January 12, 2009

Dear Client:

Q4 2008 Market Update

For the year, the U.S. stock market declined 37% and foreign equities (developed countries) declined 43%. Emerging market equities declined 53%.

The 2008 loss was the largest calendar-year loss since 1931:

It's important to consider investment performance within the framework of your personal objectives. The impact of recent portfolio returns depends on several factors: when you need funds from the portfolio, the amount you need, and whether the needs are discretionary or required.

Someone who has just begun an investment program, or has a significant cash position, is in an enviable position. The stock market gained 20% from November 20th through December 31st, which constitutes several years worth of returns in less volatile market environments.

If you do not have a large cash position, but are periodically saving for future objectives, there is every reason to believe that your portfolio will recover and go on to earn positive returns sufficient to fund your objectives.

Those who are currently need, or will soon need, to withdraw funds from their portfolio have different challenges. One is behavioral: it is very hard for people to stay invested after experiencing large losses. Our reflex is to avoid more pain. The second is mathematical: withdrawing funds from a portfolio after a large decline reduces the future value of the portfolio, even when returns turn positive again.

Our financial planning process models the effect of markets like this one on your ability to fund your financial goals. If we have not updated your financial plan in the past year, and/or if your income, spending, or objectives have changed, we strongly suggest an update to your financial plan. Please feel free to contact us to get the ball rolling.

Avoiding a Madoff

Bernard L. Madoff Investment Securities LLC had both professional and individual clients. The professional clients should have performed appropriate due diligence such as reviewing trading strategy vs. returns, confirming the competence of counterparties providing audit and brokerage services, and reviewing the potential for conflict of interest by affiliates of "feeder" hedge funds.

Individual investors could have easily protected themselves from fraud by working with an investment manager who uses a third party custodian to hold portfolio assets. Madoff served as manager, broker and custodian of the portfolios they managed, which deprived clients of an important third party accounting of their portfolio assets.

We custody client assets at Schwab and Fidelity, so it would be impossible to give false reports of your holdings.

A quick look at their Form ADV, filed with the SEC, raises several questions. How does a firm that manages $17 billion have only 1 to 5 employees performing investment advisory functions? You can view the Form ADV at SEC Investment Adviser Search. Enter "Madoff" in the Firm Name and "Contains" in the Type of Search.

Professionals and individuals alike should have used their common sense: if something sounds too good to be true, it isn't true. Consistently high returns, in both up markets and down markets, are virtually impossible to sustain.

Your own portfolio returns are consistent with our stated investment strategy: we use asset allocation to drive investment returns, while minimizing "drag" on the portfolio by using low-cost, tax-efficient investment vehicles to implement the asset allocation. Portfolio return will be easily attributable to the weighted average of the asset allocation.

For example, if the U.S. stock market index lost 38% and bonds gained 5%, a portfolio with an asset allocation of 50% U.S. stocks and 50% bonds would be expected to have lost 17%. Your return will be close to the weighted average of the returns of the asset classes that make up your portfolio. Differences occur only when the asset allocation changes significantly.

As a firm that subscribes to the theory and practice of passive investment management, the investments we make are transparent, the holdings of the funds are easily available, we do not invest in complex derivatives, and we do not "subcontract" management to hedge funds or other investment advisers.

The "Smart Money" vs. Passive Managers

Each December, BusinessWeek magazine publishes an annual survey of the top economists' forecasts of economic statistics for the upcoming year.

Following are the forecasts made in December 2007, for the year 2008. Note that not one of the 54 "experts" forecast GDP, Treasury bond yields, unemployment or housing price changes that were worse than actual results.

   BusinessWeek December 2007:
      Survey of top economists' predictions for 2008

   Top 5 winners of BusinessWeek December 2006 survey

   Actual value

BusinessWeek and other financial publications publish similar surveys of investment managers' forecasts. I am always struck by the close resemblance that experts' predictions have to recent past performance. In December 2007, the experts surveyed by BusinessWeek predicted an average 9% gain in the U.S. stock market for 2008. The twelve-month gain of the U.S. stock market prior to the predictions was 8%².

By November 30, 2007 the stock market had already begun to decline. The mortgage crisis was in the headlines. (Remember when President Bush gave out the wrong telephone number for the "Hope Now Hotline" in December 2007?). So why was a 9% loss the lowest forecast for 2008? The 2008 actual return was more than four times worse than the lowest prediction.

Besides missing the mark on overall market performance, their individual stock and sector picks even underperformed the stock market as a whole: the favorite picks lost 40% on average, while the stock market lost 37%.

The problem is not that these folks aren't very knowledgeable, it's that it's impossible to consistently predict short-term performance. How did the 40% average loss of the "Smart Money" crowd compare to the passive management folks, those of us who do not attempt to pick stocks, and instead focus on asset allocation? Well, a passive portfolio of 75% equity and 25% bonds would have lost 29%⁴. A more conservative portfolio of 50% equity and 50% bonds would have lost 18%⁵.

We don't know when the stock market will recover. Investors have had time now to price in aggregate expectations of economic conditions in 2009. The stock market does not react to good or bad economic news, it reacts to news that differs from expectations. Many of us expect unemployment to rise throughout 2009. We expect more foreclosures, reduced consumer spending, and low or negative inflation. The question for investors is whether economic conditions will be better or worse than aggregate expectation. We may expect that unemployment will increase to over 8%; but will it rise to 10%? I don't think anyone can know at this point. Equity markets may well rise if economic data is better than expected.

The December 2008 unemployment rate of 7.2% was announced on Friday. Although the rate was higher than analysts' consensus estimate of 7.0%, the stock market barely hiccupped. This supports our belief that very bad economic news is probably already priced into stock prices.

Actions, Taken and Expected

We realized losses in most taxable accounts before December 31, 2008. The market decline presented an opportunity for a tax benefit in the form of capital losses. When appropriate, we sold positions in non-retirement accounts to generate capital losses. To recognize a loss, a position sold cannot be repurchased within 30 days of the sale. We replaced positions sold at losses with similar but not identical positions to maintain the desired portfolio allocation.

On your tax return, losses offset gains, plus an additional $3,000 of ordinary income. Excess losses are carried forward to future years until used up. This is an opportunity to reduce or eliminate capital gain taxes for many years into the future, at no cost.

We also increased bond allocations either actively, passively or both. Actively, by adding to existing bond holdings; and passively by intentionally not rebalancing the bond allocation. The bond allocation exceeded the proportions defined in some clients' Investment Policy Statements. We took this unusual step due to the extremely volatile performance of the security markets and our opinion that bonds were caught up in the wave of panic selling. We are in the process of updating our Investment Policy Statements. If your bond allocation exceeds the current Investment Policy, we'll update the allocation in the new IPS to be mailed in early February.

Bond prices and yields normally have an inverse relationship; when prices fall, effective yields rise, and vice versa. Typically Treasury bonds and corporate bonds move in the same direction, but corporate bonds offer a "risk premium": corporate yields are higher than Treasury yields to compensate for higher risk. But since October, the yields of corporate bonds and Treasury bonds have moved in opposite directions as a function of supply and demand. Investors sold corporate bonds, pushing prices down and yields up, and bought Treasuries, pushing prices up and yields down. Prices of short-term Treasuries were so high at times that the effective yield to the purchaser was negative - a buyer was willing to receive less money back than s/he paid for a bond, for the privilege of owning a government bond.

It's irrational though, to buy a 30-day Treasury bill at a price that guarantees you'll pay more than you will receive at maturity, when an investor can instead buy a CD with the same government backing that provides a positive 2% yield.

As you may know, we have favored individual bonds over bond funds in the past. Individual bonds, held to maturity, provide a known return (the difference between the price paid for the bond, the face value, plus interest payments), while bond funds trade bonds continually, increasing the cost of the investment and subjecting investors to more volatility than the underlying bonds.

In a tactical departure from buying individual bonds, we have implemented the increase in our bond allocations using bond mutual funds. It would be difficult to find enough desirable bonds to quickly implement the increased bond allocation, and with the government interventions, we can't know which companies' bonds will receive an implicit guarantee of Treasury backing (e.g., GMAC bonds, worth less than 50% of face value on December 15, 2008, now worth 80% more since government intervention) and which might not (e.g., Lehman Brothers).

As we find desirable bonds, we are buying the bonds and selling the equivalent amount of the bond funds.

Another tactical change has been to purchase exchange-traded funds ("ETFs") instead of mutual funds whenever possible. ETFs are index (passive) funds that trade continually throughout the day. Mutual funds are priced once, after the market closes, each day. In the current environment, in which markets have moved 10% in one day, and frequently have a trading range of 3%, we feel we can add a small amount of value by capturing prices during the daily swings, instead of relying on end-of-day pricing.

As always, but especially now, please do not hesitate to contact us with questions, or for a more detailed discussion of your financial affairs.

Regards,

Audrey Grubman
Portfolio Manager and President
GRUBMAN FINANCIAL

¹BusinessWeek December 10, 2007.

²November 30, 2006 through November 30, 2007.

³BusinessWeek December 20, 2007.

⁴30% to U.S. large cap stocks (S&P 500 index), 15% to U.S. small cap stocks (Russell 2000 index), 30% to foreign stocks (MSCI EAFE index) and 25% bonds (Barclay's Aggregate Bond index), assumed investment expense of 1.5%.

⁵20% to U.S. large cap stocks (S&P 500 index), 10% to U.S. small cap stocks (Russell 2000 index), 20% to foreign stocks (MSCI EAFE index) and 50% bonds (Barclay's Aggregate Bond index), assumed investment expense of 1.5%.