10.15.20082008 3rd Quarter Client Newsletter Economic Update: Can’t Avoid a Recession Now? The world economy is in the midst of its worst times in decades due to the excess leverage over the past two decades. The credit crisis, the bursting of the commodities bubble (energy and industrial materials), weak unemployment, and wealth destruction are all extremely deflationary, and inflation concerns have evaporated. Unemployment increased to 6.1% in the 3rd quarter, the highest rate in five years. The housing market continues to decline as do new housing starts. We believe the housing problems need to stabilize before the banking system can begin to recover. Unemployment will escalate as companies lay more people off due to business credit constraints and softening consumer demand for goods and services. We have added an appendix to the newsletter to explain the credit crisis, because of its publicity and severity. We explain the problem, the cause, the affects and the remedies. Market Update: Beyond the Bear? The ride of late has resembled the downhill leg of a roller coaster with no brakes. Through October 10th, the S&P and the NASDAQ were down more than 42% from their highs in October 2007. The stock market continues to work-off its high valuations dating back to 2000. From 1982 to 2000, the S&P 500 gained a cumulative 1000%. The bull market culminated with historically high valuations in terms of price/earnings (P/E) ratios and profit margins. It is taking many years to unwind these valuation excesses. The significant decline in the stock market has improved stock valuations. The S&P 500 is trading at a P/E ratio of 17, compared with valuations just a few months ago of 25. However, even though stock valuations have improved significantly over the last month, US stocks are still not cheap. Historically, as markets re-value from excesses (going back to 2000), they don’t only revert to their mean (P/E= 15), they overshoot and become quite cheap. Individual investors and investment advisors are 60% and 53% bearish, respectively. Can you blame them? There bearishness is a result of the news of late; it was not in anticipation of the bad news and market sell-off. Investor sentiment is usually a reaction to the news. These sentiment extremes occur near market bottoms. We believe that once confidence returns to the financial system, the probability of a bear market rally is high. We, as contrarians, believe the negative investor sentiment is an opportunity to buy. The investor sentiment will change to the positive after the market recovers. Portfolio Update: “Buy when others are fearful and sell when others are greedy.” (Warren Buffet)? Our decision to reduce equity risk last November, avoiding the 40-55% loss on world equity markets, has turned out to be very beneficial. Although our investment portfolios have outperformed the equity markets year-do-date, we have not been spared from the devastation. Typically fixed income investments (corporate and government bonds, collateralized bank loans, government-backed mortgages) are much safer than stocks and much less volatile. The sell-off in corporate debt securities has been spectacular and way overblown. Most of these declines occurred in the last month. Corporate bonds (investment grade and high-yield) are reflecting expectations worse than the Great Depression when inflation, interest rates and unemployment were much higher than they are today. As Warren Buffet has invested in GE and Goldman Sachs, we too have been buying equities at these depressed levels. We believe the equity markets will surprise investors to the upside in 2009. We are positioning portfolios for this as we have added positions in emerging markets, US high quality equities, and corporate bonds. The market declines have been extreme. We want to stress the current crisis will end and the sun will shine again. Successful investing is not a day-to-day activity – it is a long-term process. The most vital ingredient is patience. Especially during these trying times, we thank you for your continued trust and support. Trevor K. Holsinger, CFP? Overview and Analysis of the 2008 Credit Crisis? Currently, the world economy is suffering from a severe lack of confidence in the financial systems resulting in a freeze in the credit markets. By “freeze” we mean, banks are not willing to make loans. The well publicized failures of various financial enterprises worldwide beginning with Countrywide and Bear Stearns and followed by Northern Rock in the UK, Fannie and Freddie, Lehman Brothers, AIG, and others have led to government intervention on a scale last seen 80 years ago. This freezing of the credit markets has severely constrained most company’s ability to conduct business as usual. What Caused the Credit Crisis?? Traditionally, banks make their money (profits) by accepting deposits from and loaning money to their customers. The interest rate that banks pay to depositors is less than the interest rate banks charge to borrowers. The difference between the two rates is the “spread” or the bank’s profit. Bank customers range from Aunt Mary (savings account and car loan) to Pete’s Imports LLC (checking account, line of credit, letters of credit) to IBM (business deposits, business loans) to another bank (short-term commercial paper loans from one bank to another). The banking system of borrowing and lending works as long as the customers have confidence to make deposits in banks and the banks have confidence in their borrowers. In addition to making loans, many banks (particularly very large ones) pursued other ways of making a profit. Such Big Banks (and a few large insurance companies) saw an opportunity to invest in a variety of high-yielding corporate debt and structured investments, some of which contained sub-prime mortgages (CMO’s). Investments in sub-prime mortgage pools would ordinarily be akin to low-grade junk bonds. However, investment banks structured new investment vehicles (SIV) containing sub-prime mortgages by slicing or “tranching” the mortgage pools into thirds and assigning different repayment priorities and risk to each pool. The major rating agencies (Standard & Poors, Moodys) rated the least risky of the tranches “AAA”, the highest credit rating possible in the investment world. If these investments were not rated AAA, banks and other investors would not have bought them. If the banks didn’t buy them, the real estate bubble wouldn’t have been so exaggerated and the current credit crisis wouldn’t be nearly as severe. These investments should have never been rated AAA! At first, these investments performed wonderfully (the housing market was booming). The returns were so good that these Big Banks (and insurance companies) decided to use leverage (borrowed money) to buy more CMO investments. Large investment banks who created these investments were the holders of much of the worst of these CMO’s (the third slice which took the first of any losses but paid the highest yield). No worries – as long as the underlying sub-prime mortgage borrowers kept up with their mortgage payments. Then the low, temporary “teaser” rates reset to much higher mortgage rates, the housing prices stopped appreciating and the home owners could no longer afford to make their mortgage payments. The CMO’s stopped being such great investments. Typically, commercial banks were required to maintain capital reserves or equity equal to 6-10% of the value of loans outstanding. This capital reserve was intended to cover any loan defaults that might arise to ensure that any money borrowed by the bank (customer deposits) could be repaid even if money loaned out wasn’t recovered. Under normal circumstances, good banks experience very low loan losses – far less than 10%. Instead, the banks began to use more leverage which works fine as long as the investments from the borrowed money provide a positive return. When the leveraged investments decline in value, the investor (Big Bank, insurance company) may suddenly owe more than the investment is worth. For example, if the investor is leveraged 10 times to 1, for every $1 the investor puts in as equity, he borrows (owes) $10 for a total initial investment value of $11. If the value of the loans and investments decline 20% to $8.80, the investor has lost his entire $1 plus $1.20 of the $10 borrowed. The investor is now worth -$1.20. What made the credit crisis of 2008 far from normal is that losses exceeded normal levels, because loan losses and investment losses occurred at the same time. To make matters worse, many of the investment banks were leveraged 30 to 40 times to one, not just 10 to 1 in our example! What is the impact of the Credit Crisis?? Banks don’t trust other banks: Banks lost confidence in each other – not knowing the strength of the other bank’s balance sheet; they stopped lending to each other. The Big Banks (and AIG, et al) were in such dire straits that private investors were not confident to invest in these entities. As the credit crisis has unfolded, the required confidence in repayment has steadily declined. Depositors withdrew deposits: individuals and businesses lost confidence in the Big Banks and took their money elsewhere (Treasuries). Banks which needed to de-leverage and recapitalize called in loans made to Pete’s Imports and IBM and told Aunt Mary to forget about the new car. So Pete can’t buy inventory and has to lay off employees as does IBM. Neither Pete nor IBM can buy imported goods, because the banks guaranteeing their letters of credit (LOC) aren’t trusted. LOC’s are the vehicle for international payments. GM can’t sell cars, so they shut down some factories and layoff more people. Since fewer people are employed and business sales are down, so are bank deposits. Big Banks need deposits to recapitalize and keep making loans. It is a vicious downward spiral. What is the solution?? The economy is based on trust. We trust that a dollar is worth something. We trust that if we perform a service or produce a good, we will get paid. We trust our money is safe in the bank. Without trust, we have anarchy, not an economy. Banks are de-leveraging and recapitalizing. De-leveraging occurs when the banks sell their assets/investments and pay down their debts. Recapitalizing is the when the bank sells equity to investors. In both cases, it lowers their risk. In the end, the last resort to help stem the rapid deterioration of the global financial system was government intervention. The US federal government took over Fannie and Freddie and AIG. Although not perfect, the TARP rescue bill passed by Congress was a key step toward restoring confidence. The US Federal Reserve and Central Banks around the world have been injecting massive amounts of cash into the world financial system in an attempt to get credit flowing again. In addition to the $700B TARP bailout, the FDIC will insure bank accounts up to $250,000 per account owner through December 31, 2009. The US Treasury will guarantee money market funds and provide short-term loans to businesses. The Treasury has also opened its vault to Big Banks in need of short term loans. In Europe, Central banks are guaranteeing all deposits in all banks. Governments around the world are intervening on increasing scales to help alleviate the credit crisis. In time, we believe that these efforts will succeed and credit will flow (banks will lend) again. One reason the Great Depression was so severe was the lack of money. The federal government extracted capital from the economy assuming it wasn’t needed. Their thought was if businesses were going bankrupt and Americans were unemployed, then they didn’t need as much money. This concept was errant and Bernanke understands the Great Depression as well as anyone. He understands the need to supply money to the economy in times of stress. This is exactly what he is doing. As a result, this won’t turn into the next Great Depression.