Client Name Market Analysis / First Quarter 2009

Client Name

Market Analysis / First Quarter 2009

1Q09

2

Losses Continued in the First Quarter of 2009

• Concerns about the damage to the financial system, mounting job losses, and sharp declines in corporate earnings sent stocks to new lows by the second week in March

• Stocks have rallied since, but still finished the first quarter with double-digit losses (though a continued rally has brought them close to breakeven for the year by mid April)

• High-yield bonds had the best quarter of the asset classes we follow, while REITs had the worst

Market Analysis 1Q09

1Q09 Asset Class Returns Past performance may not be indicative of future returns.

3 Market Analysis 1Q09

Asset ClassAsset Class 1st Qtr. 1st Qtr. 20092009

12 12 MonthsMonths

5 Years 5 Years (Ann.)(Ann.)

Russell 1000 Value iShare (Domestic Large-Cap Value) -16.7% -42.3% -5.0%

Russell 1000 Growth iShare (Domestic Larger-Cap Growth)

-4.2% -34.3% -4.5%

Vanguard 500 Index (Domestic Larger-Cap Blend) -11.0% -38.1% -4.9%

Russell 2000 Value iShare (Domestic Smaller-Cap Value)

-19.6% -38.7% -5.4%

Russell 2000 Growth iShare (Domestic Smaller-Cap Growth)

-9.7% -36.2% -5.4%

Russell 2000 iShare (Domestic Smaller-Cap Blend) -14.9% -37.3% -5.2%

Vanguard Total Intl Stock Index (Foreign Stocks) -13.0% -46.6% -1.0%

Vanguard REIT Index (Real Estate Investment Trust) -32.1% -58.1% -8.8%

Merrill Lynch High Yield Master (High-Yield Bonds) 5.3% -19.9% -0.3%

Vanguard Total Bond Mrkt Index (Domestic Invest-Grade Bonds)

0.3% 3.2% 4.1%

Citigroup World Gov’t Bond (Global Invest-Grade Bonds)

-4.8% -3.8% 4.6%

Dow Jones-AIGCI (Commodity Futures) -6.3% -45.0% -3.2%

JP Morgan Emg Local Mrkt+ (Short-term Local Currency Emg Markets Bonds)

-3.9% -11.8% 6.8%

1Q09

4

A Rising Spiral of Debt and Wealth Is Now Inverted

• For decades, steady growth in debt has fueled spending and profit growth

• In recent years the trend was self-reinforcing as purchases with borrowed money drove up asset prices (such as homes) and profits, which supported even more borrowing

• But now the trend has reversed . . .• Falling asset prices and lower spending/profits is a self-

reinforcing “feedback loop” that is doing serious damage to the economy

• This kind of debt-deflation spiral can be difficult to break


1Q09

5

The Total Volume of Debt Has Grown Steadily


Total debt has grown from aprox. 1.4X GDP to 3.5X GDP

1Q09

6

We Think the Government Will Do Everything it Can to Prevent a Debt-Deflation Spiral from Taking Hold

• No one knows for sure how successful their efforts will be

• Efforts to date have been positives, but serious problems remain

• Longer term there will be a cost for the actions taken today

• Likelihood of a weaker dollar

• Higher interest rates

• Higher inflation

• Both the uncertainty and the real economic damage is taking a toll on any investment perceived as having risk


1Q09

7

Our Longer-Term Outlook for Equities

• We consider four broad scenarios in assessing equities as well as other asset classes

• Our scenarios look ahead five years, and are the basis for our investment decisions

• We don’t know what scenario will play out, but we believe it will involve components of one or more of the scenarios we analyze

• We can gauge potential returns based on earnings, dividends, and ending valuations in comparison to where we are today

• We can also assess possible worst case outcomes and the tradeoffs between risks and potential return


1Q09

8

Our Four Broad Scenarios

• Scenario 1: “Muddle Through”

• Economic recovery in late 2009/early 2010 but subpar recovery for several years. Inflation gradually rises.

• Scenario 2: “Stagflation”

• Economic recovery in late 2009/early 2010 but subpar recovery. Strong inflation (mid single digits) near the end of the five-year period.

• Scenario 3: “Severe Recession/Deflation” (Worst Case)

• Extended/deep recession and potential deflation through 2010, due to severe deleveraging and negative wealth effects. Recession does end but recovery is anemic.

• Scenario 4: “Goldilocks” (Best Case)

• Gov’t policies are effective and economy starts growing in the

latter half of ‘09. An average recovery with moderate inflation.


1Q09

9

Our Worst-Case Scenario, #3, Includes an Earnings Decline Nearly as Severe as the 1930s


• We assume a peak-to-trough earnings decline of 65% (close to that seen in the 1930s)

• We then assume earnings growth recovers more slowly than in past recoveries (usually steeper declines have sharper recoveries)

• We then assume valuations (P/E multiples) that are low relative to history

• These assumptions allow for a very poor earnings environment, a slow recovery, and a lingering risk aversion as a result of the difficult deleveraging period we are going through

• Stocks would be roughly flat over the next five years in this scenario (from current levels) but significant losses from current levels are unlikely.

1Q09

10Market Analysis 1Q09

Quarterly S&P Earnings During the Great Depression and Now

T for Great Depression = Dec 1929T for "now" = Jun 2007Note: Litman/Gregory estimates and adjustments used after September 2008

1Q09 Investors Typically Become More Risk-Averse

After Major Bear Markets

Market Analysis 1Q09 11

Lower P/E multiples following bad bear markets reflect periods of risk aversion (remember that because each point reflects the trailing five years there is a lag relative to the dates shown).

Rolling Five-Year P/E Ratios

1Q09

Our Optimistic Scenario, #4, Assumes Earnings Climb Back to Their Long-Term Trend Over the Next Five Years

• Prior to the financial crisis that took hold last year, this was our baseline scenario

• But, we now believe this is less likely than other scenarios we consider

• Returns in this scenario would be strongly positive over the next five years

• This is the reason we are not more underweighted to equities right now

• Our other two scenarios fall between the optimistic and pessimistic scenarios


1Q09

Equity Return Ranges Under Each Scenario


S&P 500 at 843 on 4/23/09

1Q09

14

Extending Our Time Horizon Leads to Return Assumptions that Are Closer to Our Optimistic Scenario

• Without the spending tailwind of debt growth, the economy will likely reset at a lower level in the years ahead

• Even so, there will be a recovery in earnings at some point

• Over a five- to 10-year horizon, earnings are more likely to revert to their (lowered) long-term trend lines or averages

• This would result in good equity returns over that span• But the path is likely to be bumpy with possibly big dips

along the way


1Q09 Active Managers May Have an Advantage in

this Highly Disrupted Environment

• Our overall equity return expectations are not exciting from current levels

• But some of the active managers we use report finding “once-in-a-generation” opportunities

• They don’t know exactly when the market will reflect what they believe are the true underlying values of their companies but are highly confident that over the next several years they can earn very good returns

• We have already seen sharply improved performance from some of our active managers over recent months

• Longleaf Partners and Oakmark Select are examples

• Bond managers also have a unique opportunity to add value in this environment


1Q09 Quarterly Performance of High-Yield vs. Equities

Since 2007 Market Peak


1Q09 We Are Considering the Longer-Term Impact of

Governmental Actions

• We continue to believe deflation is the primary concern in the near term, but we are also taking a hedge position in selective securities given our longer-term concerns about inflation and the dollar• TIPS (Treasury Inflation Protected Securities) - which

provide insurance against inflation• Gold – through an ETF (Electronically Traded Fund) or

within the Permanent Portfolio• Global bonds – our preferred holding is Templeton Global

Bond • Commodity Futures – through PIMCO Commodity Real

Return or natural resources stocks through the Permanent Portfolio


1Q09

Shorter-Term Risk Remains

• The sharp rise in stock prices in the second half of March and first part of April have investors feeling good for now

• But rallies of this and even larger magnitude commonly occur within bear markets

• Remember that the rally in late November and December had investors feeling better, but it was followed by painful new lows

• We aren’t predicting another steep decline, but investors need to consider the possibility and more importantly how they would react

• We can help you gauge possible portfolio losses in the event of another big downturn in stocks to help you determine what level of risk you can handle


1Q09 Short-Term Losses Are Painful but Also Create

Longer-Term Opportunities

• Markets often overshoot what rational analysis suggests is fair value - this happens on both the upside and the downside

• Buying an undervalued investment is difficult because losses will likely continue in the near term

• Investing exactly at the bottom is not possible

• Therefore investors must be willing to accept near term (temporary) losses as a requirement to taking advantage of compelling longer-term opportunities

• It is easier said than done

• As valuations change, we expect to adjust our portfolios to reduce risk if an asset becomes overvalued

• We will also take action if an asset is compellingly cheap


1Q09

We Are Taking Nothing for Granted

• There is a great deal of uncertainty and this is a challenging investment environment

• We have worked very hard to gain all the information possible to assess the return environment and risks in the years ahead

• We are challenging our own assumptions and seeking out contrary views to make sure we are considering all possibilities – both at the macro and asset class level

• The investment approach we employ will, as always, seek to capitalize on mis-valued assets and take a long investment view

• Though it will be a tough road, we are confident that ultimately the economy will emerge from this difficult period and grow again

• And we are confident we can add value beyond what the markets give us, especially in this often dysfunctional market environment


Documents

Client Name Market Analysis / First Quarter 2009