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Down for the Year

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The last 14 months have been all about economic recovery and the tremendous gains seen in the stock market. Yet this afternoon we are down 3% on the year after a 4% decline this afternoon. Just two weeks ago, the day before the “flash crash of 2010” we were up 5%, and saw a high for the year on April 23 (up 10% for the year).

So what gives? Once again, volatility reigns. Interestingly, on the day of the flash crash the S&P500 reached a low point of 1065, just 1% away from where we stand today. While the market mechanisms on the day clearly failed with some stocks trading at a penny, the overall level was not a mistake. This is where the market was headed, and the panic of electronic trading run amuck was just a diversion.

I don’t have any remarkable insight into the market volatility over the past two weeks, other than to reiterate our view that the equity markets were far too complacent. Despite a balance of news this week, some good and some bad, nothing was going to keep equities from falling. In many ways, this is a sentimental sell-off after another short-term bubble.

How are things different from the collapse of 2008?

  • Companies are already trading at low stock prices to their absolute highs. GE is trading at 1/3rd of its peak. Citigroup is 1/10th of their peak. Both have dramatically cut or eliminated dividends.
  • Companies have finished cutting jobs. Manufacturing has stabilized, people have cut back on their spending and debt levels are going down in the US (I don’t think we can say the same about Europe, however).
  • Other asset classes are reacting well. Government bonds are up. Corporate bond spreads have widened, but not significantly. Gold is stable, yet oil has shown some declines. Municipal bonds are up and utility stocks are flat.

There is clearly a set of economic unknowns around Europe and their debt levels, which could impact the US. That has got to be worked out over time with the corresponding impact known later. In a worst case scenario, the EU may have to drop the single currency. More likely, some of the EU “states” will have to rework their sovereign debt with a corresponding impact on the debt holders. But as far as we can see today, we are not revisiting the Armageddon scenario of 2008.

From an investments perspective, anyone who’s spoken to me in the last year has heard one mantra from me: bonds. This is why we use them, for their stability in these scenarios. We have maintained a highly underweight equity exposure, and been hording cash for the past two months. There will be a time to buy. Until then, it is wait and learn.

Regards,

David B. Matias, CPA

Good Luck, Goldilocks

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It has been over two months since my last market update and the stock market is just roaring ahead, repairing all the damage from last year’s financial collapse and indicating that the recovery is in full swing. Or is it? In fact, I feel like a backseat driver in the movie, “Thelma and Louise,” careening towards the cliff with the top down on my vintage convertible. The financial reality is that we are facing some of the greatest uncertainty seen in generations which is starkly exhibited in the markets today.

The stock market change since my last market update is a up 3.6%, not a robust return for anyone who jumped into the market this past September. Gold has beaten the living snot out of the market, up 19.5% and even TIPs are up by 3.8% (TIPs are the Treasury-Inflation Protected Securities, a safe haven that also indexes to inflation). But here is the paradox – there is no inflation and no one is predicting for strong inflation anytime soon, even though Gold and TIPs are traditionally used to hedge against inflation. The only other time there is a flight to these securities is during times of severe financial risk.

Yet the stock market shows no such signs of financial risk. In fact, the main volatility indicator for the stock market, the VIX, touched a low of 20.05 last month, the lowest point we have seen since August of 2008, well before the collapse of Lehman. In a nutshell, the stock market is plunking along as if all is fine in the world while traditional safe havens are seeing enormous inflows of cash. Where is this split view coming from, and what does it mean for the next few months and years?

These stark numbers were reported by Bloomberg last week. In November, the rate on 3-month treasuries went to zero (it even went negative for a brief moment) while the equity indicators are showing minimal risks after a 25% gain this year. This has happened once before in modern financial history. It was 1938: the stock market had gained 25% that year and short-term Treasuries were yielding 0.05% (read: 5/100 of one percent). For the next three years starting in 1939, the stock market lost one-third of its value. Is this where we are headed next? Maybe – it all depends on whether policy makers can get it right this time.

Economy

The biggest battle that the financial markets will face is the improvement of the economy. Almost 70% of our Gross Domestic Product depends on the consumer – their ability to spend money on everything from gel toothpaste to plasma TVs. This consumption has been driven by two factors, disposable income from earnings and the ability to borrow. A key impetus to spurring consumption was home growth – the purchase of a new, larger home and all the items needed to fill that home. Yet today, in every aspect of this dynamic, we are hurting.

The housing market is in the toilet for a while longer. Prices have increased for the past few months, but have done nothing to repair the enormous loss of home value and home equity. As reported last week by the Wall Street Journal, one-in-four homes are underwater (worth less than their combined mortgages) and 5.3 million homeowners are more than 20% underwater. While this collapse has headlined the news for two years now, the reality is that we have many more years before the residential real estate market again becomes an impetus for growth.

Credit is declining commensurate with these events. Credit card reform legislation takes effect in February, and already banks are increasing rates and limiting lines to “buffer” themselves against the changes (in fact, this is an egregious abuse of their banking privileges to be discussed in another article). Combined with the current job market and mortgage delinquencies, it will be years before the consumer credit market again extends credit to consumers to fuel consumption. In fact, expect to see major lenders from Bank of America to Capital One suffer enormous credit losses in the coming year, well beyond their current projections.

Jobs are scarce, and growing scarcer. The “official” unemployment rate has passed 10% this year, months earlier than expected. And while layoffs continue at a clip of over 500,000 per week, the creation of new jobs is stagnant. The reality is that employers are finding ways to do more with fewer employees, and this trend shows signs of continuing. At the current trajectory, we will soon hit an employment level of 57%. That is, roughly 1-in-2 working age Americans are working. That compares to 2-in-3 during a robust economy. The last time we saw these levels was in the 1970s, when far fewer women viewed career as a viable option. For the first time ever, more women than men now have jobs.

(As side note from December 4: this morning’s unemployment figures show an improvement for November. While this could be an encouraging sign, I suspect there is a distortion in the figures that would be revised in January. I don’t believe this marks a sudden change in the employment scene.)

Policy Makers

Simply put, the Great Recession is here and the damage will be felt for years to come. In my view, it will be a decade before we see a return to “normal.” America needs to find a new source of growth. The consumer is not in a position to be the growth driver this time around. They are overextended on credit, underwater on their home, underemployed as a family, and wondering what happened to their 401k plan. In short, things are tough.

For the interim, the government has filled this void. With spending measured in the hundreds of billions of future tax dollars, cheap capital is flowing into the markets. This may in part explain the run-up in equities earlier this year, and the current bubble in gold and other assets. But it also explains the dramatic losses in the value of the dollar as a currency and the rush to inflation-hedging securities. Fiscal stimulus can be a zero-sum gain if not managed well, with future generations holding the “tax bag.”

Back to our parallel crisis in the late 1930s: In response to the situation, the government tightened monetary policy for fear of inflation, with the hopes of stemming it before inflation dramatically eroded the dollar. Turns out that was a bad move – leading to a double-dip economy as inflation never materialized. They may have succeeded in one aspect, but killing off the economy was not the intention.

Ironically, Bernanke did his graduate work on the Depression making him one of the best candidates to take us through this economy. He has repeatedly asserted that monetary policy will remain loose for the next six months, if not longer, allowing for the economy to mend. Many of the current policy makers have also attested to the fact that they can remove the stimulus and tighten policy before inflation roars back – sort of like Goldilocks and her “not too hot, not too cold” foray into culinary arts. The other prospect is that Congress now wants a hand in this process – if that comes to fruition then it might be time to pack you bags.

In the end, it comes down to human judgment. If the Fed gets it right, all is ok. But if they get it wrong, we face two detrimental scenarios – either a stagnant economy or hyper-inflation. Remember these are some of the same folks who thought it would be ok to let Lehman fail (in case you missed it, that was an “oops”). While they will be employing some of the best minds at solving this conundrum, we think it prudent to assume that they won’t get it quite right.

Regards,

David B. Matias, CPA

Out of the Woods, Into the Diner

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The numbers this past quarter are simply astounding, for both good and bad. The US stock market was up 16% for the quarter, the largest gain in the past ten years for a single quarter. The bond market had a similarly remarkable rebound. But at the same time, the US lost another million net jobs bringing the unemployment rate to 9.5%, and rising. On the flip-side, the percentage of total Americans employed continued its plunge to 59.5%, matching the lows in 1983. Factoring in demographic changes, we might soon face the lowest level of employment since the last World War. How does one explain such a dramatic dichotomy in the financial and economic news?

I would like to draw an interesting analogy to a book I am currently reading, Bill Bryson’s A Walk in the Woods, that tells the story of his hiking various portions of the Appalachian Trail with a good friend (to the best of my knowledge, he really did hike it). In the book, their daily routine would consist of hiking ten or more miles with heavy packs, sleeping in wet tents and subsisting on a daily allotment of dried noodles. Then after a week or more of this routine, they would temporarily leave the trail and look for a motel. Bryson remarks on the transformation from wilderness conditions to the conveniences of civilization such as home-cooked meals, a soft bed and a hot shower.

Bryson repeatedly describes just how amazing they felt reentering the civilized world, while in fact the motels they slept in and the meals they ate were probably some of the worst examples of modern hospitality. Given the contrast to living in the woods, it didn’t matter how dirty the motel or greasy the diner they frequented. It was simply delightful.

We have experienced much of the same in the financial markets. As recently as early March, the world looked like it could end. Fear ran throughout the financial world and stocks as well as bonds were sold into oblivion. Since then, we have migrated away from the Armageddon scenario and now simply face a crummy recession for the next year or more. In comparison to Armageddon, 10% unemployment looks simply stellar.

The reality is that we’re in one of the worst recessions in generations. The relief that we’ve seen in the past quarter is one based in the perception that things are getting “less worse.” Unemployment is increasing, but the rate is slowing. Home prices are still declining in many areas, but not all. In fact, April home prices improved in six of the twenty major city centers. And as recently as this week, China’s growth engine may be showing signs of resuming.

The hope is that as soon as bottom is reached in many of the key economic sectors the overall rebound will be quick. This could be the case, causing some of the spurt in the market this past quarter. It is by no means a guarantee, however, and we are still in a very difficult situation. The falling employment levels not only reduces consumption but puts a further strain on home prices. Banks are reluctant to lend, and have done little to increase credit since the heart of the crisis. Not only is employment down, but so are wages and hours worked. House foreclosures are clipping at a ferocious pace.

For these reasons, we continue to remain cautious in our risk taking and asset allocation strategy. we have cut our equity exposure to half of the long-term target and used the excess cash to purchase investment grade bonds with unique structures and attractive yields. The next part of this update reviews the markets in depth.

Equities

The stock market, or equities as I refer to them, is in fact the least interesting market for us today. Yes, the S&P 500 had a stellar rise this past quarter but for the year to date the stock market is still showing a loss (down 3% as of this writing). That is not a remarkable performance, especially given the level of volatility we have seen this year. The key driver here is the economy, with an expectation that corporate earnings are going to be depressed for several quarters to come.

There are still bargains to be had in the equities market, but they are going to take much longer to realize and it will be a bumpy ride. Information technology has been the best performer to date, showing a net gain of 10% for the year. Industrials, on the other hand, continue to face pressure from names such as General Electric and Alcoa. As the global economy begins to right itself, everything from commodities to industrial manufacturers will see the benefits to their bottom line. After more than a year of capacity reduction and expense trimming, the best managed firms will reap some of the greatest profits.

As we track the equity markets, we pay close attention to the VIX, or volatility indicator. Reported as the expected future volatility of the S&P 500, on an annualized basis, VIX is finally coming back in line with levels that we experienced before the crisis. In a stable bull market, VIX reached into the low teens. During the crisis when all the risk models collapsed, it peaked at 89. A level in the 20s indicates that we are back to market stability, above that is unclear. For us the magic number is 30, which is where the VIX is hovering right now. For the duration of this summer, we are likely to vacillate between these two ranges as the market consolidates and gains comfort in the notion of long-term stability despite a recession.

Consistent with much of the technical analysis we have seen in the past few months, we believe that the S&P 500 will continue to gradually slide this summer. After being down 7% from its recent peak on June 12, we would not be surprised to see another 7-10% drop. Longer-term, however, still shows that equities have some room for improvement this year, but unlikely to exceed a level of 1,150 on the S&P 500, or up 20% for the year.

This all depends on the factors above: a strong decline in job losses, home price stabilization, and of course an improvement in corporate earnings.

Fixed Income and Inflation

My biggest concern, and our closest focus this past quarter, is inflation. Currently the US Consumer Price Index shows that we are in a mild deflationary environment, or declining prices. This is due to a combination of price cutting by companies, excess labor, and a steep drop in commodity prices. As the economy strengthens, fueled by the tremendous stimulus spending by the US as well as foreign governments, there is a risk that inflation comes back with a vengeance. While a few economists are predicting hyperinflation, one thing is certain – inflation will kick back in again. It is less likely to be 2%, as targeted by the Fed, than 8% as predicted by some. We’re planning on something in between at roughly 4-5%.

Combined with this view and the current economy, we have been active in placing a variety of fixed income instruments into portfolios, from US Treasury Inflation-linked ETFs to LIBOR and CPI floating rate corporate notes, that will increase in value with inflation. Some of these instruments are insanely cheap from the aftermath of the crisis. Others are fairly priced given the current CPI and will increase rapidly with inflation.

In addition to inflation-oriented fixed income, we have also augmented the portfolios with strong yield corporate bonds that were battered by the liquidity crisis in February and March. Some of these are common names, such as FedEx and GE. Others are less common but still investment grade credits with solid balance sheets and cash flows. Irrespective of the method, the result has been the same. We are seeing either abnormally high yields with these corporate bonds or significant price appreciation, sometimes in just a matter of weeks.

The net of all these moves is that we have side-stepped the volatility from the stock market while maintaining upside as the economy improves. Our returns have reflected this positioning. While we have dramatically lowered the volatility and risk in the portfolios, we have maintained steady gains in line or ahead of the market. While your individual returns will vary based on the specifics of your risk profile and portfolio, we are happy to see solid performance across the board.

Look for a quarterly performance report with commentary in the coming two weeks. In the interim, if you have any questions or concerns, please do not hesitate to call or write..

Regards,

David B. Matias, CPA

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

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

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