Kotok-Swine Flu

Swine Flu, Bird Flu, Human Flu. April 27, 2009 We'll use this commentary to address the current flu scare. First, some short notes on public health issues, and then we will discuss portfolio strategies.

We’ve consolidated previous bird flu publications and posted it on our website (http://www.cumber.com/special/BF%202006-2007.pdf).

We recommend the CDC website (www.cdc.gov) as a bookmarked spot for reliable information about U.S. daily events and preparedness. We also recommend the World Health Organization website (http://www.who.int). We look at both daily.

Flu pandemic status falls into three categories. We say that notwithstanding the fact that the World Health Organization actually breaks it into six phases.

At Cumberland, there are really three activity levels for individuals. The first is to learn of the events and watch activity around the world. We don't do things much differently than when there was no flu threat. Obviously, we are no longer in that state. We were two weeks ago, but that "nothing to do" phase has passed.

The second activity level is to take hygienic preparation and defensive measures such as washing hands, not sharing cell phones, and thinking about the fact that the virus involves respiratory functions. Exposure to people with flu-like symptoms is more risky now than it would otherwise be. People who have flu-like symptoms should not interface with others -- they should seek treatment and follow the CDC guidelines.

The third status is a full pandemic. We're not there now. We're still in the middle status so we must use our brains, take precautions, and respect the risk.

In all likelihood, we are going to stay in this middle status, but that is not clear.

Remember, flu viruses are in constant mutation. This one shows some characteristics of swine flu, some characteristics of bird flu, and some characteristics of human flu. Its mixed-up structure is evolving every single day. Not enough is known about why people were dying in Mexico City but aren’t dying elsewhere. Was it because only the extreme cases were fatal and that was due to lack of prompt treatment? Was the Mexican medical system inadequate? Was attention to sickness not given fast enough? There are many unanswered questions about the Mexico outbreak. So far, in mature OECD countries, there seems to be active contingency management and no fatalities.

Let's segue to financial markets.

There is an initial flight to quality in the currency markets. The dollar is stronger. There is also a flight into quality like the rally in short-term Treasuries. There are things that

you would expect when there is a global risk developing and the outcome is uncertain.

We would expect lots of volatility in all financial markets based upon the news flow.

In bonds, our strategy has been, and continues to be, avoidance of Treasuries because we think they are overpriced, yields are too low to be attractive for investors. The bargains in the bond market are in higher-quality credits in tax-exempt municipal bonds, taxable municipal bonds, and high-grade corporate bonds. This evolving flu situation is only an additional impetus to continue with our bond strategy. Our bond accounts are fully invested; we favor the spread area and longer duration.

In stock markets, things are different. Mexico is the epicenter of the flu outbreak.

Clearly, its markets have trouble ahead.

In the U.S. and other major economies, we expect the flu to be a negative shock that comes on top of an already-weakened economic and financial system. Somewhere, someplace, some conference will be cancelled, some group will not travel, some airline seat will be empty, some restaurant won't serve a meal, some hotel room will be empty, and some movie theater won't have an attendee, and so forth.

The end result is that consumption is temporarily reduced by the threat of flu.

Furthermore, the savings rate rises by the fall in consumption. Those savings are temporary. So they get applied and invested in this low interest rate environment. As risk sentiment worsens, those savings remain risk averse. Flu-based savings are not likely to buy stocks or bonds; they are more likely to accumulate in cash equivalents. At least, that's how we think flu will affect investors.

Cumberland has made portfolio changes in its equity accounts to create a cash reserve. In balanced accounts a commensurate shift has occurred as it has in international, emerging markets and global multi-asset class accounts.

Cash reserves at this stage are precautionary. They will dampen portfolio performance if the market rallies strongly from here; they will cushion portfolio performance if the markets fall.

The purpose of a cash reserve in an evolving risk situation is strictly defensive. If the markets sell off viciously and present a buying opportunity, the cash can be redeployed based on longer-term strategic views and the economic outlook. If the markets rally and the flu risk subsides, the other issues relating to the economy, the financial crisis, the banking system, and global trade and economics will drive the decision to deploy the cash.

We've elected to trade some flu risk to others by raising a basic cash reserve. We will be watching the evolution of the financial and economic outcomes as the world moves through this developing financial crisis and banking system shock.

We eliminated cash reserves last fall and took our balanced accounts' basic allocation to 50% stocks and 50% bonds. At 50/50, our stock allocation was 20 points below the baseline 70% equity exposure. At 50% bonds, our allocation was 20 points above the baseline 30% bond market allocation. We are now lowering the stock market allocation to approximately 40% and allocating that 10% shift to cash. Our basic, unrestricted, balanced account allocation today is 40% stocks, 10% cash, and 50% bonds. The deployment in bonds is in the high-grade structures we outlined above.

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com ********* Copyright 2009, Cumberland Advisors. All rights reserved.

The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-6926690. This report has been derived from information considered reliable, but it cannot be guaranteed as to accuracy or completeness.