This Too Shall Pass–

This weekend’s news of Lehman’s bankruptcy, Merrill’s distress and purchase by Bank of America, and troubles with AIG is distressing, indeed. What we’re seeing are the chickens coming home to roost, as the free markets begin the important process of weeding out the bad apples and beginning to rebuild trust and confidence in the US and global banking system. This is a necessary and highly beneficial purging of the excesses of the past, and proof that sometimes regulation is needed and good. Witness the number of hard-core free marketers calling for increased regulation.

Unlike past traumatic events, however, the good news is that the Federal Reserve, US Treasury Secretary, Securities and Exchange Commission, and the financial and banking industries are cooperating to help alleviate the situation by forcing parties to find solutions and providing substantial liquidity to help ease the credit crisis. Some entities – Fannie Mae and Freddie Mac – have been deemed "too big to fail," while others, like Lehman Brothers, addressing the issue of “moral hazard”, will be allowed to fail, a clear message that poor behavior brings potentially dire consequences. We see this as good, and so far the process has been quite orderly.

In our opinion, the huge resources of the US government should not be underestimated, and there is clearly a commitment to limit the impact. While there will continue to be concern about certain overly aggressive institutions like Wachovia and Washington Mutual, the vast majority of local and regional banks are sound, and the banking system should be able to weather the storm. There are few major brokerage firms of the size of Lehman Brothers left to be concerned with (i.e. Goldman Sachs, Morgan Stanley), and their situation appears far less problematic. Some of the European institutions may be challenged, however, and international insurer AIG remains another open issue. We see continued pressure on the financial sector as a whole, even with some of the insurers. The overarching issue continues to be lack of transparency – no one knows exactly what many of the institutions are holding as assets.

Clearly, there will be plenty of finger-pointing at the end of the day. Unquestionably, we are all suffering for the lack of proper regulation and the easy merging of investment banks, the insurance industry, and securities industry – hallmarks of the free-market fringe.

That said, we can’t imagine a scenario where there would be a major run on banks, given the government’s commitment to supporting the banking industry, as exhibited by the effective handling of IndyMac and Countrywide banks earlier this year. We’re not saying it can’t happen – and banks like Wachovia and Washington Mutual may be hit -- but the probability is extremely slim that it would become system-wide, despite headlines.

In our last newsletter, we saw several trends that led us to take an increasingly cautious position regarding the equity markets (July ’08). We essentially continue in that perspective. While we correctly anticipated that the commodity bubble was nearing its end (oil has, in fact, dropped from $145 to $95 since then), we saw that a global economic slowdown was pointing to a delay in a solid rebound for equities, and we had become more defensive. We’ve anticipated increased unemployment for some time as another leg in this slowdown, and we expect this to remain an ongoing problem.

We do see some positives, however. For example, the dramatically reduced prices of commodities are acting effectively as a tax cut, although gas prices have risen recently with the hurricane impact. This should help reduce input costs throughout the corporate process and reduce some consumer pressure. Homeowners will also probably be looking at lower costs for natural gas and home heating oil than anticipated. Moreover, this means that inflation is far less of a factor for now – extremely good news – and gives the Federal Reserve latitude to ease rates or otherwise provide more liquidity.

The housing crisis may also be seeing a light at the end of the tunnel. Mortgage rates have finally dropped and housing price drops of 25% or more in many locations have burst the real estate bubble and made housing more affordable. With added liquidity from the Federal Reserve along with the resolution of some of the uncertainties in the credit markets, the slow healing of borrowing and credit markets may begin.

Despite many advisors calling this a "market bottom," we remain in our defensive position, and our negative conviction is somewhat increased at this point as we see the increased debt burden to the government of the added liquidity to shore up the credit markets as only adding to the economic drag and reduced ability to borrow globally. We would not be surprised to see market rallies around any perceived shoring up of the financial sector, and there will be good opportunities here and there, but we just don’t see sustainable upside of the broader markets until we’re further through the housing situation and see significantly more available credit generally. In simple terms, it’s hard to buy a home at these distressed home prices if one can’t get a loan, and right now, getting a loan is a challenge.

We must, however, keep in mind, that market rebounds are usually rapid and unpredictable, with a large percentage of gains taking place in a short period of time. For this reason, our approach is to stay diversified, and be opportunistic. Many of the prices of stocks today will be seen as tremendous values in the future.

Just as the Enron and WorldCom debacles earlier in the decade intensified scrutiny of corporate accounting and led to an improvement in analysis, important lessons are being learned here, and our system will be improved.

Portfolio Actions.  

We’ll be looking to reduce equity positions somewhat over the next few weeks, perhaps even selling into small market rallies. We’ll also be vigilant about identifying market opportunities. Many companies are nearing very appealing prices. We ask our investors to keep the long term picture in sight, and continue to dollar cost average purchases through investments and retirement plans. This too shall pass.