September 1, 2011

Farewell to August!  

Dear Investor,

August is normally a month of quiet vacations and calm markets. Not this year! Volatility was virtually unprecedented and investors were justifiably shocked and frightened by the large swings, primarily downward, in their portfolios. The logical question then is “Where do we go from here?”

For the sake of simplicity, let’s break this down into two issues – market volatility and market direction. Unfortunately, market volatility is a fact of life these days. High frequency trading (HFT), where cleverly programmed, high speed computers execute millions of rapid fire trades each day, effectively turns market ripples into waves. HFT was a primary cause of the “flash crash” in May a year ago and the daily 400 point market swings this past month. HFT is obviously bad for the markets. It not only unnerves most legitimate investors, but it also leaches money from the capital markets and probably hurts the economy in the process. However, until it is harnessed by government regulators, we must learn to live with it.

The more important issue is market direction. Five weeks ago, our stock market was firmly in the black for the year. Now those gains have evaporated. That should not really be a surprise since the US and European economies essentially downshifted from second gear to first (possibly even neutral) and growth rates in Asia also came under pressure. As a consequence, investors’ expectations of future earnings were adjusted downward and stocks slumped. The degree of the tumble was exacerbated by the sorry spectacle of the debt-ceiling negotiations in Washington, the credit downgrade of US Treasury debt, and resurfacing of bank solvency issues in the Eurozone. There is now widespread expectation that our economy may be stuck in the doldrums for many more months or possibly even sink into another recession.

As bad as things seem, we at FIM anticipate that an extended period of little or no growth is more likely than a recession. The real wildcard is Europe, where potential bank failure could negatively impact financial markets around the world. We have no way to predict the extent or duration of such an impact.

Even more important than the outlook for our economy is the outlook for the companies in which we invest. In sharp contrast to most governments, our corporate community is in excellent shape. Balance sheets are solid, margins are firm and inventories are in line. Many of our companies actually see no signs of a slowdown ahead and are conducting business as usual. Other portfolio holdings may be experiencing some near term business challenges, but we are confident that they will surmount those and do well in the long run.

In summary, we may or may not have seen the market lows for the year. But stocks are trading at relatively low valuations historically and the interest rate environment remains very favorable, so the market is unlikely to fall much further. There are pockets of growth out there and many companies are paying good dividends. So we may shift our focus a bit from economically sensitive companies to those that are able to grow without economic tail winds. But that won’t be any different than what we’ve always done, which is to invest in companies which we believe will become more valuable in the future, either by growing their earnings or by delivering a rising stream of dividends. We still expect the Dow to reach 15,000 in 2015.

For the team at FIM,

Jeff Friedberg