CLARK & STUART, INC.

Investment Counsel

“In May 1937 the economic recovery building since 1933 had crested, well short of 1929 levels of employment. … By the winter of 1937-38, more than two million workers had received layoff notices. … In the ninth year of the Great Depression and the sixth year of Roosevelt’s New Deal, with more than ten million workers still unemployed, America had still not found a formula for economic recovery.”

Freedom From Fear, David M. Kennedy

In our last report (July 4, 2009) we discussed our view that the U.S. economy, and corporate profits, may surprise on the upside in the short term. The strong recovery in stock prices indicates that many investors now share this expectation. In the third quarter the Standard & Poors 500 Index provided a total return of 15.6%. From its low on March 9 the Index has risen more than 55%.

We have also cautioned that some of the forces now boosting the economy will begin to fade over the next several months and the powerful headwind of deleveraging, by consumers and financial institutions, will limit the pace of economic growth over the next few years. Nothing has changed to alter this conclusion. Indeed, we believe the “V-shaped” recovery now assumed by many investors is an illusion.

Many economists believe that every sharp contraction is followed by an equally quick recovery. However, unlike every other post World War II downturn this recession has been driven by a severe contraction in the supply and demand for credit following a protracted period in which personal consumption and fixed investment (residential and commercial) were inflated by ever-increasing debt. Today, beneath the headlines which suggests an improving economy, incomes are under pressure and consumers continue to reduce their debts, increase savings, and restrain their purchases. Financial institutions continue to tighten lending standards and restrict the availability of new credit.

Gross Domestic Product (GDP) decreased at an annual rate of just 0.7% in the second quarter; much better than the 6.4% collapse in the first quarter. Importantly, the only positive contributions to second quarter GDP came from increases in federal, state and local government spending -- helping to stabilize (though not necessarily stimulate) the economy by offsetting much of the decline in consumer and business spending and investment. Later this month the Commerce Department will report the initial estimate of GDP for the third quarter. That report will show another strong sequential improvement with economic growth of 4% or more. However, third quarter GDP has been driven mostly by temporary factors: (1) a slower pace of inventory reductions; (2) another sequential increase in government spending from the $787 billion stimulus program; (3) the tax credit for first time home buyers; and (4) the ‘cash for clunkers’ program. The ‘clunkers’ program may actually have a negative longer term impact on the economy because consumers with a new monthly car payment will have less cash available for other discretionary purchases. Encouraging consumers to take on more debt, when they already have too much debt, demonstrates the folly of programs crafted by politicians who often seek to impose a simple solution on a complicated economic issue.

The lessons of history are clear – an economic recovery built on a foundation of government rescue and stimulus programs is fragile and vulnerable to errors by policy makers. The experience of the late 1930’s is particularly instructive. As David Kennedy points out, “the government had committed several economic crimes in late 1936 and early 1937. First the Federal Reserve, inexplicably worried about inflation even in the midst of high unemployment, contracted the money supply … Then came a sharp reversal in the federal government’s fiscal policy.”

Throughout the financial panic last year Federal Reserve Chairman Ben Bernanke relied on lessons from policy mistakes in the 1930’s. We believe the FED will continue to be guided by those lessons and will err on the side of exiting easy-money policies too slowly rather than too quickly. Therefore, we believe the economy will successfully transition from recovery to self-sustaining expansion. Still, the transition may not be smooth and the expansion is likely to be weak by historical standards. Consequently, the widespread optimism currently reflected in stock prices may yet give way to fears of a double-dip recession -- triggering a correction in share prices which looks to be overdue.

In recent months we have reduced your holdings of some issues that have appreciated significantly; increasing your cash reserves even though the return on money market funds is currently very low. Your cash reserves will allow us to take advantage of buying opportunities. In the meantime, our continuing emphasis on companies with enduring business franchises, long lasting competitive advantages, and consistent profit and dividend growth still seems ideally suited for the challenging economic environment which lies ahead.

Charles ‘Rocky’ Clark, CFP and Michael Stuart, CFA

September 30, 2009 : S&P 500: 1057