For this month’s Report, I would like to focus on three meetings, two that took place in early May, and one that has yet to take place. They are very different in character, but each in its own way has important implications for how we manage your investment portfolio.

The Federal Reserve Open Market Committee
The importance of the Federal Reserve’s actions on your investment portfolio is obvious – the level and direction of interest rates affects both stocks and bonds alike -- and each meeting of the FOMC is widely anticipated and widely dissected afterwards. This includes a nearly word-by-word parsing of the official communiqué at meetings end.

At the end of their May meeting, the Fed, as expected, raised short-term interest rates for the eighth consecutive time, bringing the Federal Funds rate to 3% -- the highest this short-term interest rate has been since the fall of 2001.

Some highlights from the communiqué:

• Even after eight rate hikes, for a cumulative increase of 200 basis points (2%) from their lows of last June, the Federal Reserve stated that short-term rates still remain “accommodative”; that is, stimulative (rather than restrictive) for the economy.

• The Fed acknowledged that higher energy prices are starting to slow spending growth, though they also reiterated that labor market conditions continue to improve gradually. (For those of you into a word-by-word analysis, this time they added the word “apparently” to the statement about labor market improvement.)

• They retained the statement that with proper monetary policy action, the risks to economic growth and inflation should remain balanced. However, it is apparent that they are more concerned about inflation than the recent moderation in growth and that “proper” monetary policy action in that case means more rate hikes to come.

• They also retained the language that further increases in interest rates are likely to remain at a “measured” pace -- which has so far meant 25 basis points (1/4%) at each meeting.

What does it all mean? While the news that still higher interest rates are in the cards would seem to be a clear negative, it’s actually not quite that simple. While, all else being equal, rising short term rates are indeed a negative, it does not take into account many other aspects of the interest rate picture. The overall interest rate environment for investors is much more complex than just the Fed funds rate.

When we add it all up, our view of the interest rate environment is a mixed bag, albeit one with a more positive than negative tilt for the financial markets. The key elements in our reasoning are as follows:

• Earlier, I mentioned the importance of the level of interest rates as well as their direction, and while (short rates) are rising, the absolute level of interest rates across the spectrum is still historically quite low – which in turn supports economic activity and financial market valuations.

• Adjusted for inflation, (real) interest rates are low, which is also stimulative for the economy.

• While short-term interest rates are trending higher, longer-term rates are actually lower than they were before the Fed began to tighten short rates!

• While lower long-term rates are positive, the fact that the difference between short-term rates and long-term rates, called the yield curve, is getting flatter (tighter) isn’t a positive. One reason is that tighter yield spreads between short and long maturity interest rates often suppresses lending activity, which in turn curtails business activity and spending.

• Speaking of falling longer-term rates, the rates (yields) on lower-quality corporate bonds have come down much more that the rates on high-quality government bonds making the so-called “credit spread” very tight. On a relative basis, this makes government bonds more attractive.

We recognize that the levels and trends of each of these markets can change quickly. (Just a few weeks ago, the worry was that the Fed might drop the “measured” language as a precursor to hiking rates by 50 basis points (1/2%) at their next meeting. But with the economy suddenly slowing, thoughts turned to whether they might skip an increase at their next meeting!) We will be on the watch for any changes and will adapt accordingly.

Berkshire Hathaway’s Annual Shareholders Meeting
Over the first week-end of May I had the pleasure of attending the Berkshire Hathaway Annual Shareholder Meeting in Omaha, Nebraska. Perhaps it should really be called “Warren Buffett Day.” Much like Punxsutawney Pennsylvania’s famous groundhog, “Punxsutawney Phil,” is scrutinized each Groundhog Day to see if winter is over, many in the audience come to see what the “Sage of Omaha” thinks the “weather” will be like for investors.

Buffett was, as usual, quite frank about a number of investment issues and I will highlight some of the more important ones.

• On his expectations for the stock market going forward …
  
  “ If people have the choice of owning just bonds yielding 4.5% or owning equities for the next 20 years, they should own equities. But if people think they can earn double-digit annual returns, they are kidding themselves. Stocks should generate average annual returns of 6%-7%.”

  We agree that expectations should be reduced from long-term averages of 11-12%. That said, by looking at a broader investment universe than just domestic stocks and bonds (including unconventional asset classes); identifying superior money manager; dynamically adjusting asset allocation to take advantage of relative valuation imbalances; and caring about mutual fund costs – including transaction and tax costs we believe we can add value above what the market offers.

• On what he and his partner Charlie Munger want to see in a manager …
  
  The most important quality they look for is a passion for their work. Integrity, intelligence, and energy were also cited as critical attributes.

  At Kobren Insight, a key part of our research model is talking directly to the managers of funds before (and after) we buy them for your portfolio to assess these very same attributes.

• On what it takes to be a successful money manager …
  
  “ You need an IQ of 125, tops—anything more than that is wasted. But you do need a certain temperament, and must be able to think for yourself. Then constantly look for opportunities. You can learn every day. You can’t act every day, but you can learn every day. It’s like any game, if you enjoy playing it, you’ll do well.”

  At Kobren Insight Management, we love what we do and we constantly challenge one another to examine our views.

• On the housing market …
  
  “ The current state of the housing market brings to mind what happened 25 years ago in farmland in Nebraska…Land was selling at $2,000 an acre, that could be bought a few years later at $600 per acre from the FDIC…The thinking during the farmland boom was that cash was trash. Inflation was high. A lot of banks, some of which had survived the depression, failed… People go crazy in economics periodically… Residential housing is a bit different from farmland, of course. People live in houses, so that the investment isn’t purely economic. But I’m not sure why prices should be expected to rise faster than construction costs over a long period.”

  Just a sobering thought given the temptation many currently feel to be investing more in real estate.
  
  In a similar vein…

• On why he has no exposure at all to REITs (real estate investment trusts) …
  
  “…right now many properties have bubble-type valuations. All my rich friends have been selling their worst properties at high prices. When NASDAQ hit a high, REITs were cheap. They were selling at discounts to the value of their properties. Now REITs are unattractive. Property valuations are high, and REITs themselves trade at premiums to them. Plus, REITs have phony accounting.”

  Needless to say, Kobren Insight Management is also negative on REITs at present.

The Most Important Meeting Of All
The last meeting I would like to talk about won’t get any press like the others, but it is arguably the most important -- a meeting with your KIM Account Manager. Whether in person or on the phone, periodically talking with your Account Manager to discuss any changes in your personal financial situation or objectives, as well as simply to get a better understanding of the people, philosophy and process behind your portfolio is a vital part of successful relationship between you and KIM. If you haven’t spoken with your Account Manager recently, then by all means feel free to pick up the phone and arrange a time to review your portfolio.

Sincerely,

Rusty Vanneman