10.30.20092009 3rd Quarter Newsletter October, 2009 Economic Update: From a depression to growth In the last six months, public perception of the economy has gone from a depression to expansion. Third quarter GDP may be positive, technically ending the recession, but the US economy is not back on track. There are many serious economic headwinds including too much reliance on government stimulus to keep the economy afloat. The federal government had a $1.4 trillion dollar deficit in fiscal year 2009, 35% of its $3.9 trillion budget. The government deficit is 10% of the total U.S. GDP. If the government were to only spend what it receives in tax receipts, the economy would be down more than -10%, year over year. Warren Buffet’s two favorite leading economic indicators are rail shipments and housing permits. Each gives an early indication of future economic growth. For the first 39 weeks of 2009, U.S. railroads reported cumulative volume of 10,381,905 carloads down 18.1 percent from 2008. Total volume on U.S. railroads for the week ending October 3 was estimated at 29 billion ton-miles, off 16.6 percent from the same week last year. All of the 19 carload freight commodities groups were down from the same week last year. Secondly, housing starts are averaging 580,000 new starts annually. This is down from over 2,200,000 at the peak and below the historical average of 1.25 million per year. These are not signs of growth. Market Update: Back to irrational exuberance During the 3rd quarter, the DJIA had its best quarter since 1998. The S&P 500 ended its best two-quarter rally since 1975. The S&P500 is currently priced to return 5.3% annually over the next 7 years compared with an historical average of 9.6%. Our “fair value” for the S&P500 is 801 - not 1050! The S&P 500 is 31% over-priced in a “no-growth” economy. The stock market must return to record profit margins over the next two years to justify these valuations. This expectation is against the headwinds of rising unemployment, minimal organic growth and a lack of available credit. The record profit margins seen in 2007 are not repeatable as they were in large part due to easy, cheap credit allowing individuals and corporations to leverage their assets. Easy credit is no longer available. Portfolio Update: Caution and Opportunism This is a dangerous environment with limited economic growth and an overpriced stock market. We expected a retracement last quarter in equities, which we now anticipate will occur in October and early November. We invested to make 1% in Q3. Although we made 2%, we are disappointed. We believe the market is primed for a correction. The foundation of our investment philosophy is to minimize risk when it is unjustified and avoid major losses. At the end of the 2nd quarter, we reduced equity exposure, because stocks were no longer undervalued and the risk was not commensurate with the probable reward. We added to our fixed income positions and continued to avoid stocks as they became even more expensive and overvalued – and thus higher risk. We continue with this stance. After the stock market corrects, another rally will ensue based on the hope that the (anemic) economic recovery is sustainable. We will buy stocks after a correction, but we won’t hold them for long in this over-priced environment. We continue to maintain a cautious stance with a bias towards shorter term bonds. We will invest in riskier assets when the risk is commensurate with the reward. Thank you for your continued trust and support. Trevor K. Holsinger, CFP