CLARK & STUART, INC.

Investment Counsel

“I couldn’t forgive him or like him but I saw that what he had done was, to him, entirely justified. It was all very careless and confused. They were careless people, Tom and Daisy – they smashed up things and creatures and then retreated back into their money or their vast carelessness or whatever it was that kept them together, and let other people clean up the mess they had made.”

The Great Gatsby, F. Scott Fitzgerald

For much of the past year the financial markets were gripped with fear that the current recession would rival the Great Depression. These fears were not totally unjustified. Gross Domestic Product (GDP) had contracted 6.3% in the fourth quarter of 2008 and 5.5% in the first three months of this year. Over the past few months debate has shifted from the severity of the recession to the shape of the recovery. Many economists now anticipate a decline in GDP of only 1-2% in the second quarter and a resumption of growth in the second half. Sometime in the next year the National Bureau of Economic Research, the non-government committee of economists which dates every business cycle, is likely to conclude that this recession ended in the second or third quarter. The worst of this recession is behind us and a sustainable economic recovery will soon take hold.

As you know, we have maintained an optimistic-but-sober point of view; strongly disagreeing with analogies to the Depression. The American economy is very different today than in the early 1930’s. Government programs and policies which help to stabilize the economy (e.g. Social Security, bank deposit insurance, unemployment benefits) did not exist at that time. Indeed, they were born in the Depression. More important, key policy-makers, particularly Federal Reserve Chairman Ben Bernanke, have deliberately avoided the mistakes made by monetary authorities 80 years ago. Nevertheless, there are important similarities between then and now.

The Great Gatsby was published in 1925; long before the stock market crash of 1929 and the Depression which followed. Fitzgerald did not predict these events, but he did see and expose the reckless behavior of the 1920’s which eventually lead to catastrophe. Not surprisingly, Americans did not appreciate Fitzgerald’s criticism of their values and their conduct. The first printing of less than 21,000 copies sold slowly. A second printing of 3,000 later in the year did not sell out. In fact, a small number of copies from the second printing were still unsold when Fitzgerald died in December 1940 at the age of 44.

Today, of course, The Great Gatsby occupies a hallowed place in American literature. Unfortunately, the generations of students for whom it has been required reading failed to heed its lessons. Once again, at the start of a new century, millions of Americans engaged in an orgy of financial speculation and immediate self-gratification -- financed mostly with borrowed money and with little or no regard for risk. “It was all very careless and confused.” The Great Depression and the Great Recession are similar in their origins and, perhaps, in their consequences.

In 2008 as in 1932, Americans went to the polls and chose a President who promises to “clean up the mess they had made.” Now as then, a powerful backlash has erupted against those who should have known better; especially the leaders of the financial industry, whose actions, to them, were “entirely justified,” and also against the economic ideology with which they are often identified. To the delight of many, and the anger of many others, the Federal government has injected itself into the affairs of private industry on a scale not seen since the 1930’s.

One of the biggest mistakes investors can make is to allow their personal political views to dictate their investment decisions. Agreement or disagreement with the policies and programs of the party in power is not, by itself, a reason to invest or to refrain from investing. We believe that in every age, every political and economic environment, there are companies whose enduring franchises and competitive advantages will continue to produce an infinite stream of profits and dividends for shareholders. Still, when the political winds have shifted it is critical to identify some of the potential risks for the economy.

• Cleaning up the mess will be costly. The increase in government spending and debt suggests that the burden of taxation will surely increase for individuals and for corporations.

• Reform-minded politicians and bureaucrats are likely to overreach; enacting legislation and regulations shaped by ideology and, therefore, ignorant of the unintended consequences.

• Increased regulation implies a less efficient allocation of resources across the economy; limiting the growth of productivity -- the key driver of long term economic prosperity.

• Uncertainty surrounding reform will make businesses reluctant to spend and invest for growth. For example, some of the measures now being debated as part of health care reform would raise the cost of labor -- creating a strong disincentive to hire workers and causing unemployment to remain stubbornly high even as the economy recovers.

• All government interventions give birth to new constituencies which later resist any efforts to reduce their benefits. Try as he may, President Obama will find it difficult to scale back the aggressive fiscal measures which he has characterized as temporary but necessary.

As happens in every business cycle, stock prices have increased sharply in anticipation of recovery. After falling 25% from its value at the start of the year until early March, the S&P 500 index rose more than 40%; ending the first half with a gain of 1.8% (excluding dividends). Given this dramatic shift from pessimism to optimism, investors are now debating the shape of the coming recovery. Will it be V, W, U, L or “an inverted square root?” Along with the risks listed above, investors’ expectations should incorporate the following critical assumptions.

(1) In the short term, the domestic economy, and corporate profits, may surprise on the upside.

Given the length of the recession, the speed at which consumers have reduced spending/increased savings, and the magnitude by which companies reduced inventories over the past nine months, there is now substantial pent-up demand. Even if consumer spending simply stabilizes at current levels, then business inventory liquidation will end -- giving a significant boost to the quarter-over-quarter rate of change in GDP. The economy will also soon receive a lift from the $787 billion fiscal stimulus. Less than 10% of these funds have been spent thus far, largely in the form of transfer payments to state and local governments and social security recipients -- helping to stabilize incomes and spending in recent months. The largest sequential contribution to GDP from the stimulus will occur over the next few quarters. The combination of rising production and massive cost cutting in recent months (i.e. worker layoffs) could produce a surprising improvement in corporate profits in the short term.

(2) After the next six to 12 months the cyclical forces boosting the economy will begin to fade and powerful secular headwinds will reassert; limiting the pace of the economic expansion over the next few years.

Many pessimists did not anticipate the recovery in the economy and the equity market because they failed to distinguish between positive cyclical forces and negative secular trends. Still, the latter have not disappeared. Deleveraging will be a multi-year process. Personal consumption, which constitutes 70% of GDP, will be restrained by a preference for increased savings and debt reduction, as well as stubbornly high unemployment. The remaining 30% of the economy (government spending, exports, business capital expenditures) will not fully offset a slower secular pace of consumer spending. Also, the banking system, impaired by bad loans and securities related to residential and commercial real estate and consumer credit, will be slow to relax the higher lending standards now in effect. In short, the economy will not soon return to the credit-fueled growth rates of the past generation.

(3) Inflation will remain subdued, but long term interest rates will eventually increase.

The Federal Reserve has rescued the economy and the financial system by printing vast amounts of money. Investors’ fears that this “quantitative easing” will produce a sharp acceleration of inflation are justified, but premature. This excess liquidity will not create an inflation problem as long as consumers and the banking system are both hoarding cash. If our assumption about long term deleveraging is correct, then the Fed will have plenty of time to mop-up the excess money and prevent a meaningful acceleration of inflation. Also, we believe the coming recovery will not be sufficient to provide pricing power to businesses nor wage negotiation leverage to workers. However, as noted above, borrowings by the Federal government will increase significantly over the next several years; raising the ratio of government debt-to-GDP. Finally, although the Federal Reserve is likely to err on the side of easy monetary policy until recovery is firmly established, the Fed will eventually raise short term interest rates to normal levels – removing the anchor which has kept long term rates at unusually low levels.

The bottom line: Given recent gains, a significant correction in stock prices is possible at any time. Headline economic data may give mixed signals and traders with vivid memories of earlier losses will be quick to take profits on any hints that the recovery will falter. Still, a sluggish-but-sustained economic recovery, accompanied by low inflation, provides a favorable fundamental backdrop for stock prices over the next few years.

Charles Clark, CFP (207-775-1140)

Michael Stuart,CFA (860-478-9012)

June 30,2009 S&P 500: 919