October 16, 2009

Dear Client:

Your statement is now posted to Your Online Access. Please call or email us if you require assistance logging in.

Q3 2009 Market Update

What a Difference Six Months Make

Major equity asset classes peaked on dates[1] ranging from July 2007 to October 2007; they all bottomed out on the same day: March 9, 2009[2].

The size of the gain from the bottom through September 30th was a direct function of the size of the preceding loss of different equity classes. U.S. large-cap stocks[3] lost 55% from peak to trough, then gained 58% through September 30th. Foreign stocks[4] lost 60%, and then rebounded 74%. Overall the major equity asset classes lost about 30% from their peaks through September 30th. Emerging markets lost 63%, then recovered 95%. However impressive a 95% return may seem, an investor is still down 28% off the high. It would take a 173% gain from the bottom to regain the previous high of emerging market equities, or about 40% from the September 30th values. Equity investors are still hurting.

The market decline was breathtaking but not unprecedented. There have been many major market declines over the past one hundred years[5]:

Typically the periods of steep declines have been followed by large gains, as shown below:

Are Recent Gains Warranted?

Is the increase in market value since March justified? This is the $64,000,000,000 question. Actually, $64 billion is too little compensation, because if anyone knew the answer to this, they would be the wealthiest person on the planet.

Let's review the basics of stock valuation. Stocks have an intrinsic value, which is the present value of the expected future income to the stockholder[6]. There are many factors that can affect the future income of an individual company such as management expertise, the cost of labor and supplies, and the cost of capital.

These factors can affect the value of a single company or an entire industry. Other factors can affect entire countries or regions, such as interest rates, inflation, currency and government policies. Rarely, conditions combine to create a perfect storm, pulling down the value of the entire global market, as we've witnessed over the past year.

The interplay of economic factors on market value is complex; so complex that no person or institution is able to consistently predict market value. Some brilliant people may have a better than average track record, but no one can do it consistently.

Despite the inability of an individual or institution to consistently predict changes in market value, there are a lot of people trying[7]. The irony is that the more people who try to predict market value, the harder it becomes for one person to distinguish him or herself. With so many participants analyzing, writing, discussing, investing, etc., it becomes highly improbable that one participant will consistently outperform others.

"Highly improbable" to outperform is a high hurdle, but the challenge for investors to benefit from such outperformance is even greater. Although some participants will outperform some of the time, it is rare for an individual's skill to persist for a more than a few years. In the rare cases when managers outperform consistently for years, they raise their performance fees, reducing the investor's net return. Hedge funds often charge "2 and 20", or 2% management fee plus a 20% performance fee, annually, but the best managers often charge much more. James Simons' Medallion Fund extracted a 44% performance fee PLUS an annual 5% management fee.

Many funds forego performance fees until they recover their losses ("the high water mark"). It seems fair that managers who are rewarded richly for performance should not be paid for losing money. This is a step towards aligning manager and investor interests, though the funds still charge annual management fees of 2% to 5%.

It does make me wonder if this is a factor in some recent hedge fund closings. A record number of funds closed in 2008 and 2009. JD Capital Management liquidated their one billion dollar Tempo Master fund in January, after losing 40% in 2008 (vs. the hedge fund industry average loss of 23% in 2008). But, guess what: they will continue to manage money.

Good Investment Decisions

If market prediction is not a realistic objective, how can we make good investment decisions?

When stock markets were crashing in February and March, we contacted each client to discuss appropriate investment strategy, with regard to the unusual economic conditions at the time. We conducted back-to-back meetings and phone calls, sometimes up to ten in a day. We spoke with clients as frequently as needed to help them make good investment decisions.

Reviewing my notes from these calls, I find that the points discussed with our clients in February and March are as relevant now as they were six months ago:

• No one knows what the market will do in the short-term.
• If the decline has been unbearable, you should have a more conservative portfolio, with a smaller proportion of equity investments.
• One way to quantify the appropriate proportion of equity is to consider how much more of a loss you could stand before you would "throw in the towel", then back in to the equity position by assuming a worst case scenario of a 50% loss from current values. For example, if your loss threshold was 20%, you should have no more than 40% of your portfolio invested in equities. That would cover the worst case in which the market dropped another 50% (40% equity allocation times 50% market decline = 20% loss).
• The markets are riskier now than normal; investors will expect to receive a greater reward (return) than normal as compensation for stepping up to the equity plate[8].
• Markets tend to recover sharply following large losses; a recovery of 50%, 75% or even 100% is certainly possible[9].
• The stock market is a leading indicator; it gains before we are aware of an economic recovery, as it turns down before we are aware of a recession.
• As anyone who has worked with Grubman Financial for a long time knows, I truly do not know whether market values will increase or decrease; but if you pressed me I'd say that I think prices will be higher a year from now (said in February and March 2009).
• No one knows what the market will do in the short term. Warren Buffett doesn't know, nor do Bill Gross, Nassim Nicholas Taleb (Mr. "Black Swan"), Paul Krugman, Suze Orman, Charles Schwab, etc., etc. You shouldn't base your decisions on any person's prediction, and especially not on what talking heads might say on CNN, in the Wall Street Journal, or from Schwab's marketing pieces.

I am relieved that the equity markets have recovered much ground, and overjoyed that our clients were able to maintain equity positions during this extraordinarily difficult time, even if with white knuckles.

You may hear some people now say that they knew the markets would recover back in March. I can say categorically that everyone we spoke with in February and March was fearful; no one said to me "I know that we've reached the bottom here."

Do Equities Still Make Sense?

The fact that the markets have recovered so strongly does not preclude additional gains. It's still a good idea to think about whether a loss of a certain size would cause you to change your allocation, and if so, adjust it accordingly.

Are equities no longer a good investment? The total return of equities has been less than bonds for twenty years now. The total return of government long bonds was 373% vs. 348% for the U.S. stock market for twenty years ending September 30, 2009. The last time bonds gained more than stocks for a twenty year period was in the late 1940s, when the twenty year periods included the Great Depression.

The question is whether that underperformance will persist, i.e., do equities still make sense for investors who desire returns that outpace inflation?

Bond returns have been very high for two decades, primarily because inflation rates have declined from 15% in the early 1980s to near zero now. Bond prices and returns increase as inflation and interest rates decrease. If interest rates are very low, the likelihood is greater now that rates will increase (thus prices will decrease). This would create a period in which returns of bonds are low or even negative.

Equities should provide higher returns than bonds, because equity owners are taking more risk than bond owners. Equity owners expect to share in the growth of an investment, but bond holders expect only to earn interest on a loan, and get their principal back at the end of the loan. Looking at the chart below, we see that the vast majority of the time, the annual return of equities is higher than that of bonds.

It is my belief that because returns have been so low for so long, it is probable that equity returns will exceed bond returns in future periods, i.e., the current relationship between stocks and bonds is more likely to revert to normal than to persist.

As always, please do contact us with any questions.

Regards,

Audrey Grubman
Portfolio Manager and President
GRUBMAN FINANCIAL
www.grubmanfinancial.com
ph. 510.883.1350
fax 510.548.3148

[1] U.S Large-Cap peaked Oct 9, 2007; U.S Small-Cap peaked July 13, 2007; Small-Cap peaked October 31, 2007

[2] Emerging markets bottomed on March 2, 2009

[3] Measured by the S&P 500 Index

[4] Measured by the MSCI EAFE Index

[5] Measured by the S&P 500 Index

[6] I'm leaving out the discussion of what constitutes "income", whether it should be earnings, free cash flow, dividends, etc., as well as the method of discounting future income to its present value.

[7] And even more people trying to convince others that they can do it.

[8] Average monthly returns of stocks have been 4.3% during the three-month period around the trough of a recession, vs. -1.4% for the three-month period at the peak of expansion, vs. 0.7% for all periods, since 1926.

[9] See the gains of 491%, 282%, 355%, etc. in the chart above.