Q3 2008 Notes on the Quarter

Q3 2008 Notes on the Quarter

Overview of the Quarter:

  1. The stock markets weakened during the third quarter along with commodities. Lehman Brothers collapsed, AIG was rescued last minute by the Fed and Merrill Lynch fell into the arms of Bank of America.
  2. No longer a housing crisis, the credit markets began seizing up as financial institutions no longer trusted their counterparties’ collateral.
  3. Reserve Fund, the oldest money market in the U.S. “broke the buck” due to the Lehman failure, which in turn squeezed corporations and investors who couldn’t get access to their funds.
  4. Banks pulled in credit lines because the demand put too much pressure on their capital, leading to a further credit squeeze on corporations.
  5. Investors started pulling their funds out of hedge funds, forcing sales—driving down the previously hot areas of the market such as commodities and energy stocks.
  6. The liquidation of leveraged funds led to margin calls which led to even more selling.

Portfolio Specifics:

  1. Everything is getting hit. Stocks, bonds, real estate, commodities—you name it. Unwinding the leverage has led to panic selling of anything possible. Buyers have stepped back from the markets until things become clearer and this has led to mispricing, in both the fixed income and equity markets.

    Many bonds of solid companies are priced as if they are barely surviving. Four week U.S. Treasuries are yield 0.05%! Such extremes are making portfolios valuations markedly worse than we believe is reasonable. When buyers come back into the market and prices become more realistic, valuations will jump dramatically.

  2. Covered call writing strategies have helped to significantly hedge losses. We will continue to utilize the strategy as volatility is unusually high.

Looking Ahead:

The Big Picture

The collapse of the securities markets over the past month has taken everyone by surprise; it will take many months before enough information came be obtained and sifted through to truly understand everything that caused the collapse. Indeed, it is not even over yet. The rest of the world markets are just starting to catch up to what the U.S. has been through.

What we know for certainty is that the massive leverage being utilized in the economy was much greater than anyone understood. Common knowledge had it that just U.S. consumers, with our arrogance and extravagance, were leveraged and were spending ourselves into oblivion. Turns out “they” were wrong—most of the entire world was playing the same game. The average German bank is leveraged 50:1. Iceland’s entire economy and currency has collapsed, its major banks taken over by the government. Japan announced the takeover of its first insurance company and additional capitalization of its largest bank.

The banks and investment banks were leveraged, so were insurance companies. We already knew individual consumers were leveraged, and by this past summer investor margin levels reached new highs. To top it all off, regulators have been asleep at the wheel. They have ignored many of the signs and refused to enforce regulations that were in place.

So, what to do?

  1. It is likely that the amount of leverage used around the globe will continues to contract, and significantly less leverage will be acceptable for some years to come. Thus, it would be reasonable to postulate that the global economy has been growing at an artificial high rate for five to ten years, perhaps longer, and that would suggest the average rate of economic growth going forward should be significantly lower.
  2. The United States accounted for 23% of the globe’s economy in 2007. Japan’s economy was the second largest at just under 8%. Thus, a delinking of the world’s economies is unlikely. Of the fastest growing economies, approximately 35% of China’s growth has been due to exports. The same is true for South Korea. Mexico can attribute 26% of its growth to its exports, Japan, 16%, 13% for Australia, 12% for Brazil and 10% for India. Thus a slow down in the U.S. and Europe will impact the emerging markets, but to varying degrees.
  3. Both the stock and bond markets are oversold. Volatility is at higher levels than ever before and many securities are irrationally priced. This indicates panic and when everyone else is selling, it is a good indication that it is time to buy.

There are two questions we have to answer: 1) if stocks and bonds are cheap, but we do not expect a very strong economy anywhere, what do we do; and 2) if the emerging markets are going to provide the majority of the economic strength, what will drive their economies?

In a slowing economy necessities always do the best. Cash flow investments will be the most attractive. In developed economies, food, power and basic healthcare will still be utilized, although at lower levels of demand than in a strong economy.

The same is true in developing economies such as China and India. However, without the infrastructure in place to deliver these goods, the need for commodities (the building blocks for any infrastructure), transportation, logistics and industrials will also be needed. Companies that can produce such products globally should be beneficiaries.

Inflation is not likely to be a major problem very soon because commodity prices are dropping. This means that fixed income could be a very attractive alternative that may provide equity-like returns. When the markets stabilize, the spreads between treasuries and other debt securities should narrow, with treasury yields rising and other yields falling. The possibility of lower interest rates increases the chance for yield spreads to drop further.

The Bottom Line

It is time to buy both stocks and bonds. The bottom may not have been reached. We are certainly going to experience a recession (which we may be in already). However, if you wait until it is obvious that things are better, you will have missed the opportunity.

As we have said for some time now, when prices for commodities and industrials finally drop we would want to buy. We are starting now. We are also buying companies that are the building blocks of infrastructure and technology that are cheaper than we have seen in 20 years and have large amounts of cash. We will continue to utilize covered call writing strategies to hedge portfolios and we will continue to add high grade fixed income securities with durations of between three and ten years.

This has been the worst investment environment seen in almost 80 years. It has destroyed huge amounts of capital. However, in times of great upheaval great opportunities arise and we intend to find and take advantage of these opportunities for our clients.

Alan E. Rosenfield
October 28, 2008

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