Welcome to the Holiday Season 2008

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Welcome to the holiday season, 2008. If you ever believed in the Grinch who stole Christmas, then all of your childhood fantasies are coming true. The list of superlatives can go on for days, but in a nutshell things have gone from bad to worse during the past month. This, however, is not new news, or at least is not unexpected. With the financial collapse of Lehman in September and the global credit seizure that ensued for several weeks, we are seeing the full extent of the damage caused by those events.

The commentary this month will cover a number of areas given all the events that have occurred in the past few weeks. A short version of this report will also be distributed in a few days for those who want the “quick and dirty.”

Elections:

However you lean politically, the presidential election was a tremendous positive for this country and perhaps the world. Putting politics aside, there are a number of themes that were critical.

First, this was a decisive election. No doubt about it, the popular vote and Electoral College were both decisive in their outcome, with no need for legal maneuvers or intervention by the Supreme Court. This was both calming to the financial markets, and sent a clear signal to the rest of the world that the US is headed for change. In some corners of the world the vote was viewed as a repudiation of the Iraq war. While this might be true to a small extent, the decisiveness of the vote was largely driven by current economic events. Irrespective of the reason, the perception is what matters most, the perception that we as a country have voted for change.

Second, the campaign was brilliant. Never in the history of American politics was a campaign run so efficiently and thoroughly. It doesn’t matter whether you agree with Obama’s politics, his ability to bring together strong minds and harness their abilities is unlike anything we’ve seen in quite some time. This bodes extremely well for his ability to tackle the biggest crisis we’ve faced as a country in decades.

Third, his politics are going to help this country. Beware of this partisan statement, but the Democratic policies are needed for this country to regain its world position. From healthcare to energy programs, we need the policies that were outlined during the campaign. And while taxes will be going up, this was a forgone conclusion regardless of who is coming into office. After eight years of massive deficit spending, fiscal prudence and balanced budgets are going to have to take priority.

US Economy:

The US economy stinks. There is no way around it. While I have been saying all year that our recession began back in October of 2007, the NBER finally came out with the declaration that the recession in fact began in December 2007 (I wasn’t too far off). The recession began as a cyclical event, a part of the normal ebb and flow of the economic cycle. The housing crisis and credit market freeze have turned it from a “normal” event to a dramatic downturn with little indication of how we’ll recover. Certainly fiscal stimulus packages will be crucial, as will the release of credit to the markets and the stabilization of real estate prices.

The key for the Fed and the Obama Administration is to identify the solution that ends this spiral. We need banks to issue mortgages to end the housing decline, without which personal net worth will continue to fall, driving down consumption. Yet banks won’t lend funds until they know the risk of default is low, a reflection of the borrower’s ability to generate income. With lower consumption, there are fewer jobs and lower incomes, so banks won’t lend, so houses won’t be bought. Hence we have the spiral, along with the varied solutions that have already been proposed and implemented.

Global Economy:

As goes the US so goes the world. Or at least that used to be the saying. Today, the global economy is more independent from the US than ever before, yet they are facing the same issues we have. When our financial system teetered on collapse, so did the world’s. And when our credit markets froze, so did theirs. And when our consumption is in a slump, so slumps their manufacturing. As best exemplified by the price of oil (from $147/barrel to $47/barrel in just five months), the globe is slowing down, quickly.

On the bright side, the risk of systemic collapse seems to have passed. That was a real issue back in late September and October after Lehman failed. I blame this risk squarely on the Bush Administration and a handful of loose-lipped Congressmen (remember the WWII saying, “Loose Lips Sinks Ships”). Rather than solve the crisis and assure investors, Paulson and gang did a superb job of worsening the crisis on a weekly basis and freaking out investors. It took the Brits, and an old solution from Sweden, to finally get the financial system back on track when they bailed out their own financial system.

We saw a dramatic change of approach two weeks ago in the rescue of Citigroup. While past interventions by the Treasury required devastating shareholder pain and piece-meal solutions, this time around the solution was gentle and extensive. Citi will survive, and no one was sacrificed. The markets resumed their dance without a massive capitulation.

Current Markets:

So as a recap, November was another wild month with daily swings of up to 10% and a market decline of -7%. What is important to note is the absolute change in the market. The stock market, while it found a new bottom in November, is not much changed in the past seven weeks. The extreme volatility has been a change, as we’ve seen nine days of 5% intra-day movements in the market, more than we’ve seen since the 1930s. This volatility creates risk, and with risk is fear. Although the monthly decline is modest given the volatility, the market is still in a state of panic.

As complex or insightful as you wish to describe the financial markets, in the end it is simply a game of “eBay.” You have sellers, and you have buyers. When one of those groups overwhelms the other, the markets move in the corresponding direction. This is no different than selling your attic toys on eBay. If a few people really want that old box from your Three-Stooges blow-up punching bag, then it will be worth a fortune (this is a true story). On the other hand, if no one feels like buying crummy old boxes, then you might as well put it back in the attic for another day.

Despite all the economic and political events I describe above, at the end of the day we are faced with massive selling and little interest in buying. As best as I can tell today, much of the avalanche in selling is driven by large hedge funds. When Lehman failed, hundreds of billions in hedge fund assets were frozen. Then with the ensuing market collapse, both equities and credit, many more funds failed as their trading strategies were broken. With such a large swath of the hedge fund world frozen or in failure, the request for redemptions by investors started to pour in. With nearly half of all hedge fund investors looking to take out their money, even the good funds are now forced to sell their remaining assets. But no one is willing to buy. We are left with yet another spiral.

The Future:

I do not know the right “solution” to the economic crisis, nor which measures will work best. Regardless, there are so many sources of support in the global financial system today that they will start to help the economy – some now and some later. I am an optimist: the system of financial markets as we know them today will likely change, and the economy will regain its footing. I would not be surprised if unemployment reached 8%, and we see a spate of corporate bankruptcies. While I do not support a bailout of Detroit, they are likely to get their loans and continue to make cars we don’t need.

Don’t be surprised to see more headlines as the market gyrate in the coming months. We will continue to perceive economic crises over the coming few months, while more fallout from September emerges. We should not, however, face any further financial crises. At worse we will see a handful of US financial institutions suffer from extensive credit card losses, which the Treasury is already addressing. Hopefully this time they’ll get it right.

Our investment strategy is adapting to these circumstances. We’re heavy in cash, allowing us ample opportunity to invest in depressed assets as the markets recover. As a forward-looking indicator, the financial markets will rally well before the economy recovers. While our long-term value-based strategy does not change, our value opportunities are going to vary from past opportunities. Sustainability, alternative energy and cash flow are all consistent strategies, while emerging markets and growth firms are fraught with risk now. We’re still forming our explicit strategy, and would be happy to discuss how this will apply to the specifics of your account.

In the mean time, enjoy the holidays and let’s hope it is a mild winter. I think I’ve already had enough stress for one year.

Regards,

David

To TARP or Not to TARP?

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A primer on TARP and some political commentary:

With all the brightest minds in finance and politics focused on this one problem, why could they not find a better name? TARP, the Troubled Asset Relief Program, is not exactly a bailout nor is it a plan to fix the U.S. economy. It is a program that creates a new “superbank,” designed to take on risk along with the prospect of a profit or loss, and solidly address a gaping chasm in our financial system. Let me explain.

The dysfunction that we have seen over the past three weeks highlights a basic collapse of the capitalist model and its reliance on the concept of a rational agent. The belief was that greed, the primary motivation of people and the stewards of business, was so truthfully efficient that in the end you had only the best, most productive organizations flourishing in the economy. Starting in the 1970s, a form of hypercompensation, stock options, was layered onto this model to provide the ultimate reward for the best performers. To a certain degree, it worked for a number of decades.

It turns out the system had at least one major flaw. While the individuals running these companies acted to improve their fortunes, their actions became more and more short-sighted. This myopic view was driven by two primary forces: the introduction of stock option compensation that could improve one’s fortune in just a few short months, and the wild volatility made possible by electronic trading. With short-sighted fortunes to be gained came short-sighted decisions.

Additionally, the innovations brought by financial engineering such as fancy mortgage products and the ability to ship those obligations around the globe allowed financial institutions to gorge themselves and literally grow 100-fold in a very short time. Add to this the lack of regulation during the past ten years and what we had was unchecked gluttony.

Here we are today: with obese financial organizations ready to burst, we need to find a home for the billions in mortgage-based assets that were engineered this decade. Not to say that the assets are worthless. In fact, they are probably worth about 60 – 80 cents per dollar on average. The issue is that with some worth a lot and others worth close to nothing, no one is willing to take a bet on them today. With no buyers, there is no market. And with no market, the holders of these assets are forced to value them as worthless, even the good ones. It is a cascading problem when combined with accounting rules that leads to one conclusion – any institution holding a large number of these assets are forced to replace them with good assets or fail. That replacement game takes an awful lot of money and after a year of this scramble the money has run out.

Rather than continue to find money to throw at the institutions, the TARP plan is going to address the root problem – find a value for the mortgage assets. By entering as an unlimited buyer of the assets, the government has now created a new market in which the price for these assets will be readily determined – basically whatever the government is willing to pay. Set the price high enough, and all these institutions are now solvent again. Set it too high, however, and the government ends up overpaying for assets that are worth less.

If this is done correctly, the loss to the US government is minimal, and is equally likely to be a profit. Remember, these assets on average are valuable in the long-run. Hold enough of them long enough, and you’ll get that value. How much value is there? Tough question. It depends ultimately on the fate of the housing market.

The subtle twist here is that TARP does not need to buy all the assets, just enough to convince the market of their current and stable value. If TARP is too small, the market will fail to believe the determined value is stable. TARP is, in effect, a program designed to transfer risk away from financial firms to a new institution, allowing the financial markets to continue to do what they do and give us a chance to recover as an economy.

That is my objective commentary. Here comes my not-too-subtle biased commentary.

First off, this could have been avoided six months ago. As you read in my last Market Update, Treasury Secretary Paulson (arguably the most powerful person in America at this moment) made a series of bungled steps in his attempt at the children’s game of “Whack-a-Mole.” With a personal fortune of $800 million, he seemed little concerned about common investors when forging solutions to the crisis du jour each weekend. The intended effect lasted for about six minutes while the unintended effects increased risk-taking (a result of the Bear Stearns bailout), elimination of the preferred stock market (created by the Fannie Mae and Freddie Mac takeover), credit insurance failure (from Lehman Brothers’ failure), and consumer bank failures (triggered by all the above plus losses from the AIG bailout). There seemed to be no end in sight.

TARP should end this cycle. Being a government program, however, it is faced with a far greater foe. A foe that for centuries has scourged the planet, brought tears to grown men, forced women to question humanity and left children screaming in their sleep–politicians.

Leave it to the politicians in Washington to turn a crisis into personal gain. After two days of hearings last week, it became increasingly clear that few Congressmen had the slightest idea what a bank is, much less how one actually functions. Nonetheless, the core of the plan looked intact, with a number of feel-good measures thrown on top to satisfy the national obsession with sound bites. Executive compensation caps, homeowner protection and other measures were routinely thrown in and out of the plan to give politicians their moment in the spotlight. In the end, it was still about restarting the credit markets.

Then came the crusaders. Let’s put aside the fact that deregulation and corporate greed have been core tenets of the Republican platform since Reagan (along with small government and balanced budgets – seems someone forgot to read that memo). On Thursday, McCain and his merry men tried to turn TARP into SMAFED, “Save My A** From Electoral Defeat.” The Republicans proposed to replace TARP with a self-paid insurance program in an attempt to give the Republicans the chance to claim they saved the American taxpayer $700 billion. In fact, it was insurance that exacerbated the financial meltdown and did nothing to re-establish a market for these assets. It would be a disaster from the start. Whack-a-Mole redux.

As I write this article, reports are circulating that we are close to an agreement that would maintain the core of the plan as designed by Paulson and Bernanke. Irrespective of the political tinkering, this should work to restart the credit market with little long-term damage to the Federal budget. Should this crisis pass, we will still have many months to sort out the damage from this near-collapse. Higher unemployment, lower profits and slower growth are all here for the near term. We have a long road ahead to address the core problems with the system. It will take a form of basic capitalism with a socialist twist to solve this – regulation of the financial system layered on top of the free market principles that we know still work. We can no longer rely on greed to motivate business leaders to serve the public good. From the fate of the environment to the financial system, we have seen first-hand that overriding self-interest does not translate into collective prosperity.

Regards,

David

Making the Headlines

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The speed at which the financial markets have gone from one crisis to the next is simply stunning. Rather than try to lump all the events into a single update, we’re going to split them into multiple updates spread out over several days. There are just too many things going on to wrap into one message.

In short, we’ve had four major events:

Fannie Mae and Freddie Mac were bailed out by the US Government:

Put succinctly, this was one of the most botched government actions I’ve ever witnessed. While protecting some debt holders completely, others were sacrificed. It would have been just as easy, and cost far less, to protect all the constituents. As you will read in a subsequent update, I suspect there is more to this than has been disclosed. One theory is that certain foreign governments demanded a bailout (namely China), which may have turned this into a foreign policy matter as opposed to domestic economics.

Lehman Brothers declared bankruptcy:

In the same way that Bear Stearns fell to hubris and greed, Lehman Brothers fell into bankruptcy this weekend because of heavy bets in the mortgage market. The circumstances are simple – they have assets supposedly worth $600 billion that are likely worth far less, and liabilities of $600 billion. Cash is king, and if you don’t have enough, then you will fail. That is the oldest axiom of finance.

Merrill Lynch sold themselves to Bank of America:

In order to avoid the same fate as Lehman, Merrill ran into the arms of a better capitalized, deposit-based bank. It seems that Merrill was in much better shape than Lehman, and might have survived on their own. But in this market, that is not a risk they were willing to take.

AIG is on the verge of collapse:

The insurer to the world is running out of dough. With a trillion dollar balance sheet, AIG is about to report tens of billions in losses on insurance contracts against mortgages. While a bailout is possible, we’re all waiting for news on this one.

Outlook and Perspective:

However you choose to frame these events, the conclusion is the same – we are in extraordinary times. Never before in the history of the markets have institutions of this size faced such dire circumstances. The GSEs alone represent $3 trillion in assets – that is a 3 followed by twelve zeros. The magnitude is astounding. When these markets move, nothing can get in their way.

For perspective, this is all about finance firms. The rest of the economy, while going slowly, is certainly going. Companies that make stuff are still making stuff, and there are plenty of long-term opportunities in these industries. In the world of economics, when the employer of the analyst, the person responsible for commenting on the state of the world, is in trouble the analyst tends to believe the world is about to end. Put another way, our financial news is governed by folks who are losing their jobs. This puts everyone in a bad mood.

While these events affect everyone in some way, we have managed to stay out of the storm with our investment strategy. In the long-term, these issues will resolve themselves and we’ll once again go back to business as usual. Unfortunately, that will be many months away with a few more headlines until then. If you have questions regarding your account, please do not hesitate to call. We are contacting people directly if there is something specific in these events that affects their account. Otherwise, rest assured that we are working through this with a level head and long-term focus.

Regards,

David

The Torch Is Lit

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It has been our practice to send out quarterly market updates, but given the anxiety about the economy, we are breaking practice and sending out more regular updates. As a quick aside, our portfolios in July remained relatively neutral showing us that the global economy still has strength even in the midst of a bear market. While there are certainly more surprises hiding in the dark corners of the market, we think we have seen the worse and are now focused on the timing of a recovery, whether it be months or years from now.

Ironically, the quadrennial event that starts this evening provides a useful analogy for our general economic condition. As the world turns its telescopic lens on Beijing for the Olympics, we are given a unique view into China and their economy. At once memorable, starting on auspicious 08.08.08, and controversial, the torch coming in on a tide of protests; the Games are a chance for China to fashion itself a new world image and lay bare its strength and weaknesses.

What China is experiencing economically can be seen as a microcosm of the conditions the global economy is struggling with. Intense inflation has pushed the consumer price index to over 7% in the first half of the year, making it hard for the country’s population to purchase necessities. Pollution, one of the worst in the world, has induced the government to take extreme measures to clear the sky for the Olympics. Half of all cars in Beijing have been ordered off the roads in the weeks leading up to the opening ceremony and rainmaking rockets have been utilized to clear away the smog. All this to no avail-the skies are still heavy with the weight of pollution. Oil supply is a major concern for China as it is for the rest of the world and the Chinese government has resorted to hoarding oil to ensure a steady supply when it takes center stage.

The Games are a source of pride for any host country, for any country sending a delegation for that matter. For the Chinese especially, it is a time to show the world that it has progressed socially, politically, and economically-all areas that would help the global economy as well as their own. We eagerly await the Games of the XXIX Olympiad.

As with the Chinese, the themes of inflation, pollution and energy dominate our thoughts as well. In our quarterly market update, we spoke of how these forces, combined with a housing collapse, came together to create the perfect economic storm. We believe that that storm has raged its worst and is now showing signs of abating.

Housing Market

The first force is the plight of the housing market. We have discussed extensively the short-term causes and long-term effects of the flawed subprime lending practices that has mired the housing market in foreclosures and defaults. The effects of these practices have rippled through the financial industry and have affected institutions that had little to do with the subprime collapse. As these institutions work to correct themselves, there are signs that the housing market is stabilizing, even strengthening in affluent communities. Weaknesses are still evident in developments and low-income housing and will take many years to recover; but, at the very least, the horizon looks a whole lot brighter.

Unfortunately, the two Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, are the latest casualties of the real estate collapse. While they did not extensively engage in subprime lending (by definition, subprime is a loan that does meet the standards of the two GSEs), the follow-on effects of the subprime collapse have driven up defaults on all types of mortgages. As a result, both GSEs are now projecting enormous losses that could jeopardize their capital base.

Historically, neither GSE has maintained high capital under the belief that the US government can provide emergency backing. That belief is now being tested. Our opinion is that both GSEs will survive intact with the need for a government infusion in the form of common or preferred stock purchases. While the final amount will be minor given the government’s other obligations and the prospect eventual profit from this infusion, it will lead to significant changes in the way they are regulated in the future.

Economic Downturn

The second force is a general economic malaise exasperated by a disastrous deficit, the weakening dollar, and rising inflation. Out-of-control governmental spending for the last eight years has detrimentally slowed our growth and contributed to the decline of the dollar. With a total debt approaching $10 trillion, we have spent our savings for at least a generation. Generating enormous interest costs and driving down the value of the dollar, Americans are paying more and getting less.

The Federal Reserve aggressively cut interest rates seven times since the end of 2007 bringing it down from 5.25% to 2%. But now the Fed is in a quandary. Its primary policymaking tool has not been able to spur the US out of an economic downturn despite the fact that interest rates are at a three-year low. Inflation, however, has risen to 4.1% in the last year, the largest rate in 17 years. Herein lays the problem-interest rates are decreased to stimulate growth, but increased to battle inflation. The Fed is, in essence, immobilized in an economic Catch-22 and hard pressed to choose a solution. Its decision then is to hold steady at 2% with the likelihood that it will not change interest rates if the economy continues as it has.

The Price of Oil

The third force is the omnipresent price of oil. After hitting record highs this summer at $147 per barrel, oil prices have dropped to a three-month low in August at $118. It is still undetermined whether this is merely a short respite or an indicator that oil prices will return to what has been deemed as normal. The hope is that the price of oil will stabilize around this level, but anything short of the sharp rise from the past two years will be a relief.

Alternative energy is painting the town green. Or maybe just a patina of green. Everywhere from politics to even oil companies, green is the catchphrase that lends a sense of conscientious credibility. The push for fuel-mileage regulation is gaining momentum in Congress as the US flounders for a solution to its energy crisis. Perhaps soaring oil prices have finally been able to imprint into our national consciousness the need for sustainable energy. Automakers are already feeling added pressure to meet the demand for more gas-efficient vehicles and Americans are driving on average 4% fewer miles since the onslaught of the oil price increase. Given that Americans account for 11% of global consumption, this is a significant decrease and a sure sign that good consumer behavior can positively affect global oil demand.

Change on the Horizon

The most important change about to occur, and frankly one that we desperately need, is the Presidential administration. As the race moves forth towards the national conventions, economic concerns top the agenda for Barack Obama and John McCain. Neither candidate has an economic platform that truly addresses the situation-all of the economic stimulus packages to date are little more than crowd pleasers. We hope that behind closed doors it is a conversation about changing the shortsighted, destructive policies of the past eight years. We will look for sound, long-term economic policies that emphasize sustainability and global responsibility. While this is an extremely tall order, we are optimistic that any change will help the situation.

To conclude, we have a guarded, yet optimistic outlook for the coming months. We view oil prices and the housing market as the keys to eventual recovery and will closely monitor them. Throughout this entire process, our investment strategy remains the same-careful and adaptive selection of equities and fixed income with an emphasis on cash flow. As the clouds begin to clear, we will stay in regular contact regarding any changes or fluctuations.

As always, feel free to call or email us with your thoughts.

Regards,

David

The Perfect Storm

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There is nothing pretty about the past three months. While the positives regarding the global economy remain, such as growing populations, growing demand and a phenomenal explosion around international trade, the US has entered the witching hour. Namely, our economy here has been battered by three concurrent forces that are creating what may prove to be the perfect storm.

The first of these factors is the ever-present subprime debacle. I have already explained this in length, but it is worth noting the situation in review and how it is still affecting us today. With grossly overinflated home prices and a lending practice that placed unrealistic demands on borrowers in a declining home price environment, the mortgage industry created an explosion of defaults and foreclosures during the first half of this year. The effects have been felt globally since these mortgages were repackaged into supposedly safe investments and placed into everything from bank portfolios to money market funds. To date, the reported losses by the financial institutions related to these subprime securities have reached $400 billion, and could still be climbing by some estimates.

The effects of the subprime debacle that we are still feeling are quite pervasive. In the US, it has accelerated foreclosures in many situations where it would not have occurred under normal circumstances, even with declining real estate prices. And second, it has erased the profits of the financial sector, dragging down the overall equity markets. Third, with so many aftershocks past and present, the bond markets are still reeling; and in the case of municipal bonds, go through fits and spasms, eek out some gains, only to be gripped by another seizure when more bad news is revealed.

This in itself would be enough to cause tremendous distress in the financial markets as we have seen starting exactly a year ago this month. The conventional belief just two months ago was that these issues would work through the system in time and after a correction in the markets we would resume with growth in the markets and economy, albeit anemic for some time to come.

Now enter factor two. While it may seem more like an inconvenience than a financial crisis, the US government deficit has grown astronomically during the past eight years (yes – read, Republican out-of-control spending). The effect has been singularly devastating-the rapid decline of the value of the US dollar. From 2001 to today, the dollar has lost over half its value and the decline could continue. I’ve been writing about this topic for four years now as a priority for our political and economic policies. Unfortunately, we are now here.

The follow-on effects are pervasive. In a simplistic view, it makes it more expensive to purchase international goods or to travel abroad. The opposing argument, that our manufactured goods are now cheaper and more attractive stimulates the US economy, is true to some extent. The larger issue is that we import far more than we export, including the bulk of our energy needs and many raw materials.

And now the third factor and the great behemoth that pervades our headlines: the price of oil. Unfortunately, or perhaps fortunately, oil is traded in US dollars. And we buy a lot of oil from overseas. For our cars alone, we spend $1.3 billion dollars a day on oil to convert to gasoline, more than half of which comes from overseas. Because of growing demand from growing economies such as China and India and the deteriorated value of the dollar, we are spending twice as much for our foreign energy sources than we did just two years ago. Viola – inflation.

So we have a dismal real estate market with increasing foreclosures, the prospect of real inflation for some time to come, and a recession that would have been a slowdown if it were not for these factors. Put it all together, and you have one of the worse financial markets that we have seen in decades.

That is the bad news. The good news is that our world is about to change. Gone for good is the era of cheap gasoline, and good riddance. While we may feel the enormous pinch today, the impact of the mighty buck will accelerate changes that have been needed for quite some time. Americans are driving fewer miles (by close to 10% according to some estimates), SUVs are no longer in demand, and energy conservation in every aspect of life is on the tips of EVERYONE’s tongue. These are good changes. We will use less, we will waste less, carbon emissions will decline, and in the long run we will be a more efficient and conscientious society.

While it would have been nice to do this at our own pace and in our own time, that luxury has been squandered. The time is now, and the pace is immediate-at least as immediate as humanly possible.

Going Forward

Prospects for the remainder of the year are a haze for all. We have officially entered a bear market, with the major US indices down 20% from their highs. The question is, do we recover to close out the year where we began (our initial forecast), or do we continue a decline and remain in this quagmire. In either case, it could be at least two years before we revisit a bull market with annually rising values. For the immediate term, we are waiting to see and gathering as much information as possible. The primary factor we’re watching is the price of oil: if oil remains stable or declines, then we will make it through this in short order; if oil continues its rise, then I fear the bear market will deepen.

Our investments have continued to emphasize the same principles we have held for the past few years – cash generation augmented by well-researched growth opportunities focused around technology and demographic changes. While we performed extremely well in the months of April and May, June was the worst month on record, leading to an overall loss for the quarter. Surprisingly (or maybe not, given the market), it was our cash generation portion of the portfolio that suffered the most, from stable defensive stocks such at United Technologies and GE to very high income, tax-efficient global preferred stock.

Our approach to weather this storm is going to be grounded in the fundamentals. Historically, even stronger bull markets follow bear markets, placing tremendous emphasis on riding this out while positioning ourselves for the recovery. While it is tricky to predict the bottom of the market, it is important to look for buying opportunities on undervalued equities and hold onto those positions that will survive and ultimately thrive in the next cycle.

Reports regarding your individual accounts will be going out in the coming week, with a brief analysis of what worked and didn’t work for the year to date. Depending on your investment profile, we may include research notes on companies that we are strongly considering as we look to boost equity positions in the coming months. As always, please write, call or simply stop by with questions and concerns.

Best wishes for an enjoyable 4th,

David

The Waiting Game

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As you have read, heard, and seen in hundreds of headlines and news clips, it has been a troubling year in the markets thus far. From the viewpoint of the general stock market, it was a tough quarter. The S&P500 lost nearly 10%, and down much more earlier in the quarter – a bad downturn, but we’ve seen worse. If you look at volatility, by one measure this was the most volatile market since 1938 when measured by the number of days in which the market was up or down by at least 1%. But on another level that we cannot quantify, we had many ingredients that could have led to a complete meltdown in the financial system.

As you will read in this update, there were some important counter-forces that prevented this scenario, but the confluence of events is alarming. Fortunately, I think the worst is behind us now.

To summarize:

It all starts with real estate. We are in the midst of the worst housing correction since the 1980s and perhaps far beyond. Housing prices have declined by as much as 30% in some markets, erasing over three years of house price appreciation. While some of the decline is cyclical in nature, the largest driver is the aggressive and sloppy lending practices of the banks originating the loans.

From these sour real estate assets, the global banks have reported losses of roughly $200 billion in just a few months, mainly driven by the subprime lending market. These loans were extended to folks with marginal credit and overvalued houses. To make the payments palatable for the borrower and attractive to the lender, most of these loans were structured with rapidly inflating payments. This structure, combined with the cyclical decline in real estate values, has led to a vicious circle of declining values and defaulted loans.

Exacerbating the situation, the subprime loans were sliced, diced and spun into a wide range of financial products used by institutions around the globe. Because of this financial engineering and sloppy rating practices, a number of these new products were classified as “safe” investments with AAA ratings. They were in fact illiquid and subject to steep losses.

These events led to the collapse of one financial insurance company (ACA Financial) and jeopardized the health of several others. The financial insurance companies were mainly engaged in the business of insuring municipal bonds in the event that a town or municipality defaults. Unfortunately, these same companies also insured some of the new subprime-backed financial instruments. As those instruments start to fail, so goes the capital of these insurance companies. In an overreaction to the situation, the market started to view any municipal bond with insurance as risky, even though municipal bonds are historically very safe and insurance is a recent addition.

The culmination of these circumstances led to the freezing of the credit markets. In short, banks and institutions refuse to trade bonds with each other. Starting with corporate bonds, then municipal bonds, then basically any bond that isn’t a US Treasury Bond, the market eventually said, “no way, not today.” If you’ve got bonds – you are stuck with them. On the other hand, if you willing to buy bonds, there are some great bargains to be found.

A freeze of the credit markets is akin to playing with fire in a refinery. Not a good idea. Fortunately, the Fed had some inkling of what was about to happen, and took a series of aggressive measures to avoid the obvious. They instituted four new lending facilities for banks followed by the purchase of Bear Stearns’ ailing mortgage debt, effectively dousing the entire financial system in a blanket of fire retardant foam. Not a promise of ultimate safety, but as close as we can get to one.

Oh, and did I mention that we’re in a recession? Of all the stuff going on, this is the least worrisome of the issues. Recessions happen – it is a part of the business cycle. Frankly, we’re in a good position to recover in a timely manner. While the economic recovery may not occur as fast as some would like, we will get back to economic expansion.

These events have had a profound effect on the markets. First, the equity market continued a decline that began last fall. Dropping another 9.5%, the market is skirting on bear market territory. While the downside may be limited now, the US equity markets will likely bump along for some time until there is certainty around corporate earnings and economic growth. By lowering our equity exposure last fall and early in the quarter, we have buffered ourselves from much of this volatility.

The larger problem has been the impact of the credit markets on our holdings. Some of you are already aware of these issues, but many of our bonds and preferred stock holdings have been priced at a discount because of illiquid markets and unusual pricing. We have responded in a number of ways. In some instances we have sold out of the highest-grade debt to take advantage of the high prices we can get for such instruments. In other cases, we have purchased debt and preferred stock with steep discounts and high yields. The risk here is the underlying credit – the company’s ability to remain a solid firm – placing emphasis on our analysis of the company and understanding of the debt structure.

For fixed income securities, we have been loading up on discounted bonds and preferred stock that will pay interest or dividends of seven to 14% for anywhere from a few months to 15 years. In all of these cases, we have been purchasing the debt of high quality firms with solid credit ratings and ample ability to cover their obligations. The availability of such high yields when treasury rates are so low is a by-product of the market’s aversion to any form of risk, no matter how slight it may be.

For stocks, we have followed our tried and true approach – buy value-based companies at low prices. Firms such as GE, J&J, CSX, FedEx and United Technologies constitute the core of our equity holdings. Other firms, such as Apple and Alnylam, have gone out and come back into some portfolio as we sold at peaks and bought at valleys. In such a volatile market, these opportunities abound. It is our job to find them.

In this next quarter, we are still in a wait-and-see posture. The first three weeks have been very positive, with some bond markets regaining their equilibrium and US stocks showing respectable gains. We expect the equity markets to slowly move off their bottom with the possibility of additional volatility. As volatility subsides, the perception of risk will also subside leading investors to slowly come back into the debt and equity markets. Combined with the Fed’s monetary actions and the stimulus package, we expect the economy to slowly stabilize as well.

Our research and investment focus will swing towards global commodity prices and the impact it will have on the basics such as food. Furthermore, water is increasingly becoming a scarce resource across the globe, a situation that will factor heavily into food prices. We have already incorporated these views into our portfolio with investments in companies such as GE and baskets of alternative energy stocks. Expect to see further investments of these types in the coming months.

As usual, please call with questions, comments, or the like. Also visit our retooled website with an updated look and new research.

Enjoy the spring,

David

Bear Stearns

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The following is a brief overview of the events leading up to the collapse of Bear Stearns on the weekend of March 15, 2008:

Last week, the financial trading firm, Bear Stearns came to a near collapse and was subsequently purchased over the weekend by JP Morgan. The speed at which Bear reached this point was a shock to many, but the purchase was executed in nearly as quick of a timeframe. This purchase was done hastily to prevent any disruption in the mechanics of the financial system both in the US and abroad.

The consequences are more intricate. Bear Stearns was in a fragile position because of the manner in which they operated their business. Most of their revenue was derived from short-term transactions, with a lot of borrowing in short-term instruments. As rumors spread last week that Bear might have issues meeting their short-term obligations, many of their business partners withdrew their assets. We may never know if in fact Bear was in trouble, or it was simply a misguided perception, but given their unique position the rumor was enough to stall their business.

JP Morgan’s purchase of Bear was engineered to avoid any further disruptions in the markets. Unfortunately for Bear, because of the speed of the transaction and the lack of competition, JP Morgan paid a song for Bear Stearns. The total purchase price of $240 million translates to roughly the first 10 floors of their swanky NYC headquarters. Basically, JP Morgan got the deal of a century.

The fallout from this weekend is going to impact the market in several ways. As I write this, we saw the market dip quickly with a minor rally. While we don’t know which direction the market will take this week, the events around Bear Stearns has many investors rattled. In response, the Fed has been an active participant in the acquisition, assisting JP Morgan in managing some of the risk inherent in Bear’s assets and increasing funding into the credit markets.

Tomorrow is another important event, with the Fed meeting to discuss borrowing rates and the overall economy. As of this writing, there is a 90% chance that the Fed will lower the discount rate by another 1.0% to a rate of 2.0%. This would be the fifth time the Fed has lowered rates in the past few months, creating a tremendous stimulus to the economy.

We have now had several months of bad news from every corner of the world. First, the major banks announced nearly $150 billion in losses related to sub-prime loans. In January, Societe Generale, the French bank, dumped all the positions from their “rogue trader” causing the European markets to drop 9% at one point. We’ve had a couple of major hedge funds fail, unemployment is rising and the economy is slowing. These are the fact-based events which have led to the volatility in today’s markets.

But now we’ve had two major events that are based in perception rather than fact. Three weeks ago the municipal bond market froze up, behavingas if muni bonds are risky assets (their historical default rate is a miniscule 0.03%). And this weekend a trading firm has sold at a fire sale price because of a rumor-induced “run on the bank.” We have left the world of fact and are now reacting to irrationalities, a sign that we are reaching the crescendo associated with the bottom of such a market.

While this does not mean we are bullish on the markets, we are closely watching the situation for opportunities. Our current equity holdings are scrutinized and selected based on their long-term value prospects. For many of our clients (as appropriately deemed by our individual risk profiles) we continue to strive for a high dividend yield to buffer the inherent volatility in equity investment vehicles. While our equities may fluctuate in the short-term with these market conditions, we have vetted them extensively for their growth and income prospects as the economy improves and the market stabilizes. We will continue to navigate the global markets with this perspective, while using stable assets such as bonds and cash to mitigate the short-term volatility and provide long-term income.

As usual, please call or email me with questions and comments.

Regards,

David