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There has been much discussion over the past few months about the stock market and the economy and whether or not they are recovering or whether there are still dangers lurking. While both are still on shaky ground, it does appear that things are improving for our economy, although at a slow pace. We will likely continue to shed jobs and see the unemployment rate climb through the first stages of economic recovery. The stock market has also recovered over the past four months, although it remains well off of its highs.

We have often pointed out that during a recession the stock market normally bottoms out well before the economy does. As bad as the market was during the first quarter of this year, over the past sixteen weeks the S&P 500 has risen over 35%. To continue this momentum, we will need to see continued economic improvement over the remainder of this year. History suggests that this should be a good time to invest in equities. Since 1957, the S&P 500 has averaged a return of 35% in the first year following a bear market and 8% in the year following a down year for the index. As is the case with most bear markets, panic selling last fall has provided opportunities for long term investors to buy quality companies at reduced prices.

If you like volatile stock markets, the first quarter of 2009 was for you. The three month period we just finished saw a bear market and a bull market, all on its own. From its low point on March 9 th , the S&P 500 gained more than 20% over the next three weeks, including the fourth best one day return in the last fifty years. March ended the month as one of the best months for the stock market in the last twenty years after starting the month as one of the worst.

An obvious question to ask is whether we have seen the market bottom or is this just another bear market rally that will not hold. Consider that since the market reached an all time high in October of 2007, we have seen three different rallies of at least 15%, including the latest, which is the largest of the three. While short term market prediction is impossible, there are signs that the market is behaving in a more reasonable manner. We are also seeing better, although not great, economic data that suggests the economy is beginning to show some signs of life.

The unfortunate thing about the current financial crisis is that it did not have to happen. While our economy has always gone through cycles, a crisis like this one cannot happen without a lot of help from a lot of people. A tremendous lack of oversight allowed Wall Street firms to run wild and take enormous amounts of risk. These same firms cultivated a self serving culture, seemingly creating products that served no purpose other than to make themselves vast amounts of money. Government regulation not only allowed the emergence of an unregulated shadow banking industry, but required financial firms to make mortgages to borrowers that had little ability to repay. People cared little about what they paid for a house because they had the mistaken belief that home prices would never go down. Leverage can be a good thing, but too much can be devastating. This is true for individuals, businesses, and the economy as a whole.

The U.S. economy has been in a recession for twelve months, but the stunning events of September, October, and November surprised almost everyone. With the near collapse of the financial sector, consumers and businesses basically stopped spending money, causing further economic contraction. With consumer sentiment readings reaching all time lows, it is clear that people are bracing for the worst. At this point it is impossible to know when this recession will end, although it seems clear that we are not as of yet out of the woods. There are those that have stated that we are headed for another 1930’s like economic depression. It is important to keep in mind that there are major differences between today’s crisis and the depression:

A lot happened during the third quarter of this year, and almost none of it was good. To recap the events of the past few weeks: A segment of our financial sector has been nationalized; we suffered the largest one day drop in the stock market since the crash of 1987; the credit market completely seized up; and investments that were rock solid a month ago have suddenly become very shaky. The rapid worsening of the financial crisis has thrown all of the capital markets into disarray and threatened to spill over into all segments of the economy. We will discuss the scope of the problem and what we think should be done about it, as well as what we think investors should do and not do in response to these extraordinary events.

We have talked in past letters about the housing bubble and the subprime mortgage problems. It initially appeared that the problems were confined to the subprime market, but these problems quickly expanded into a full blown credit and liquidity crisis that has affected leveraged holders of all assets. This lack of liquidity and credit has led to rapid write downs in asset values and an inability to raise the necessary capital to make up the difference. This is how we can go from having well capitalized companies to bankrupt companies literally over night. We have been seeing a classic run on the bank as investors try to dump securities where there is no market, causing prices to tumble.

You need only look at two pieces of data to understand why the capital markets have struggled through the first half of this year; consumer confidence is at its lowest level since 1980; and only 17% of the American people are optimistic about the direction in which we are headed as a nation. This pessimism, driven by a number of factors, directly causes the economy to slow down and stocks to fall. The factors causing this pessimism include the following:

The price of oil and other commodities We have discussed the price of oil often over the past couple of years and it remains an issue. The high price of energy affects almost every segment of our economy in addition to making people feel poorer every time they fill up their car. Food prices and other basic materials are also rising rapidly. This type of inflation has always unnerved consumers and causes them to slow their spending in other areas. A worker making minimum wage spends almost 25% of their weekly earnings to buy one tank of gas for their car. Farmers earn more on their crops but spend huge amounts on fuel and chemicals. Nobody benefits from spiking commodity prices.

Economic concerns and soaring energy prices combined to whipsaw the stock market during the first quarter of 2008. While this is not the first quarterly pullback stocks have experienced since the beginning of the latest bull market in late 2002, it is the most severe. The bond market posted gains as interest rates dropped in response to the slowing economy. There are many questions being asked about the capital markets and we will do our best to answer the most common ones.

Are we in a bear market like the one that lasted from 2000 through 2002? While it is impossible to know what will happen in the future, we are confident that this is not a secular bear market like that one was. Over the past one hundred years, we have only experienced three secular bear markets and they have all come after historic bull markets that drove valuations to record levels. Going into this slowdown, valuations have fallen an unprecedented 50% from the record levels seen in 2000. This should provide a cushion to stock prices.