3rd Quarter 2009 Review

From the Desk of Ron Rowland

As I write this letter, the condition of the global economy is still an open question, the U.S. Dollar is plunging in value, and the stock market is trending higher. The rally from the March lows has been one of the best periods in history. How long can it continue?

In one sense, this question may seem irrelevant for technically-oriented methods like ours. Our buy and sell decisions are not fixated on fundamental information. At the same time, we do not completely ignore the environment in which we must operate. In late 2008 and earlier this year, when the financial system seemed like it might be on the brink of collapse, many investors decided to err on the side of caution. As it turned out, the better course would have been to throw caution to the wind. Was caution a bad idea? No, not at all. As I like to say, "just because risk did not materialize, does not imply that it never existed."

As investment managers we have a professional responsibility to make sure that the strategy we implement for you matches your goals and your risk tolerance. Markets can change frequently, but your objectives should be fairly stable. Major life events – career changes, marriage, retirement, etc. – are all good reasons to re-evaluate. Make wise choices at those times and there is usually no reason to change your strategy afterward.

If you intend to retire in, say, 2025, the fact that your account went up, down, or sideways in 2009 is not particularly important. The fact that other people made more than you did – or less than you did – isn’t important, either. What counts is whether you are on course to meet your long-term goals, whatever they may be.

Investors often tend to overestimate both their risk tolerance and their profit expectations. They forget risk is typically proportional to reward. If you want to participate in every bull market, you must also accept that you will be a part of the inevitable bear markets, too. If you want to avoid bear markets, you will necessarily miss some of the bullish moves.

What we try to do at CCAM is find a middle ground between being always exposed to the markets and always in cash. As you well know, this is not a perfect science. That's why we have programs for various risk levels. You should be in a strategy that fits your personal situation. If you are, staying the course is usually the best decision.

The Quarter in Review

In some ways, 2009 is turning out to be an even crazier year than 2008. Stock market benchmarks reversed sharply about two months into the year, and they could easily do so again before we flip the calendars to 2010.

The SPDR Trust ETF (SPY), which follows the S&P 500 index, was up +19.2% year-to-date as of the end of September and gained +15.5% in the third quarter alone. We like to refer to the Sector SPDR ETFs to get an overview of sector trends, since they break down the S&P 500 into nine industries with no overlap. Here are results for the third quarter, in descending order from best to worst.

The leading sectors in the third quarter were Financials, Industrials and Materials. Not by coincidence, these also happen to be three of the worst sectors in the trailing one-year period. Some analysts argue the 2009 summer rally was really nothing more than the greatest bear market bounce in history. Time will tell, but we find it interesting to compare five-year sector performance with the third quarter of 2009.

ETF Name SPDR Energy (XLE) SPDR Utilities (XLU) SPDR Consumer Staples (XLP) SPDR Materials (XLB) SPDR Technology (XLK) SPDR Health Care (XLV) SPDR Industrials (XLI) SPDR Consumer Discretionary (XLY) SPDR Financials (XLF)

5-Year Return as of 9/30/09 (annualized) 10.5% 6.7% 5.6% 4.8% 3.1% 1.6% 0.6% -1.3% -9.7%

Notice that both Financials and Industrials were among the worst sectors on a five-year basis. What does this mean? For one thing, short-term performance does not necessarily tell you anything about the long-term. Likewise, long-term results can be quite different from any short period contained within. We are not convinced that the sectors showing impressive recent gains will continue to do so.

Another important point about the quarter was the decline in the U.S. Dollar against other currencies. Once again a look at ETFs helps reveal the trends. Here are the third quarter results for the CurrencyShares ETFs.

ETF Name CurrencyShares Swedish Krona (FXS) CurrencyShares Australian Dollar (FXA) CurrencyShares Canadian Dollar (FXC) CurrencyShares Japanese Yen (FXY) CurrencyShares Russian Ruble (XRU) CurrencyShares Swiss Franc (FXF) CurrencyShares Euro (FXE) CurrencyShares Mexican Peso (FXM) CurrencyShares British Pound (FXB)

3Q 2009 (annualized) 10.4% 10.0% 8.5% 7.2% 5.0% 4.8% 4.2% -1.8% -3.0%

When one of these funds goes up, it means that the value of the U.S. dollar in terms of that currency goes down. As you can see, almost all the major currencies outpaced the greenback last quarter by significant amounts. In one sense this is good news because it makes U.S. exports more competitive in the world market. The underlying implications are not good, however. Our huge and growing government deficit, caused by a combination of higher spending and lower tax revenues, is making it harder for the economy to recover.