First Quarter 2009 Outlook
   Finally stock market investors have a little something to smile about.  If you've been tracking your investments monthly, you haven't witnessed a market value increase for at least the past seven months.  Realistically, there's been little to appreciate since October 2007.  However, take a gander at your March statement and you'll see something many of us felt like we might never see again - the market value is actually higher than the prior month-end!  Does this mean we have finally reached a bottom?  Is the economy ready to start growing again?  Have fiscal and monetary stimulus already begun working their magic, lifting us out of this nearly 2-year mire?  Stay tuned...
   Despite what is now nearly a six-week rally from the early-March lows, the market is still in negative territory so far in 2009.  Even sadder, the 30% rally from the bottom has done little to repair the damage that has occurred over the past 18 months.  If the market experiences future returns near its historical average of 10%, we won't reach 2007 highs until the year 2017.  2014 is in our sights if we can average 15%, and an average annual return of 20% will get us there by 2013.  If you give up on stocks and retreat to the safety of low-yielding Treasury Bonds currently yielding less than 3%, you'll need nearly three decades to earn your money back.  These are some pretty lofty numbers and we caution long-term investors to avoid the "getting-back-to-even" mentality.  We instead recommend investors focus on what they would like to achieve from this new starting point.  Still, the real question is, can we expect to see continued progress from this recent rebound?  We'll provide our opinion later in this quarter's review, but first let's look at the first three months of the year.
First Quarter Performance Review
   We'll start off with our own good news.  St. Nicholas clients continue to benefit from the value-added of our investment management.  We began 2009 holding significantly higher levels of cash, and the negative equity market returns so far have made that a wise decision.  Our equity-only and total account returns were significantly better than the markets in the first quarter.  In fact, on average, our equity accounts only declined by about half as much as the markets did in the first quarter.  It's never good when you lose money, but if we're doing that much better than the markets, then that means our clients have smaller losses to recover when the market starts to turn.  Simply stated, St. Nicholas clients' head start means that more than likely they will be back in positive territory much sooner than the average investor and/or mutual fund.  We'll again remind our clients to examine total portfolio returns rather than equity-only.  The equity-only returns reflect a less diverse portfolio of stocks and do not take into account the return-cushioning effect of significant cash holdings.  The cash holdings have a two-pronged effect: first, they have allowed St. Nicholas client portfolios to outperform the markets by a range of 5% - 15% over the past twelve months; second, the extra cash will help us magnify gains as we begin to put money back to work in the coming/continuing market rebound.
   In spite of improving sentiment at the end of March, equity markets in general still produced extremely poor returns for the quarter.  Following the worst January on record, US markets experienced quarterly declines exceeding 10%. NASDAQ turned in the best quarterly performance, declining only about 3%.  The S&P 500 did much worse, dropping 11%, and the Dow plunged 12.5%.  Overseas markets were mixed.  Japan was down 8.5% and large cap international stocks (MSCI EAFE) were down almost 14%.  Emerging markets, the biggest decliner in 2008, began a stronger rebound and actually finished up 1% for the quarter.  Real estate prices continued their fall, and home inventory increases were just another indication that we've got a lot farther to go.  Commodities improved with news that the biggest user, China, has begun a noticeable turnaround, but still finished the quarter with declines.  Finally, oil prices continued to fluctuate in the $35 to $50/bbl range, but forecasts for continued global weakness have likely put a cap on oil prices for an extended period.
A Tough Road for the Banks
   Regardless of the improving sentiment, the hole that the banks and large financial institutions dug for themselves is gaping.  Many of the failed companies have started to be merged into the survivors and the costs, both financial and personal, are resulting in some sweeping changes.  Assuming President Obama hasn't fired a banks CEO, corporate leaders are saddled with the responsibility of consolidating budgets, business lines, compliance, and personnel.  We have already heard many firsthand accounts of massive layoffs in the investment management and trust industries.    Our friends and former co-workers were sent packing with little notice and little severance or assistance; those that remain show up each day wondering whether they'll be next on the furlough list.  Undoubtedly, many of our former clients are experiencing turnover in bank employees that they once trusted with all of their personal wealth.  Those clients will soon be hearing of service reductions, fee increases, or both.  Many of those clients have no idea who manages their money now, and many will later be surprised to find out that the unit that makes investment decisions on their behalf is part of an entirely different company.
   The banks and brokerages didn't just wake up one morning and realize that they had a huge problem - it took years to grow to excess before it literally imploded.  This is not a problem that will be cured overnight - it will take years to fully recover, and what's left will be a shadow of what the banking and investment management industry once was.  We will repeat the irony of St. Nicholas' own story.  We left our former employer (we won't mention any names, but it might be a failed bank that rhymes with 'run-over-ya') in 2004 to start a fledgling investment advisory company whose chance of survival was legitimately questioned at the time.  We are now the "safe and solid" manager who continues to attract clients, and our former company has basically failed and no longer exists!   This bank took extreme risk with its own assets, and failed to hedge against worst-case scenarios; they took shareholder capital and threw it in the incinerator!  Taxpayers are now footing the bill to cover the survivors.  There's some irony for you - you, the taxpayer are paying to keep your bank, whose probably looking to increase your fees and/or reduce your service, alive.  Quit getting double-dipped - pay us a visit.  Your financial services provider has a long way to go, and we can guarantee you will not be tops on their 'to-do' list for several years.  Don't let them control your destiny - take charge of your own situation and use this toxic eye-opener as the catalyst to improve how your investments are handled and to assure you won't be tossed around from person to person while your bank tries to figure out how they can provide less service for more money.
" Git yer Toxic Assets heeeere!"
   We'll get off of our soap box on the bailout so that we can re-focus our discussion on...the bailout.  While the Federal Reserve, the FDIC, and the Federal Government may have come a little late to the party, they came bearing many important gifts.  Former Treasury Secretary Paulson's first dip into the $700B bailout fund (TARP) was basically a $350B handout to the largest institutions, and the resulting effect did little to change the direness of the circumstances impacting survival.  Subsequent use of TARP funds came with much needed restrictions, and current Treasury Secretary Geitner deserves credit for providing some much needed calm to the markets with his proposals of the Term Asset Lending Facility (TALF), and more importantly, the Public-Private Investment Program (PPIP).   Combining all of these efforts with the new Build America Bonds (BAB), the Fed's purchases of mortgage backed securities (MBS), the bailout of AIG, and the forced bankruptcy of GM, we'll label the whole thing CRAZIE (Constant Re-use of the Alphabet by Zealots Identifying Enigmas).
   All kidding aside, it appears that we may actually have a credible approach to address the heart of the problem, that being credit.  Banks can't lend if they don't have the regulatory capital to do so.  Bank capital is impaired by toxic assets, preventing them from having the necessary capital to facilitate lending.  Banks can't sell the toxic assets because the market for these assets (most of which still carry AAA credit ratings) disappeared in the run for the exits last fall (basically the failure of Lehman Brothers scared everyone away - if they could fail, no one was trustworthy), and they can't mark them to market because you need a market to determine a price.  So, the banks are stuck with assets they need to sell to free up capital for lending, but they can't sell them because there is no market.  Enter Geitner and PPIP.  The US government effectively becomes a hedge fund manager using TARP funds, FDIC loans, and private capital (hedge funds) to fund the purchase of these toxic assets.  In essence, the government is putting up about 84% of the capital via loan guarantees so private investors can start buying these assets and creating an improved credit market.  A better credit market and cleaner bank balance sheets theoretically increase the availability of credit, simultaneously bringing down the cost of financing.  More and better financing means more loans for business expansion which means more jobs - exactly what the government would like to see.  Will it all work out?  Will the government actually make money along with private investors when the prices improve (through better markets or simply maturity to par value) and the government cashes in on its 17% equity stake in the PIPP program?  In a perfect world, absolutely...but then again, we're talking about the US government here.  We'd also suggest Geitner's best shot would be to start the program in the evening, outside of normal trading hours, in order to facilitate the smoother matching of supply with demand.  Geitner could then rest easier...he'd be glad it's night with the PPIP.
Where's the consumer in all this?
   We heard time and again that the consumer is two-thirds of GDP, so what is the consumer's role in this whole mess?  First and foremost, the consumer is feeling it on several fronts.  Obviously, anybody with stocks has endured extreme pain.  Unfortunately (or perhaps fortunately, depending on your time horizon), it's not just the wealthy that own stocks today.  Realistically, it could be argued that a majority of Americans own stock.  Virtually anyone participating in company retirement plans does, and those covered by defined benefit plans own stocks indirectly.  These folks have seen the damage and may be retrenching simply as a means of replenishing their retirement savings.  Many consumers that have lost their jobs or fear that they may lose their jobs are extremely reluctant to spend.  Those without jobs spend less for fear that their unemployment benefits will run out before they find gainful employment.  Any consumer that owns a home has seen their equity disappear - home equity loans are the newest dinosaurs.  And finally, sentiment plays a huge part.  Consumers can't pick up a paper or magazine, turn on the TV or radio, or surf the web without being bombarded by bad news.  Bad news means scared consumers, and scared consumers spend as little as possible.  As a matter of fact, consumer savings rates are now reaching levels we haven't seen in years.  When consumers save to rebuild their IRAs, reduce their debt, or increase their safety nets they don't spend a lot of time in car lots or malls.  A restrained consumer that's been directly harmed by the economy combined with the lack of easy borrowing by healthier consumers is what has and will continue to produce declines in GDP.
   Unfortunately, the faltering consumer can sometimes result in a vicious circle.  Businesses retrench because they see cautious consumers slowing down.  Business output begins to fall off enough that they begin furloughing employees.  Further layoffs put more fear into consumers who now see their neighbors and friends losing their jobs, and they start spending even less.  Businesses see less spending and they retrench again, and so on and so on.  This would develop into a long and seemingly never-ending cycle were it not for one thing - government intervention.  It's the government's role to interrupt these cycles through its use of monetary and fiscal stimulus.  We can be assured that this recession will not endure forever for two reasons.  The first is very simple - they never do.  The second is that we now have monetary and fiscal stimulus kicking into overdrive, and an economy simply can't ignore the underlying fuel to our economic fire.  We can't be assured of the timing, magnitude, or duration of the coming recovery, but we can be confident that we are closer to the end of the recession than the beginning.
The Securities Markets
   Now, just because we've stated that we're beyond the trough of the recession, this does not mean that the markets are out of the woods, nor does it mean that we will experience a V-shaped recovery.  We have previously stated that the causes and effects of this recession were severe and unusual, and that this would be a recession like most of us have never experienced.  We've still got a long way to go.  The housing market is directly related to economic health, and we remain at inventory levels that are at least twice as high as historical averages.  Home prices will likely have to drop another 15% to 20% before supply and demand start approaching equilibrium.  Companies are still retrenching - some are still failing.  We expect closings, bankruptcies, and layoffs to continue throughout the year and into 2010, resulting in an unemployment rate somewhere north of 10%.  Banks appear to be getting healthier, but bailout funds continue coming and PPIP has yet to be initiated and proven.  Protectionist measures that were at least one major cause of the Great Depression are starting to appear in many developed nations, including the US and China.  If global trade becomes stalled because countries begin restricting imports, all recovery bets are off.  Finally, and most importantly, no expansion is possible without the free flow of credit, and we still have a credit market that is knotted-up.  PPIP has a lot riding on its shoulders, but credit is not only still tight, we've started to see quality spreads begin increasing again - a bad sign for credit liquidity.
   You may be asking yourself already, if things are still so dire, why the 30% equity market rally?  Our basic answer is that we know the market doesn't move in a straight line, either up or down.  We had moved down so consistently for so long that some sort of intermittent rally was inevitable.  We saw a similar rally in December 2008 of nearly 25%, and we all know what happened to that one.  Whether the current rally has gotten us permanently off of the previous lows remains to be seen, but we can certainly revert to our previous statement:  no decline is straight down and no rally is straight up.  The market has likely come too far on a dearth of good news.  Many companies have been reporting first quarter earnings that are in line with expectations, but what is getting lost is that these expectations had already been drastically lowered.  More importantly, while several companies have "signaled" a trough in revenues, they are doing little to confirm that in their forward guidance.  The bottom line is that there is probably not going to be enough good news to allow this rally to continue.  We're not predicting that the market will revisit its prior lows (not yet at least), but we are expecting it to remain in negative territory for at least the first half of the year.
   So why own stocks?  Obviously, we're in it for the long term, and whenever the recovery comes - whether it's from lower, current, or higher levels - we want our clients to participate.  This "little" 30% rally is nothing compared to what stocks are likely to do in the next five years.  There are some very compelling reasons to own stocks:  the aforementioned massive stimulus programs, the unprecedented amount of sideline cash, the springboard power of a cyclical turnaround, and earnings growth estimates that have almost nowhere to go but up.  We have sat tight on our excess cash thus far, but it will do our clients little good if we can't use some of that cash to capitalize on rebounds from still oversold levels.  Our equity clients should expect to see some of that cash being put back into the markets this quarter, and unless we see a change in this recession's direction, we'll likely want to be back to near fully-invested levels before the end of the year.  In terms of names, expect to see us add to some of the names we've stuck with, especially those that have experienced the largest price declines (like perhaps GE, Apple, Cisco, ITT, or Google).  We will also be looking to get back into some names that we sold simply as part of our risk-reduction program of last fall like Nokia, Middleby, RLI, or Penn Gaming.  Finally, we'll also re-evaluate adding a cyclical name or two that might possess more attractive rebound potential like Target, Deere, Barclays, or Goldman Sachs.  Obviously, we mentioned more names than we have room to buy, but we offer them all to make our point, which is that we do think it's time to start buying stocks again, albeit at a slower and more reserved pace.
Building on Last Quarter's Letter
   We ended our previous letter by mentioning that we were in Act III of a five or six act play.  At this point, we're only comfortable saying we've moved to Act IV, and we reserve the right to honor an encore (which in this case is a negative).  We are definitely started to see some positive indicators, although this is not unexpected considering every single indicator we follow has been negative since last July.  We are incredibly curious about PPIP.  Will the logistics of the thing work; will the individual investor and investment community as a whole participate to the extent that is needed; and, assuming PPIP works as an investment program, will it be able to produce the desired effect in the credit markets and ultimately the economy?  We correctly called that real estate had a ways to go, that the consumer would remain mired in negative sentiment, and that China would show signs of turning.  About the only forecast we're comfortable with at this point is that we're beyond the trough.  This is not an insignificant point - in fact, this is critical.  Equity markets start moving up well ahead of the end of the recession, so if we're beyond the trough we're closer to the end than the beginning and investors need to start thinking about buying stocks again.
   However, don't forget that we are working through the worst financial crisis in over 80 years.  Recovery will not be quick, it won't be easy, and our estimation is that it won't be very strong.  Don't focus on getting back to even - focus on a plan that allows you to live comfortably while your portfolio regains momentum.  The long-term historical return of the stock market is right around 10%, but stock market investors have actually lost money over the trailing 10-year period - a once-in-a-generation occurrence.  We don't know what the average return will be for the coming ten years, but we have no reason to believe that it can't be in line with the long-term average.  We will, however, confess that our feeling is that the historical return in the coming 3-5 year period will be greater than the historical average, mainly because we will be coming off of extreme lows and we'll be dealing with some very lean companies that have proven their survivability.  We won't predict 15% or 20% returns, but we certainly accept the notion that these levels are possible.  Call us CRAZIE, but even though we're not too enamored by the prospects of the next six months, the next sixty months look pretty promising.

Thanks for your Confidence and Trust!