June 1, 2010

Dear Investor,

Stock market losses were widespread in May, and our portfolios suffered with the market. Major averages lost about 8%, essentially wiping out gains achieved since the start of the year. I’d like to comment briefly on the severity of the decline and the recurrence of extreme volatility.

Corrections, defined as declines in stock market averages of greater than 10% (but less than 20%), have been a relatively frequent occurrence throughout history. What’s unusual about this correction isn’t that it is occurring, but that the market has risen so far for so long without a decline of 10%. Also unusual is the ferocity of the decline, with volatility approaching historical extremes.

The volatility is a ramification of high frequency trading, where literally millions of trades per second are generated by computers using complex financial algorithms. They seek to exploit minor divergences between similar securities or derivatives thereof and baskets of stocks like ETFs (exchange traded funds). Since these types of trades constitute more than 50% of the volume on the major exchanges, you could say that the “machines” are running the markets. To a great extent, they are -- at least in the very short term. High frequency trading has absolutely no relationship to company fundamentals, so violent movements in individual stocks often bear no relationship to a company’s business or prospects.

To be clear, high frequency trading does not of itself lead to sustained market declines or advances. Nor does it provide any benefit to the economy (other than for the traders, brokers and exchanges). It does seem to exacerbate trends, and it certainly creates volatility. Excessive volatility unnerves investors, erodes confidence in the markets and leads many investors to move to the sidelines. So in the long run, high frequency trading may be net neutral, but in the short run the inherent volatility is very disturbing. Since it is so lucrative for powerful interests on Wall Street, it will probably be allowed to continue. We had better get used to it.

The market correction now in progress can be attributed to uncertainty regarding the ultimate outcome of financial and debt problems in Europe, the degree of slowdown in China’s economy, the oil leak in the Gulf and bad behavior in Iran and North Korea. Hopefully all of these issues will be resolved without dire consequences and the market will regain firmer footing relatively soon. Expect frequent use of the word “austerity” in coming months.

From a long term fundamental perspective, there is reason for optimism. Interest rates remain low, inflation is low, growth in Asia will persist, the US economy continues its recovery, leverage is gradually being reduced, most US industrial companies are fit and trim and stocks are not particularly expensive. Seeing many stocks in our portfolios being yanked around by mindless machines performing high frequency trades is somewhat disconcerting, but if our companies do well in their businesses, their stock prices will ultimately reflect their successes. The next few months could be a bit bumpy in the markets, but we’ll stick by our projection, first stated a year ago, that the Dow will reach 15000 by 2015. We appreciate your continuing confidence in us.

For the team at FIM,

Jeff Friedberg