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Market Commentary - December 31, 2009

Posted by: STEVE ARNETT

Posted on: January 11, 2010

"What if Bill Gates had been technology challenged....?"

In spite of his unparalleled success, there were moments when you might have questioned if Bill Gates understood the technology he pioneered. For example, in 1981 when talking about computer storage capacity, he said, "640K ought to be enough for anybody." His 1993 comment was even more remarkable, when he said, "The internet? We are not interested in it." During this same period, Gordon Moore, co-founder of Intel observed the number of transistors on a chip doubled every 24 months, which effectively doubled performance every 18 months. There are many people, including Moore, who think this law can't continue to grow exponentially. It might be good to remember that Thomas J. Watson, Chairman of the Board of IBM, was quoted as saying in 1948, "I think there is a world market for about five computers."

It is interesting to put advancing technology into perspective. According to the Bureau of Labor Statistics, the consumer price index for personal computers and peripheral equipment has decreased an astounding 90.5% in the last 10 years. In 1999, an iMac computer cost $1,499. By 2009, its price declined to $999 yet it had 60 times more memory and 50 times the storage capacity. Technology has been a very important catalyst to a rapidly growing and evolving financial market. The innovation in the spectrum of products and services would not have been possible if not for technology. It has raised the standard of living to previously unthought-of heights.

In the "old" days of the 60's, 70's and 80's, home mortgages were pooled and sold to investors as government backed bonds. Then in the 80's, they added a little sizzle by breaking mortgage pools into tranches based on the pay-down speed of the underlying mortgages. This allowed investors who wanted to own short-term bonds to be allocated to the pools that were paying down the fastest and those who wanted longer maturities to be allocated to the pools paying down more slowly.

During the 90's and the early part of this decade, the process of getting a mortgage was time consuming and tedious. Consequently, it took longer to build mortgage pools to sell to investors. As interest rates fell, particularly after 2002, the demand for mortgages took off. Technology came to the rescue. It facilitated faster mortgage processing and with the help of less stringent underwriting requirements, the result was a much faster pooling of mortgages.

Even more sizzle was added with the different types of mortgages. There were mortgages for every borrower with FICO scores from 500 - 850. These mortgages were then pooled and divided up into tranches based on maturity and credit quality; insurance was purchased to get a AAA rating and then they were sold to investors as safe as government bonds. What used to take months could be done in a matter of weeks. Wall Street is populated with mathematicians, physicists and programmers with IQ's that double or triple our own. With the combination of technology and intellectual power, you can be very innovative in designing complex derivatives. Well, Wall Street came up with a doozy called a Credit Default Swap (CDS). These were derivatives sold by large brokers and insurance companies in case the above mentioned pooled mortgages went into default. These investments were not regulated so they didn't fall under the oversight of the Fed or the SEC. As a result, though they had the characteristics of insurance, they weren't required to reserve for losses and they didn't require an investor to own the underlying mortgages that they intended to cover by buying the CDS. It is like each of your friends buying insurance on your house and collecting if it burns down. We are talking about trillions and trillions of CDS' that were sold. Unfortunately, even with all the technology and PhDs, they didn't understand what they had created, but managed it as though they did. This left some of the titans of Wall Street in bankruptcy like Lehman Brothers, Bear Stearns and AIG. Had Microsoft or Intel experienced periodic spells of being "technology challenged" perhaps the technology would have obeyed the highway speed then the financial crisis could have been mitigated.

The next wave of technology that is being run at full speed on Wall Street is called High Frequency Trading (HFT). This is where you have extremely powerful and fast computers that take advantage of small stock price discrepancies by trading in a fraction of a millisecond. It is estimated that in 2008, there was between $8 and $20 billion in profits using this technology. It accounts for over 60% of all US stock trades. The speed is so important that some firms have purposefully placed themselves close to stock exchanges to cut down on the distance data must travel. Proponents of HFT argue that it brings efficiency to the market by making the stocks trade more efficiently and as a result has a lower cost to investors. Others argue you are living dangerously whenever computers make the decision. During the 1987 crash, many believed that it was precipitated by similar types of computer trading. Could this type of trading be the catalyst to the next crisis? The faster you run, the more it will hurt when you fall. Just hope there are well thought out safeguards to prevent any permanent injury.

The year 2009 turned out to be a great one for investment performance. Our Stock & Aggressive Stock Portfolios ended the year with returns of 36.51% and 40.46%, respectively versus the S&P 500 which was up 26.46%. The road to a great year started out very rocky. Our Stock Portfolio was down over <21%> at the market bottom occurring in early March. Since that time, it has risen by over 72%. Our Stock and Aggressive Stock Portfolios both ended the decade in positive territory with average annual returns of .11% and 2.34%, respectively as compared to the S&P 500, which ended the decade in the red with an average annual return of <.95%>.

Following are some interesting observations from Bespoke Investment Group. If we take the top 50 performing stocks of the S&P 500 for 2008, we find they had an average return of 9% in 2009. On the other hand, if we take the 50 worst performing stocks of the S&P 500 for 2008, we find that they were up 100.97% in 2009. From a perspective of market cap in 2009, the 50 largest stocks had an average return of 22.21% as compared to the 50 smallest stocks which averaged 113.12%. In 2008, when performance was based on international revenues, the 50 largest companies based on international revenues were down <47.89%> as compared to the 50 smallest companies based on international revenue being down <34.65%>. In 2008 the dollar was strong. In 2009, the opposite was true; we were faced with a weak dollar. During this time, the largest and smallest companies based on international revenue had returns of 71.15% and 27.58%, respectively. What can we expect in 2010? Wall Street strategists project the S&P 500 return of 8.9%, with the lowest estimate showing a decline of <.57%> and the most optimistic 17.63%.

Peter Lynch's performance when he managed the Magellan Fund was outstanding but he said that most of the fund holders actually lost money. How can that be? Investors chasing performance. They bought in after the fund had great performance and got out when it didn't maintain the same performance. Essentially, bought high and sold low. We have an example with one of our investment managers, CRM, who manages our mid-cap value fund. For the 10-year period ending 12/31/09, a fund managed identically to our CRM mid-cap value fund, had an average return of 12.36%, but the investor average return was only 1.99%. A $10,000 investment after 10 years would have grown to $32,071 and $12,178, respectively. This highlights an important value that The Trust Company adds for our clients:discipline. We have a diversified portfolio and a reallocation process that keeps our clients invested for the long term in their appropriate risk allocation. Our clients are less likely to miss out on returns because we do not try to time the market.

Year-to-date through December 31, 2009, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE, and Barclays U.S. Aggregate Bond indexes were 26.45%, 45.40%, 27.17%, 31.78%, and 5.93%, respectively. For the same period, our Stock, Aggressive Stock, Balanced and Fixed portfolio returns were 36.51%, 40.46%, 24.39% and 12.15%, respectively.