The investment environment remained extremely challenging in the first quarter. When we came into 2009, little did we know that another 20% decline in stocks lay immediately ahead in January and February. Fortunately, stocks rallied strongly in March, cutting the damage considerably. Even so, stocks in general ended the quarter with a return of some -10% to -12%. Bonds were a good diversifier during this period, but only in the sense that they declined by a much smaller amount. At year end U.S. Treasury yields reached extremely low levels, due in part to flight to quality, but retreated somewhat in the first quarter. Within this environment the portfolio continued to demonstrate a degree of defensiveness, and declined less than the popular averages.

 

In our January letter we set forth several assumptions about the shape of the economic and market environment. We wish to reaffirm those at this time, despite the market travail of the first quarter. It continues to be our belief that the worst part of the recession occurred in the fourth quarter of 2008 and the first quarter of 2009. We still expect the economy to return to growth as measured by real Gross Domestic Product (GDP) in the fourth quarter of 2009 or the first quarter of 2010. Finally, we think the stock market will begin anticipating economic recovery in advance, and that for the full year 2009 stocks will earn positive returns on balance.

 

The overall economy has recently been shrinking at a rate of 5-6%. Certain important sectors of the economy are severely depressed. Housing starts on an annual basis have declined some 75% from their peak. Auto sales are now running under nine million units per year, down 50%. Finally, manufacturing capacity is now being utilized at only sixty-seven percent. Our assumption that we are now at the trough of the recession rests partly on the belief that things simply cannot get much worse. Heroic assumptions are not required to suggest improvement. Even if the economy were to fail to go into an extended expansion, it would be reasonable to expect the normal self correcting tendencies in the economy to cause some improvement. 

 

Our belief that GDP will turn positive late this year or early next year rests mainly on the belief that the massive amounts of monetary and fiscal stimulus will provide impetus for recovery. As we have noted before, one may argue with parts of the fiscal stimulus plan put in place in February, but almost all economists agree with the need for fiscal stimulus as a supplement to current monetary policy. The problem with the monetary stimulus is that much of it must be implemented through the banking system, and right now banks are so mired with bad loans and other toxic assets that they are hesitant to lend. The recently announced plan to relieve banks of some of these burdensome assets is of critical importance. Even if this plan is only partially successful, given the amount of stimulus in place, it should release quite a bit of needed thrust for the economy.