Issue 49 - January 12, 2009

The Year in Review

2008 proved to be a watershed year for financial markets. The reckless use of leverage ultimately proved too much for many to handle, from individual homeowners to large corporations and financial institutions. The unwinding of this leverage negatively impacted virtually every sector from stocks and bonds to commodities and real estate and liquidity asserted itself once again as a relevant investment consideration. Unlike a typical slowdown where financial markets suffer at the hand of the economy; 2008 was a credit crisis which led to a global recession. Markets will face further challenges in 2009, but policy responses of historic proportions have been put into place and evidence of improving conditions within the short term credit markets is an important, initial, positive sign.

The Path Forward - Valuations, Return to Fundamentals, Stimulus


While the economic reports will continue to be grim for some period of time, history has shown time and again that markets anticipate a rebound and move forward well before the economic news provides the “all clear” sign. In addition, the need for liquidity in 2008 disproportionately punished the value of high quality assets as they became the best available sources of funds for those in a desperate position. Fundamental research and diversification, which for many years have been overshadowed by the promise of engineered alternatives, should also see a renaissance. The combination of these factors coupled with the policy responses of ultra low interest rates and strategic capital infusions by the US Government will provide a powerful remedy, but it will take time.

2009

Equities
There is enormous speculation surrounding current equity valuations. With the US consumer currently on strike, earnings estimates have become a matter of faith. However, trailing P/E ratios are running at substantial discounts to their 20 year averages. For example, JP Morgan calculates that as of 11/30/08, the P/E on the Russell 1000 Value was running at 62.6% of its trailing 20 year average and the 1000 Growth was at 45.1%. If we consider that high quality companies with the best balance sheets are available at these discounts, investors may draw comfort in the knowledge that the market is providing a cushion to the bad news that is yet to be revealed.

Bonds
Municipal bonds remain attractive by any measure – relative or absolute. After trading at a percentage of 80-90% of comparable US Treasuries for 15+ years, Municipals find themselves priced closer to 200%. In part this is a reflection of how expensive US Treasuries have become. This is more a tale of supply and demand where the failure and consolidation of a number of market makers and hedge funds has temporarily overwhelmed the market place. While there are real risks associated with some lower quality names, Municipals have a long history of resiliency through recessions. In addition, looming higher individual tax rates only serve to make this sector that much more attractive.

Commodities and Currencies
The deleveraging process took its toll on commodities in 2008. After topping out at over $147 in July, crude fell over $100 to finish the year below $40, a stunning reversal. Clearly speculation had played a significant role in the price spike and current levels may reflect an oversold position. However, the global slowdown should keep a cap on demand and subsequently prices in the near term.

The US dollar versus the Euro finished up 2008 at 1.40, almost exactly where it began the year (at 1.47) with a heck of a lot of volatility in between. Concerns surround both of the world’s leading currencies. The potential size of the US deficit will pressure the dollar, but the Euro zone is struggling with the dramatically different needs of its individual member countries. Furthermore, creditor nations such as China have no interest in seeing either currency suffer given the size of their debt holdings. Given the global needs of a low interest rate environment it would be fair to expect some stability.

Real Estate
Perhaps the biggest challenge facing the US economy is how to stabilize the housing market. The continuing deterioration of housing prices eats away at bank capital like an old game of “pac-man”. Even with the infusion of capital by the federal government, banks remain cautious lenders as the value of their outstanding loans has yet to be stabilized. There is already an enormous overhang of unsold homes and the growing run of foreclosures only adds to this. There are ongoing discussions of plans where the Treasury would be the buyer and holder of these properties until such time that supply and demand come back into equilibrium. Whatever the case, the Federal Reserve recognizes that the economy can not wait for the banks to regain their health. They are providing more programs which make credit directly available to borrowers outside the banking system. In this way, the healing process can work simultaneously for both banks and borrowers.

Patience
2009 will not be easy. The ongoing economic news will be troubling. Job losses will escalate and consumers will continue to retrench. The US Government will in part replace the US consumer as the borrower of choice. But despite their best efforts, US Government spending will only be a fraction of the consumer potential. On the positive side, as a society we are looking at investing in areas of our country that may provide both short and long term benefits. We have taken the painful steps to break the cycle of reckless leverage and have closed those businesses which only survived through high level of indebtedness. Patient and disciplined investors should be rewarded over the coming years for their willingness to look beyond the headlines.

• The Year in Review
• The Path Forward
• 2009