It seems like only yesterday we were here saying nearly the same thing.  The market went on a tear this past quarter, with the S&P 500 Index rising 10% and the larger cap Dow Jones spiking 11.3% for the quarter.  By the end of March, U.S. stock markets had surpassed their all-time high previously reached in October of 2007.  Much of the optimism driving the market arose from the agreement in early January to avoid the so-called “fiscal cliff” – the expiration of lower tax rates and the dramatic cutting of government spending which, taken together, could have easily thrown the U.S. economy into a recession.  And, once again, these gains more often than not came “in spite of” rather than because of some major catalyst.

In spite of the deal to avoid the fiscal cliff, a tax cut on Social Security contributions was allowed to expire which impacted take-home pay for everyone.  In addition, the deal did not avoid the so-called sequestration which promises to cut some $850 billion in government spending in this year alone.  Over in Europe, all was still not in order.  Italy held elections in February which resulted in a convicted felon (former Prime Minister Silvio Berlusconi) and a comedian (Beppe Grillo) being elected to Parliament.  And, in late March, a bank crisis in Cyprus dominated headlines with the big news being that bank depositors were going to lose some of their deposits to bail out their failed banks.  Meanwhile, European markets managed to finish the quarter up just over 7% (in local currency). 

Warren Buffett, as most of you know by now, is not only one of my heroes, but is often considered to be one of the greatest investors of all time.  From 1966, when he began running Berkshire Hathaway, to the end of 2012, the overall stock market (including dividends) has returned an average of 9.4% annually.  That means that $1,000 invested in the U.S. market in 1966 was worth just over $74,000 at the end of 2012.  During the same period, the book value of Berkshire Hathaway increased by almost 20% per year – twice the U.S. market return.  The result?  That same $1,000 invested in Berkshire Hathaway’s book value would have grown to over $5 million!

This is why Warren Buffett’s views are worth heeding and why his annual letter is greeted with eager anticipation each year.  I confess to eagerly reading it each year – even reading past letters from time to time.  One of the themes both in his most recent letter and in many recent interviews is the idea of dealing with uncertainty.  Buffett points out that uncertainty – much as we have in the current markets right now – has been a constant in the United States since about, oh,  1776.  The only variable is whether people ignore the uncertainty (typical for boom times) or fixate on it (as happens during crises). 

Right now, people are focusing on the problems – stocks are overvalued, we’re due for a correction, the Fed is artificially inflating asset prices, the economy is weak – and yet, we are seeing new all-time highs in the stock market week after week.  The truth of the matter is there are issues.  The Federal Reserve is artificially inflating asset prices (i.e. stocks) through low interest rates, but stocks really are the only game in town.  The interest rate on a 10-year Treasury bond is currently around 1.9% and, if you factor in inflation, this means that someone that buys a 10-year Treasury bond today and holds it until it matures is actually losing money!  Buffett stated in a recent interview on CNBC that at some point interest rates will rise, but even with that risk, he much prefers stocks over bonds, saying that today “the dumbest investment is a government bond.” 

While there is an element of truth to what he says, this does not mean that we should avoid bonds altogether.  Bonds do have a place in a portfolio, but we need to be aware of the risks and manage around those risks.  The biggest risk, of course, is that interest rates are going to go up at some point, but probably not until next year.  The Federal Reserve has said they intend to maintain a low interest rate environment until the unemployment rate drops to around 6.5%.  Given that we are currently officially around 7.6% unemployment, we still have a ways to go.  We have already prepared client accounts for the eventuality of rising interest rates, adding the PowerShares Senior Loan Portfolio ETF (ticker: BKLN) to client accounts at the start of the year.  This fund invests in bank loans – short-term loans by banks to businesses for inventory, for example.  These loans are 3- to 6-months in duration, so the interest rates are quick to adjust to any changes.  Our intent is to gradually migrate more of our bond holdings over to this security as interest rate risk rises, eventually moving back into longer term bonds as interest rates stabilize. 

One of the key things we focus on in our investment analysis is cash flows – both to the company and from our investments.  We have recently been more focused on companies that pay dividends than in past years primarily due to the lack of income from other sources.  When we return to a more normal interest rate state, we expect that we will focus a bit less on dividend yields and more on the total return potential from a stock.  We are trying to be discerning in our security picks though, as there are some stocks that are looking expensive by historical standards and this does give us pause.   We are selectively trading when we find opportunities to earn a good return.  For example, we have purchased shares in Guess? Inc. (ticker:  GES) across client accounts up to three different times now and we either have or expect to earn between 7% and 8% on each of these trades in about three months’ time.  While this is a lot more trading than normal, when offered this sort of opportunity, we are going to take it.

As always, we truly appreciate the trust you have placed in us and the opportunity you have given us to manage a portion of your assets.  If you have any questions or need to discuss any issues please feel free to give us a call.


Alan R. Myers, CFA

President / Senior Portfolio Manager

Aerie Capital Management, LLC

(866) 857-4095