1, 1987 and sold on December 31, 1987 would have experienced a 5% gain.

There are other factors that make the perception worse than the fact. One is that short-term volatility is reduced by longer holding periods. While it is normal for stocks to decline one out of every three years, the chances of experiencing an annualized loss diminishes greatly as your holding period increases. In the following chart, note that although we have had one-year losses in all of the equity asset classes shown, none of the asset classes had an annualized loss in three year, five year, or ten-year periods.

Secondly, our practice of regularly rebalancing portfolios automatically reduces positions in markets that have had large gains and reallocates the gains to markets that have lagged. This provides the opportunity to capitalize on "rebounds" in struggling asset classes. For example, real estate was the worst-performing asset class in 2007 with a return of -17.6%, but performed better than equities in the first quarter of 2008 with a return of 2.1%.

Last, but most important, is the benefit of diversification. While U.S. small-cap stocks lost 13% in the twelve month period ending 3/31/08, bonds gained 8%. A diversified portfolio consisting of 25% US large-cap stocks, 10% U.S. small-cap stocks, 25% foreign stocks and 40% bonds would have lost just 0.2% during the same period.

Further diversifying the bond portion of the portfolio into corporate, municipal, inflation-protection, and foreign bonds would have brought the return for the past twelve months into positive territory, to about +1%.

These periods are trying, but they are necessary, unavoidable and normal.

Summary

While many people who are not our clients are feeling a lot of pain, you can rest assured that your ability to achieve your long-term objectives has not changed one bit.

As always, if you have any questions please do not hesitate to call. We're always happy to talk with you about your portfolio and market conditions in more detail.

Regards,

Audrey Grubman, CFP^®
Portfolio Manager and President
GRUBMAN FINANCIAL