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January’s Whipsaw and Relief

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From a contrarian’s view, January was both an abysmal month and a month of promise. Let me start with the abysmal. For the month, US equities were down 8.5%, one of the worst Januarys on record and one of the worst months period. One recently published statistic stated that 80% of the time that January is down, the market is down for the entire year. And the other 20% ain’t so good anyway. Doom and gloom.

To continue the bad news, we learned that the economy shrank significantly in December and home prices were in the toilet again in November. That, added to the horrifying losses by the banks in the fourth quarter does make one wonder when it will end. Of course, destroying general sentiment is the disclosure that in 2008 the major banks spent nearly $20 billion on bonuses while they lost tens of billions more. And I thought that my younger sister has a sense of entitlement! Seems that the bankers don’t get it either. Similar to how the three Detroit auto executives flew in three separate corporate jets to ask Washington for help, the egos running corporate America haven’t seen the writing on the wall.

As the contrarian, let me parse the news into a reality check. To start we knew that November was going to be a bad month for housing – no one could get a loan. And to that end, we knew that December was an awful month for the economy – just look around. In short, much of this is old news being recycled in an official capacity, which now sets expectations for the future. As a society people are incredibly myopic in their expectations: it is no wonder that doom and gloom is the standard in the New Year. Studies have shown that investors use the experiences of the past 30 days as four-fifths of their reference points in setting expectation for the next 30 days. Our sense of history is amazingly short, and when it comes to exuberance or fear, we often allow the tail to wag the dog.

Range-Bound

The most reported aspect of January was the performance of the equity markets. When viewed in the context of a “range-bound” market, January’s performance was actually well within expectations. If you look at the range of movement in the S&P 500 over the past four months, the length of the current market crisis, each month the S&P touched a low point during the middle of the month and then rallied during the last few days. January was the exception to this pattern, where the market failed to rally on the last two days of the month, closing near the month’s low.

Put another way, the market was at this same low each month, but you never saw that level on your statements since it didn’t coincide with the month-close. January did close at the low-point, making it look far worse in comparison. In addition, the media fixates on month-end figures making the hype all that more intense.

In fact, the market has been moving within a well defined high and low point for four months now, or trading within a “range.” It has not broken out of that range, either on the high side or low side, during this time. This is both good and bad news. The good news is that the market has not gotten any worse during this period, but conversely it has not gotten any better.

What has improved, however are the “fear statistics” that we closely follow. Two primary gauges, the implied volatility of the S&P futures (VIX) and the actual standard deviation of daily movements in the index have both dropped by half during this period. While we are still double levels seen during stable markets, we have significantly retreated from the hysteria of a market in collapse.

Another sign of improvement is the bond market. During the past two months, investment grade corporate bonds have shown dramatic improvement in price and liquidity. During the past three months, this market is up by nearly 20% with an enormous flow of new debt offerings coming into the market in January. In fact, while January was one of the best months ever for new debt issuances, the appetite of the market was insatiable – even more debt could have been issued.

Getting Better, Not Great

My message is simple, while this in the economy is pretty bleak, a lot of this news relates to damage that has already occurred. We believe that a “recovery” is still many months if not quarters away, but a bottoming of the economy may be taking hold right now. The evidence for this is in the market, as we’re seeing both a range-bound equity market that has not broken any new lows and a bond market that is as hot as ever. Again, it will be years until the equity markets recover their full value but the prospects to halt the losses is compelling as we look forward to how and when the recovery will take hold.

I have deliberately not commented on the Obama stimulus and bank rescue packages since the details are still being formed and the rumor mill is running overtime. I will add this commentary in my next update, eagerly looking forward to the details of the most important legislation in 80 years.

With only five weeks of winter left, I wish you all a healthy and happy February,

David B. Matias, CPA

A Year Never To Forget

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There isn’t much that I need to say to emphasize just how bad this year was in the financial markets. The world went through a capitulation, and in that process all the cracks and flaws within the financial system were exposed. From dismal company 401(k) performance to the complete collapse of hundreds of hedge funds, we learned first-hand that we need to focus on the basics.

For comparative purposes:

  • The US equity markets lost 37% as measured by the S&P 500 stocks
  • The European markets lost 42%
  • The Asian markets lost up to 68%
  • Once again, US stock mutual funds lost more than the overall market. In many cases the losses approached 50% (such as Fidelity’s Magellan Fund)
  • TIAA-CREF’s managed equity funds lost 35-40%. These are supposed to be well-managed long-term retirement funds
  • Investment in Commodities such as energy, metals and agricultural lost 46% • Investments in Corporate Grade bonds stayed flat
  • Investments in Corporate Grade preferred stock lost 32%
  • Investments in US Treasuries gained over 10% – the sole bright spot last year

I point all this out to make a few points:

1. Our financial system has for years encouraged people to use mutual funds and corporate 401(k) as methods to invest for retirement and diversify our risk. For those who followed this approach, they witnessed a loss of nearly half their investments. This is an astounding depletion of value, at exactly the wrong time as the country heads into a prolonged recession and enormous job losses.

a. I have for years been a staunch opponent of mutual funds for their lack of true diversification combined with elevated fees, both disclosed and hidden. With the stresses and dislocation we’ve seen this year, these flaws came to the forefront. Most funds lost more than the market this year – at a time when risk mitigation was critical to preserving family wealth.
b. The tax benefits of deferred tax accounts are dubious at best. Placing money pre-tax into a 401(k) makes certain assumptions regarding tax burdens in retirement and the benefits of growth of pre-tax assets. With such an enormous national debt generating in the past eight years and the manner in which income is progressively taxed, it is possible that the tax benefits of deferred accounts won’t exist.
c. Firms such as Fidelity are going to have much to answer to the investing public and lawmakers as they try to explain why so much of America’s retirement savings was wiped out in a single year.

2. There was no place to hide in the markets. The traditional notion of diversification did not work, such as international versus domestic investing. Any exposure to any risk results in enormous losses. Even the sole winner, Treasuries, has likely formed a bubble and could fall quickly in 2009. That, combined with the prospect of long-term inflation would make investing in the sole winning asset class of 2008 a risky and speculative investment in 2009.

3. Cash is Always king. I have used this mantra as cornerstone of our investment philosophy, and it is true now more than ever. Whether it is the cash flow off an investment (such as dividends or interest payments), or the cash flow going to the corporation, it is the first determinant in our investment approach.

Economic and Market View for 2009

By every measure, we are in a tough economic environment. Unemployment, the primary measure of a growing economy, is headed towards a 10% level – higher than we have seen in a generation. While the Obama stimulus plan could eventually generate the number of jobs that he is projecting, it will be at a steep cost. This cost will be in terms of an enormous budget deficit and a strong potential for dollar devaluation. The only mitigating factor helping the dollar is that every major economy across the globe is facing similar issues. It is a matter of who will recover first and at what cost.

The markets, however, will advance prior to the recovery in the market. Any sign that the worst is over will generate significant inflows into the general equity markets. The bond markets are already going through a rapid recovery: high-grade corporate bonds (AA and above) have rallied to pre-crash levels, many other investment grade corporate bonds have shown a similar recovery and preferred stock are showing strength as well.

The long-term prognosis for the US is difficult to determine. Unfortunately, it will largely rest on the incoming Administration and their policies, both domestic and foreign. Through years of indulgence and short sighted (aka greedy) policies, we have gutted the core of America. Our auto industry is in need of a shot of arsenic, we have exported a large part of our manufacturing base, and our primary growth industry – financial services – is in risk of permanent impairment. We need to find innovation, productivity and vision.

The good news is that we have an incoming Administration that is addressing these very issues. Alternative energy, energy independence and the related innovation will be a crucial first step in these policies. America’s focus on savings and breaking the addiction with consumption are the other necessary steps. Frankly, as a consumer-oriented society we need to go on a 5-step recovery program and stay in that support group for some time to come. The recovery will bring a good amount of pain, and we’ll be prone to frequent relapses if the entire situation is sugar coated.

While it may sound like doom and gloom, as are still the leading innovators of the world, with our research institutions and entrepreneurialism unlike anything in the history of civilization. Most of our institutions will survive, including the corporations that produce good stuff and have strong intellectual property. The ones who produce poor goods and don’t innovate (i.e. the auto industry) are going to ultimately fail, or at the least be unrecognizable in the future. Those in between will struggle to find their place in the next economy.

Portfolio Positioning

At Vodia we had a number of successes and failures during 2008, the most destructive of which was the government take-over of the GSEs, Fannie Mae in our case (I am still pissed-off at the Treasury for this one). But to our credit, we also took many steps in advance of this crisis: we realized some impressive gains earlier in the year, we were already positioned with low equity exposure, our cash positions were high, we avoided the emerging markets and commodities collapses, and most of our investments were based on strong cash flows.

As a result, we were able to reduce the damage by half, give or take depending on your risk profile and account specifics. This is great news. With a horde of cash to invest at this market bottom and the prospects of an eventual recovery we are well positioned going forward, we can ride up with the markets at an accelerated pace, making back any losses and then some as the recovery takes hold.

For 2009, we are repositioning the portfolio as follows:

  • We have increased equity exposures over 2008’s lows. While we are not going to our long-term equity allocation level, we have found a mid-point between the low equity allocation from 2008 and your long-term target. We will be reassessing this exposure as more economic news unfolds, with the eventual goal of reaching long-term levels when we feel that the downside risks have mitigated.
  • To increase the equity allocation, we have used a combination of individual companies as well as a non-US ETF that is a composite of the global equity markets. This allows us to hedge against a declining dollar while gaining exposure to the world’s recovery.
  • Our focus will continue to be on health care, manufacturing, global sustainability and technology
  • We have been using corporate bonds as well, to take advantage of the greater yields (as high as 10%) with the protection of asset securitization and blanket liens against corporate assets. Many of these instruments have variable interest rates dependent on metrics such as yield curve steepness and inflation.
  • We have introduced a small level of commodities into many of the portfolios. With energy going through a bubble-burst, and the long-prospect for global population growth, we believe that commodities such as oil, metals and agriculture represent a solid lower-risk long-term investment.
  • Our cash positions will still remain elevated as we hunt for additional opportunities.

As usual, please call or write with questions or comments. A detailed performance report will be emailed or mailed separately. We also have our annually updated Form ADV available in print and electronic version. Feel free to write clemail@vodiacapital.com or call 978/318-0900 for a copy of it. Best wishes for a healthy winter, David B. Matias, CPA

Best wishes for a healthy winter,

David B. Matias, CPA

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