Written by: Gary Silverman, Wealth Management Practice Leader

These have been very trying times in the markets for many people, individuals and professionals alike.  The portfolios we oversee for clients are down and that never makes us feel good even when, like today, we’re down significantly less than the overall markets.  Although there’s a lot of angst and uncertainty right now, things will get better and patient investors will be rewarded.  We invite you to read this letter to get a sense of how we see the world and the markets currently, or if that is not your cup of tea, at least read the last section entitled “What should you do now?”

Contents

• Economic background and update

• Portfolio management review

• Economic outlook

• Portfolio philosophy and outlook

• What should you do now?

• Appendix: Comparisons to the Great Depression

In the last quarterly letter I attempted to describe, in plain English, the mechanics of what’s been going on in the world economy and financial markets. In this letter, I will summarize some of that information again and further hope to convey what we see as the implications and outlook of the ongoing situation.

Economic background and update
In short, home sales slowed and home prices began to fall in earnest in the spring of 2007. At the same time, interest rates were increasing on many over-leveraged adjustable rate mortgages.  As defaults on the riskiest of these mortgages (the so-called “sub-prime” loans) increased, banks and other institutions holding these mortgages, either directly or through a variety of complicated and esoteric structures, found their balance sheets impaired.  At this point, they essentially stopped lending while they tried to firm up their own reserves.  This had a ripple effect because companies and individuals suddenly found it hard to get the financing they needed to support their businesses or buying habits, creating ever more financial stress and a further tightening of available credit.

How did we get here and who is to blame?  We don’t think it helps to dwell on where to lay blame.  It’s not constructive and doesn’t provide any insights into what to do going forward. But since many people have asked us about this, let us say simply that there’s enough blame to go around.

Politically, Democrats are largely responsible for trying to accomplish a worthy social agenda (low income housing) through inappropriate vehicles - specifically the government sponsored entities of Fannie Mae and Freddie Mac – by lowering credit standards enabling people of more questionable creditworthiness to get mortgages.  Although a worthy social goal, economically it created risks greater than the system was designed to absorb.  The Republicans are to blame as well.  They pushed for the deregulation that tore down decades old safeguards keeping bank’s capital reserves safe from the risks and leverage of investment banking operations.  With these safeguards down, commercial banks rushed in to the investment banking business, either underestimating or not understanding the risks involved.

There were predatory lending practices on the part of certain mortgage brokers who cared more about their own commissions than doing the right thing for their clients.  Certain purchasers were to blame as well for buying more house than they could reasonably afford.

It is important to note that up until recently, the problem was concentrated in the credit markets, not the “real” economy.  But, when big organizations such as Fannie Mae, Freddie Mac, Bear Stearns, AIG, Lehman Brothers, Merrill Lynch, Wachovia and Washington Mutual (among others) needed to be bailed out or face bankruptcy, rational people began to question whether the entire financial system was at risk of imminent collapse.  This, combined with the negative wealth effect created by falling home and equity prices, turned concern into fear and fear into panic.  This panic was manifested in the shockingly severe sell-off that commenced in the waning days of September and continued through most of October.

However, there has been a tremendous amount of stimulus and government support for the credit system by the US Treasury and the Federal Reserve, as well as their counterparts around the world.  And whether you agree with the specifics of the interventions or not (largely we do not), the fact is that the government has shown it will do whatever it takes to protect the integrity of the system.  Liquidity is being restored albeit quite slowly and unevenly.  We may be seeing a bottom to the housing crisis, though it will still be some time before that market returns to normal.  Existing home sales nationwide jumped 5.5% in September and the stock of unsold homes is starting to decline.  The cost of home ownership compared to renter’s equivalent expense is starting to normalize.  Additionally, inflation pressures abated as oil and other commodity prices fell significantly in the third quarter providing additional relief to the consumer.

But, the October market drop in equity prices wasn’t just a result of sub-prime induced fear. There is clear evidence of a significant slowdown in economic activity, both here and abroad, stretching the consumer even further.  Forecasts of corporate earnings have been lowered.  Large job losses in September pushed the unemployment rate to 6.1% and up to 6.5% in October.  Consumer confidence dropped to an all-time low of 38.0.  While unemployment and consumer confidence tend to be lagging indicators of economic performance, leading indicators such as durable goods orders and the purchasing agent survey are also down, quite significantly in the latter case.  Gross Domestic Product (GDP) contracted 0.3% last quarter and we expect another 2% decline this quarter followed by a 1 – 2% decline in the first quarter of 2009.  There is a substantial risk that GDP in the second quarter of 2009 will be down as well. This means we are likely at the beginning of a prolonged recession most analogous to what the US experienced in the mid-1970s.  Although we do not want to minimize the seriousness of this downturn, we need to stress that we do not think this will become another Great Depression (a la the 1930s), although we recognize that many people and respected publications are making that exact comparison.  If you would like to see our take on the differences between then and now, please see the appendix to this letter.

Portfolio management review
Although we are quick to point out how this is no Great Depression, we also want to assure you we are not sanguine about the situation.  Indeed, our suspicion about the quality of the US economy and US equity prices began in 2006 (approximately) when we further increased our exposure to foreign equity markets.  In early 2007 we increased cash as we shed our real estate and small cap holdings.  We added to our cash position (in certain accounts) toward the end of 2007 when we did some tax-loss harvesting.

We kept the overweight in international equities through 2007 (smart) and 2008 (not so good).  The contagion of the US financial turmoil spread to both developing and emerging markets with much greater speed and ferocity than we anticipated, particularly in the second half of 2008.  Likewise, our commodities holdings helped us earlier in the year but worked against us in the third quarter.

With this overweight position in cash, we did not feel the need to sell into the panic as everyone else rushed (and may still be rushing) to the exits.  That is not to say we are cheerleaders for the US economy or equity markets at this time.  Indeed, in one of our earlier emails to clients we warned that another major bank such as Wachovia or Washington Mutual was at risk of failure several weeks before both banks eventually had to be acquired to survive.  We still believe there could be more downside surprises.  The International Monetary Fund, IMF, recently increased their estimate of future write-offs tied to the sub-prime mortgage market by close to $500 billion. The failure of another household name is a very real possibility.

Economic outlook
So, what does the future hold?  As we’ve seen, there is both good news (though not much) and bad news out there.  We continue to watch employment, earnings, and a variety of other economic data including credit card and auto loan default rates (and the credit quality and liquidity of the structured products based on them).  Commercial real estate default rates are also on our radar screen as we head into an economic slowdown, but to date, these have remained at less than 1%.

While we are never sure what the markets will do day-to-day, we are confident that five years from now, we will look back at this time as a good time to have been buyers (the best time to be buyers may still be in front of us, but this will still be a good time).

We believe that in the short- to intermediate-term there are a few likely scenarios.

1. The recession is a bit deeper and longer than usual (relative to recessions over the past 20 years), but is over by summer 2009. Since markets generally anticipate economic recovery by six months or so, we would expect equity markets to rebound sometime this winter.  In this scenario, equity markets would stay in a trading range between now and then.  We view this as best case.





2. A deep and prolonged worldwide recession lasting well into the fourth quarter of 2009 or the first half of 2010.  Unemployment hits 8+% and markets go down another 10% from here.  Again, the rebound would precede the recovery by 6 months, so we would be looking at a summer 2009 up turn in the equity markets.





3. A double dip or a single very deep, continuous recession that is deeper and longer than anything we’ve experienced in the last 30 years at least. Unemployment peaks at over 10%.  Markets may rebound between now and springtime (in what is often referred to as a “relief rally”, a “sucker’s rally” or “dead cat bounce” depending on your perspective) before the depth of the gloom is fully acknowledged, at which point we may see another 20-40% slide continuing into, and perhaps through, 2010.

In reviewing the above, you can see the big problem.  Scenarios one and three will look and feel similar until they diverge in the spring or early summer.  That’s why we favor economic data over market data.  (As an aside, the average volatility of both GDP growth and corporate earnings growth is 1–2% while market volatility is in the range of 16–18% implying there’s a lot more noise in the equity markets than the real economy.)

Portfolio Philosophy and Outlook
As we’ve discussed, our goal is to capture 80% of the upside of the market when markets are up and 40 – 50% of the downside when markets are down. We accept some degree of market volatility understanding that markets are mostly efficient and market timing doesn’t generally work.

That being said, we dynamically manage the asset allocation to reflect changing economic and market environments in order to manage risk.  Why do we take this approach? Simple math. For example:

• When markets are down 50%, it takes a 100% return to break even. With compounding, and an average annual return of 10%, the markets will have recouped its losses in just over 7 years.





• If we are successful at capturing half of the market slide (25% in this example), we need a 33% return to break even. At 8% annually on average (80% of the market’s upside), this would take our portfolios about 3.5 years.





• During the subsequent 3.5 years we are adding to profits while the markets are still playing catch-up.
   

Investing is not about guessing right.  It’s about maximizing the probability that your portfolio will compound over time.  (Remember, it was Einstein who said compounding was the most powerful force in the universe, and who are we to argue with Einstein?)

Through September, we were mostly successful in achieving our goal of limiting downside losses to 50% of the market loss.  However, during October’s precipitous slide we lost ground relatively speaking (although still less than the market loss).

Going forward, we are keeping a conservative risk posture and looking at where value can be found in the current market.  Pickings are slim, but we see opportunities in certain parts of the fixed income markets, specifically in high quality corporate bonds, municipal bonds and short-term treasuries.  Equities are priced attractively right now when compared with history or when compared with bonds.  However, markets tend to overshoot “fair value” on both the upside in a bull market and the downside in a bear market, so although priced attractively now, they very likely may slide further before recovering.  US equities seem more favorably positioned than international equities.  Although it’s too early to commit to equities, we must be careful about not selling at or near the bottom either.

Additionally, we are actively exploring enhanced cash management approaches to keep our clients' money safe and working hard for them during these turbulent times.

What should you do now?
Focus on the important things – your health, your family, your career and the other things you care deeply about.  Avoid reading (or watching or listening to) the mainstream media’s coverage of market events, at least not every day.  Not only are they more often wrong than right¹ , there is a frequency effect.  If you checked the markets only once a week, the volatility would seem much more subdued than if you check it three times a day.  Focusing on it once a month has an even greater calming effect.

If you are still concerned about the market and the economy, reign in your spending to whatever extent you are comfortable.  Not only will this enable you to save more, it will make you feel better if you approach it in the right spirit.  If there are things you need, now is a great time to look for sales. (I just bought a pair of Wrangler jeans for $5.99 on sale with a store coupon.)
 

Appendix: Comparison to the Great Depression

We have heard it time and again from the print media, TV and radio commentators, as well as in our own social circles and business interactions. We’re heading into another Great Depression.  Time Magazine even had a picture of the 1930s soup lines as the cover photo of a recent issue in early October (right around the time of the recent market low).  However, predictions these dire are not well-founded in our opinion. Let’s look at the facts:

Residential Real Estate: In the current crisis, new housing starts have fallen by 64% vs. a drop of 89% in the 1930s.

Mortgages: Owner occupied residential mortgage default rates are under 4%. In 1934 they peaked at 43.8%.

Banking System: 40% of US banks failed from 1929 – 1933 (and this was before FDIC insurance safeguarded those deposits). Year-to-date there have been 15 bank failures (out of 8451, or less than 0.2%) and no individual has lost any money on an FDIC-insured deposit.

Gross Domestic Product (GDP): GDP fell 0.3% in the 3rd quarter of 2008 and rose only 2.1% over the trailing 12 months. During the Great Depression, GDP fell more than 26%.

Unemployment: Unemployment is at 6.5%. During the Great Depression, unemployment went over 25%. (An unemployment rate of 4% is generally considered “full employment”, so today we are just 2.5% over this target.)

Economy: The US economy suffered its only 4 year period of contraction from 1930 – 1933 whereas we have just experienced our first quarter of contraction during this crisis. (Note: The markets rebounded significantly starting in 1932; 6 – 12 months ahead of the turn-around in the real economy.)

Stock Market: The S&P has declined approximately 40% since October 2007 vs. a market decline of 86.2% during the Great Depression.