2008 1st Quarter Letter

The downshift in the economy during the fourth quarter of 2007 and the first quarter of this year was a direct result of slowing in the housing sector. Similar to the bursting of the technology bubble in 2000, money and investors tend to “pile in” at the end of a successful trend, only to get burned when the tide turns. Easy mortgage financing for even the most marginal home buyers kept the builders and the U.S. economy humming, until the excesses, as they usually do, ended up on the balance sheets of the bankers and reflected in the prices of stocks.

I feel certain that we will look back on this period, beginning during late last summer, as pivotal to investors. The Federal Reserve, led by Ben Bernanke, orchestrated a herculean effort to keep a full blown credit crunch from pulling the U.S. economy into a recession and taking several venerable financial institutions with it. The acts of aggressively pushing the Fed Funds target rate from 5.25% down to 2% over an eight month period and also providing massive liquidity to the bankers so that their operations would continue, appear to have saved the day.

Just to make sure, a fiscal stimulus package was passed that would provide checks to consumers and highly attractive depreciation schedules to businesses to encourage spending by both.

The correction in the broad stock market and particularly its vengeance on the financial sector was quite rational considering the risk of recession and the amount of leverage in the U.S. financial system. So perilous was the environment that even money market and bond investments, generally the most conservative asset classes, had to be put under the microscope.

In our opinion, the smoke is clearing and a recession has been averted as a direct result of the Fed’s actions. Our strategy has been to remain as diversified and defensive as possible, but to underweight or avoid consumer discretionary stocks, like retailers, restaurants, etc., and emphasize staples, those very large companies with international sales that continued to have global demand for “necessities”. These are names like Wrigley, Procter and Gamble, Pepsico, Colgate-Palmolive, CVS Caremark, Kimberly Clark, Safeway and Sysco.

Even the healthcare stocks fall into this category as defensive plays that benefit from a falling dollar – stocks like Abbott Laboratories, Alcon, Becton Dickinson, Gilead Sciences, Wyeth, Bristol-Myers Squibb, Johnson and Johnson, and Novartis.

One most significant and contrary strategy was buying a gold exchange traded fund (GLD) late last summer as we saw a credit crunch unfolding and then opportunistically purchasing financial stocks as their prices corrected. This was a meaningful strategy for us as we had kept our exposure to financial stocks well under the market averages since 2001. We are of the opinion that the headlines will remain very negative for the months to come regarding the investment banks. Bear Stearns may not be the only casualty of too much subprime exposure and huge levels of hedge fund leverage in their business models. By January, we felt that the market was troughing and that the low interest rates and liquidity provided by the Fed were reducing the high risk that existed last summer to economic stability. We therefore chose to exit the gold position at that time.

Why has this period been pivotal to investors? There are many reasons, but we think the most important is a shift to more industrial companies, which are generally direct beneficiaries of a weak U.S. dollar versus the Japanese yen and the euro. U.S. exporting companies will likely benefit and enjoy a tailwind for a period of years. Also, many U.S. companies that manufacture abroad are now assessing the economics of bringing some operations home in this low dollar environment.

The U.S. economy has traditionally been driven in large part by consumer spending. However, given that home values will no longer support inflated consumer balance sheets, U.S. consumers may alter their spending habits as saving is moved to the top of their "to do" list. An environment of slow U.S. economic growth and low interest rates is a favorable one for investing in stocks. The biggest issue for stocks is their price volatility. We try to mitigate that volatility as much as we can with our diversification guidelines across style, sector, and capitalization, as well as our domestic and international exposure. Historically, the result has been lower downside volatility in negative markets as shown by the composite performance of the accounts we manage. This is shown on the enclosure entitled “STMM Market Capture Ratios.”

The wildcard in this scenario is oil and gasoline prices. We hope that current upward pressure on the commodity is the typical seasonality associated with the summer driving season. We are optimistic that by mid to late summer, the price of crude will settle below $100 per barrel offering a little relief to consumers. In the meantime, we will remain defensive and diversified in our positioning.

We maintain that quite a bit of headline risk still remains, but that stock prices have already discounted a mild recession and started their recovery. In an environment of very low interest rates, stocks are a compelling asset class alternative to money markets and bonds.

If you are interested in additional information on the 1st quarter, please view the replay of our 1st Quarter Webcast at www.stmmltd.com/webcast (type this link into your web browser and follow the instructions from there). We hope you can make our next quarterly webcast on Tuesday, June 24. Look for an invitation by email in mid-June. As always, please contact our office if you have any questions or concerns regarding the replay of the webcast or upcoming invitation. Thank you for being our client.

Sincerely,

Jeanie Wyatt, CFA
CEO and Chief Investment Officer

This letter is not intended to constitute investment advice. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this letter were or will be profitable. Securities identified in this letter do not represent all of the securities purchased, sold or recommended for advisory clients. You should not assume that any securities recommendations made in the future will be profitable. A complete list of all equity recommendations made by STMM during the past year is available upon request. Information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed.