Most of the broad stock and fixed income market indices ended the second quarter in the red, despite signs of some improvement in the global credit markets. Investor angst was centered on rising energy prices and the threat these increases pose to economic growth.

The quarter did have its share of positive developments. Many of the financial institutions hardest hit by the credit crisis were successful in raising new capital and pruning their loan
portfolios. These actions should lay the foundation for a recovery in the financial sector and, eventually, stocks in general.

A number of high profile mergers were also announced. The buyers in these transactions tended to be other corporations, rather than financial firms, suggesting that strategic purchasers see good value at current price levels.

The actual returns of some of the more widely-followed indices are provided in the table to the right of this column.

Outlook & Portfolio Strategy

Investor angst over inflation is well founded. The Economist recently reported that two-thirds
of the world’s population is likely to experience double-digit inflation this year, largely due to the surging emerging market economies. The central banks now face the challenge of curbing
these inflationary pressures without impeding the recovery of the financial sector. Unfortunately, the market’s performance during the second quarter suggests that most investors have little confidence in this feat being accomplished.

It strikes us that this pessimism plays right into the hands of long-term investors, especially those whose portfolios were conservatively positioned prior to the onset of the credit crisis.
This is the situation most of our clients find themselves in. As a result, our portfolio activity is focused in the following areas:

Where appropriate, we continue to pursue a methodical, dollar-cost-averaging approach to new investments in stocks.

• For much of the past year, we have used money market funds as a substitute for bonds. This was because the yield curve – meaning the difference between the yields on shortterm and long-term bonds – was flat, thus offering little incentive to invest in longer-dated securities. Short-term securities also proved to be a safe harbor once the credit markets began to seize up. However, now that the yield curve has

taken on a more normal slope, we are gradually moving assets from money market funds to intermediate-term bond funds.

• Our real-return-oriented investments, which tend to own commodity-related securities, have been our standout performers. Our sense is that speculative interest in this asset class has created a short-term spike in prices, leading us to slow new allocations to these investments.
  

• Our final thought comes from the work of Dr. Atul Gawande, a general surgeon who has written extensively on performance in medicine. Each year, approximately 90,000 Americans die of an infection acquired while in the hospital. It turns out that the hardest part of coping with these contagions is getting doctors and nurses to wash their hands between patient visits.

We believe there are parallels to this situation – less grave – in other professions. One could argue that the contagions of the credit crisis were spread by experienced bankers neglecting the most basic lending practices. Our point is simply this: the mundane details of all human endeavors count. We remain mindful of this fact as we shepherd our clients’ assets through
these challenging economic times.

(c) Chess Financial

www.chessfinancial.com