Realistic Probabilities

April 3, 2008

Dear Investor:

The first quarter was the worst start to the market since 2001. The S&P was down 9.47%. From 2000 to 2002 the market was down a far greater amount, nearly 50%, but the concentration of the current declines during such a limited time has made the pain seem comparable.

The crisis of confidence that felled Bear Stearns has led to predictions of another Great Depression. Such hyperbole means the details of the Great Depression have been either forgotten-or that the true genesis of that horrible time is being ignored. The Great Depression was not caused by the crash of ’29, nor by the failure of a few financial institutions. It resulted from a systemic contraction of the money supply and an unchecked run on the financial system that closed 9,000 banks. This choke on supply was not created by the initial failures or lack of confidence. The cause was laissez-faire indifference coupled with gold backing, both of which handcuffed government during a time when government was needed most.

Today we have the opposite: an activist Fed trying everything possible to re-liquefy lending, and a bipartisan effort to promote short-term fiscal stimulus (as weak as that may be compared to the monetary approach). Bernanke spent his academic career studying the Great Depression, and his actions show a deep understanding of how to prevent one.

The economy will suffer. The recession will be long and deep. Many financial firms will fail, especially leveraged players and poorly capitalized banks. Real estate will continue its descent. The unemployment rate will spike; consumer spending will plummet. All of this is likely. But a Great Depression is not.

Distinguishing correctly between these two very different scenarios will lead to very different investment strategies. For those who anticipate another Great Depression, all stock should be sold. The following should also be liquidated: gold, silver, real estate (except a primary residence), land, and any other asset remotely linked to monetary expansion and inflation. The only “safe” assets would be Treasury bonds and cash. But we think those who anticipate another depression are confusing this one remote possibility with many far more realistic probabilities.

Instead, we think the danger is inflation resulting from unprecedented monetary stimulus. Investors seeking a safe haven have pushed Treasury bonds to unsustainable prices. As Jim Grant of the Interest Rate Observer says, a Treasury now looks like “reward-free risk.” We believe large cap equities, especially financial shares, look like one of the few undervalued asset classes in a world short on confidence but long on liquidity.

We are increasing equity allocations across nearly all accounts, overweighting financials via the Davis Financial Fund, which specializes in high-quality banking and insurance companies. We believe this is a rare opportunity: the best entry point for financial stocks in over thirty years. Financial shares should produce outsized returns over the next five years.

The stock market decline has been ugly and the economy looks grim. But attractively priced, quality assets should always appreciate over time. We thank you for your patience during this difficult period.