In the third quarter, the US stock market as represented by the S&P500 stock index gained 15%, closing at 1057 on September 30th from 919 at the end of June. Stocks were driven by several factors, from a belief that the economy was recovering more quickly than many had previously thought, to the fact that cash now offers a negative real return, compelling many to go in the market and speculate. Yields on long-term Treasuries fell (prices rose) for the quarter, with the yield on the benchmark ten-year Treasury note falling to 3.31% from 3.52% at the end of June. The price of gold rose 9% from $927 per ounce to $1,009.

As mentioned above, both fundamental and technical factors were involved in pushing asset prices higher. Fundamentally, the recovery in the economy has surprised many in its strength. This has been a result of both the extraordinary fiscal, monetary, and financial measures undertaken by the government, and the extent to which panic production freezes by companies in the fourth and first quarters of 2008/2009 had to be reversed in order to rebuild severely depleted inventories. Economic strength gives investors confidence, which facilitates the purchase of stocks.

Just as significantly, however, has been the debasement of cash by the Federal Reserve with its zero percent overnight interest rate policy. Given the prospects for future inflation and the open ended nature of the policy, cash has come to be seen by many as a guaranteed loser. This has compelled such investors to move into financial markets in search of returns. This buying, in conjunction with the strengthening of the economy, lures more buyers in, sending asset prices even higher. Ultimately, those investors with outsized cash positions feel the squeeze of underperformance, and capitulate by buying assets without regard to any actual fundamentals.

We believe that this technical effect can be seen by the simultaneous rally in stocks, bonds, and gold. One would think that if the economy were revving up, as the stock market implies, or that inflation is a serious threat, as does gold, Treasuries would retreat from already elevated prices in anticipation of higher future interest rates. The fact that all three markets rallied together argues that the fundamental story was superseded by the need to hold anything other than cash. As is often case, such technical factors influence markets as much as any fundamental considerations. For many, fundamentals are the rationalizations for buy and sell decisions, while the technicals, the buying and selling of others, are the actual motivation. This should never be ignored.

Looking forward, we are cautious on the stock market as a whole. It has had a tremendous move off its March lows (56%), and much of the buying has been driven by technical, momentum based action as described above. While the recession has almost certainly ended in the third quarter, the economy is still undeniably weak, with high unemployment and a fragile real estate market. To add to this, the indebtedness of the nation is at a record level, and it is difficult to see how long-term growth can be robust with this being the case. In the future, Americans must save more and spend less. America must produce more of what it consumes and export more overseas. This is a serious challenge for the country. As a hedge against a botched or disorderly transition, where the nation seeks to get out from under its immense debts primarily by printing money, we remain committed to gold as a core holding. As important as the technicals may be month to month, or even year to year, in the long-run, the fundamentals have the last say.

For the remainder of the year, we see the S&P500 trading in a range from 950 to 1150. In spite of our cautious outlook, we have confidence in our portfolio companies. They have a proven ability to weather economic cycles and consistently deliver cash to shareholders. Although they do not operate in isolation, and would certainly not benefit from a difficult market and economic environment, we are confident they will provide both superior relative returns and positive absolute returns over the long-term.