Farragut Newsletter 12 Jan 09

The Markets and Your Portfolios January 12, 2008

Shovel Ready "Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down... enterprising people will pick up the wrecks from less competent people." Treasury Secretary Andrew Mellon to President Herbert Hoover in 1931

Next week our new President takes office, with a distinctly different set of advisors than his predecessor. The realities he faces remain the same. While the glow of history has shown favorably on FDR, and the stonework of the CCC still graces our parks and byways, we must remember that it was not deft policy measures that ended the Great Depression, rather a horrific World War.

A sound banker is one who, when he is ruined, is ruined in a conventional and orthodox way. John Maynard Keynes

Reviewing our letters of the past year, our prescience was commendable. Reviewing client statements for the past year, our execution was not. This disconnect between expectations and results is not unique to our portfolios. That said, our contrition is profound. The premise that a well-diversified portfolio would protect investors against catastrophic loss has been challenged. Statistics are used to promote an agenda. In our industry’s case, the agenda has been the sale of investment services. Trust is the basis of investing, and hard numbers convey the impression of solidity and virtue. To advise a client that the standard deviation of her portfolio is fifteen percent leaves her with the impression that will be her range of returns. However, there remains a meaningful likelihood that her results can be three times that, up or down.

This time it’s different. It always is. The Bush and Obama administrations’ commitment of public assistance to private enterprise is unprecedented. With our government allocating capital on such a massive scale, we have no doubt the consequences will be profound.

It’s hard to sell investing for the likelihood of seven to twelve percent returns if you disclose the downside as forty five percent. Now we know.

As investors, we are concerned. We invest today for deflation, with absolute certainty that inflation will return with a vengeance. We just don’t know when.

First, most losses have been booked. The capital gains distributions from mutual funds have been astonishing, given their poor performance. The next shoe to drop for investors will be the April tax bill handed them by less conscientious managers and advisors.

Deflation, a pernicious decline in prices, penalizes borrowers most. Your 20 percent down payment on a house two years ago is 100 percent gone. But as bondholders, we are happy, because future income will buy more. Inflation, the consequence of too many dollars chasing too few goods, is the borrower’s friend. Your 5 percent down payment on a home in 2001 grew like topsy, doubling and more for the next four years. The US Government is the mother of all borrowers. An expedient way out of a multi-trillion dollar government and private sector debt overload is to cheapen the dollars needed to pay it back. Change may be coming to Washington, but expediency is a constant.

Returns for our client portfolios have been less extreme, with several features worth noting.

We continue to invest for a deflationary environment, seeking safe yield and companies with modest debt and strong dividend yields. Cash balances are much higher than we would like, particularly in light of the low money market rates. The last quarter’s rout in Agency and High Quality Corporate Bonds provided an opportunity to obtain some secure and attractive yields, but more work remains to be done. In more longer-term aggressive portfolios we have initiated positions in High-Yield (Junk) and convertible bond funds, but our expectations are tempered by Recognize the woeful state of the credit market. that the TARP money given the banks has not increased their lending. Bank lending is down 55 percent year on year. These funds have been squirreled away on bank’s balance sheets. (Or in the case of Citigroup, parked in a tanker in the Outer Hebrides in anticipation of higher oil prices in the Fall).

Copyright 2009, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.

children’s educations. With the high cost of college, to help your children is a parent’s responsibility. With the high cost of retirement, this practice can be treacherous. Part of conventional retirement planning is the presumption of a marked decline in one’s costs of living. If you wish to maintain your lifestyle, you must find attendant reductions in expense. To retire with a mortgage balance calls for some multiple of that in additional retirement assets.

History tells us that excesses are self-correcting. Tulips today are ornaments, not a store of value, and their current price reflects that. Looking at the chart above (courtesy of Ron Surz, of PPCA in San Clemente, CA), we can expect an improvement in the markets at some point in our lifetime. To ensure a secure retirement income, many investors are best served by a well-selected portfolio of stocks for a portion of their investments. Stock Selection presumes an eventual recovery of business conditions, but prudence calls for a focus on strong firms with pricing power. Perversely, recent rallies have been in firms with the opposite characteristics, banks and homebuilders being prime examples. This market favors trading, not investing. We have been very selectively buying individual stocks, emphasizing high-quality and dividend yield. For a more passive investor, the broad indexes (Russell, S&P) afford an opportunity for modest gains. Should all work out swimmingly, stock investors will do very well next year. If the economy fails to gain traction, well that’s why we use stop-losses.

Student loans can be poison, leading to misguided career choices and low savings when they can make the greatest difference. But sacrificing your own income security can be equally hazardous to your children’s welfare and happiness.

Keep Shoveling… Last October we wrote that our appetite for financial punditry was sated. Our reason for writing these letters is to distill the ocean of opinions and data to a small glass of actionable text. We hope you find it refreshing. As professional optimists, paid to prepare for our clients a prosperous and secure future, our ability to reassure has been tested. What we can promise is continued diligence, a commitment to prudence, and a dedication to thrift. Frank J. Ruffing CFP McLean, Virginia [email protected]

The collapse of the commodity complex, from Palladium to Pork, gives long-term investors an opportunity to hedge for future inflation at a relatively low cost. Traditionally the cost of carry, the interest income foregone, has discouraged long-term investors from precious metals. With money market yields near zero, that objection has been eliminated.

Retirement Readiness Recently we’ve seen a pattern in the prospective clients we’ve been meeting, and it should be of concern to both parents and grandparents. Living in an affluent part of the country, we find the million-dollar home to be more Levittown than Graceland. This home is often our largest single asset, outside of retirement savings. More and more parents are borrowing against their homes (or forgoing paying principal), in order to finance their

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Copyright 2009, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.