Down but Not Out

- 2008 1st Quarter

In our Commentary for 4th Quarter of 2007, I compared the market to a flight I had recently taken and titled it “Turbulence”.  As we conclude the 1st quarter of 2008, it is apparent that we are continuing the bumpy ride that we started in the final quarter of last year.  If that was Turbulence, what we are now experiencing are those unpleasant, and often nauseating, free-falls in the Market.  But remember, the Market is cyclical and what goes down must come up!

This Market Commentary will attempt to explain the events that have occurred in the market place and inform you as to what can be expected in the coming months and the year ahead. 

We entered 2008 having just completed the worst 4th quarter in over 20 years.  Our prediction for 2008 was like many of the “so-called experts”, in that we thought the first half of 2008 would be difficult, but things would rebound in the second half and finish on a decent note.  We were a bit taken back at the rapid descent of the Market as well as other events that unfolded in the first quarter.  To fully understand what transpired during the first quarter, we need to take a step back.

As we have discussed in prior Market Commentaries, we can actually look to post 9/11 to see the beginning of our current situation. The financial markets were upside down as a result of 9/11. The Fed reacted to the market by rapidly reducing interest rates.  By doing this, they were in essence making money cheap to borrow. In addition to the cheap money, the money was extremely easy to come by.  As we have learned, cheap money is a good thing, however, easy money is not. The easy money was a quick fix for the economy, but it started a chain of deep-rooted events that we are now paying for today.  The easy money allowed people who had no credit or bad credit to borrow money, and people who had no business borrowing money, were borrowing everything they could get there hands on. While consumers can be blamed, the real problem was with the lending institutions. They competed so hard to loan out money that they forgot all about the most fundamental element in loaning money - credit standards.  With the help of the Fed and the lending institutions in 2001 and 2002, the Market appeared to correct itself and did very well.  In fact, the real trouble was just beginning to brew, as we as a nation, borrowed money we did not have, which just delayed our troubles for 5 years.

The recovery from 2002 started in the Real Estate market.  Using cheap and easy money, people were buying their dream homes and refinancing at historic lows.  This made the Real Estate market “hot” and helped homes appreciate at unheard of levels.  All the while, the Fed, which had made the money cheap in 2001 and 2002, now went back to work raising interest rates for 17 consecutive meetings.  By doing this, money was no longer easy to get and even harder to repay.  As a result of the money becoming more expensive, we entered a period of "economic headwinds". 

The ‘economic headwinds’ are part of a vicious cycle that is necessary to correct the Market.  After the “Real Estate boom” slowed down, the real trouble began in the summer of 2007 with the first wave of foreclosures.  As the interest rates increased by 4.25% in five years, people were now expected to pay more than they could afford. The first "wave" was the group of people who had taken a mortgage in 2002 because of the low interest rates, and now as a result of the rapid increase of the interest rates, was now in serious trouble.  By mid-2007, almost overnight, homes were being foreclosed at an alarming rate.  In reaction to the massive wave of foreclosures, the Fed began lowering interest rates and has continued through the first quarter of 2008.   In just the first quarter, the Fed has reduced interest rates by a full two percent from 4.25% to 2.25%.  On January 22, 2008, the day after Martin Luther King Day, there was great concern about a historic market collapse.  As opposed to idly standing by, the Fed had an emergency meeting and reduced rates by 0.75%.  It was the first emergency meeting since the days following 9/11, and the largest rate reduction since 1991. 

In addition to being extremely active, the Fed has been very creative.  It was the Fed who engineered the bailout/buy-out of Bear Stearns by JP Morgan Chase, as the Fed assumed $29 of the $30 billion dollars of debt accumulated by Bear Stearns.  This type of action is historic, unprecedented, and many believe a way to help pull us through these turbulent times. 

While the Fed has offered us some hope, the real crisis in the Market now is the Credit Crunch problem.  Part of the snowball effect of the Real Estate slowdown, and the massive foreclosures, has worked its way to the source of the problems - the lending institutions themselves.  This is what hit us in late 2007 and has aggressively continued into the first quarter of 2008.  As a result of giving money away, thus creating a massive amount of bad debt, the banks have been forced to write off tens of billions of dollars.  This loss is now passed on to the consumers in that lending institutions are making it very difficult to borrow money; even people with excellent credit are having a tough time getting a loan. While after 9/11 loan standards were virtually non-existent, they are now so difficult that lending activity has almost come to a halt.

To add to our ‘economic headwinds’, the price for a barrel of oil has not only blown through $100 a barrel, it is now in excess of $110 a barrel.  We know that a gallon of gas will hit $4; the question is when.  Some experts are even suggesting that gas could see $5 a gallon by 2010.

While most leading indicators and sectors have been down year-to-date, the optimist in me is always looking for the silver lining.  The silver lining to today’s market is that while the Market is down, inflation will decrease, even if it is ever so slightly.  Also, while the dollar may be weak, this has brought increased foreign tourism to the US and improved our exporting business.  Also noteworthy is that Disney is having its best year, with many Europeans coming to the United States, which has become, in their opinion, the “New Canada”.

When studying the Market, it should be noted that things are never as good, or as bad, as they may seem.  In 2003, when the Market had an off-the-charts good year, we viewed that Market with skeptic optimism.  Today, while things look pretty bleak, I am not overly concerned.  Even with the troubles of late 2007, big business appears to be alive and well.  The companies that make up the S&P 500 have expected earnings of 16.1% in 2008 over 2007.

So the question that we get asked all the time is `what should a participant do’?  The market was down 9.45% in the first quarter, and it is certainly possible that it may still get worse before it gets better.  But, the answer is simple.  DO NOTHING.  In an article (see enclosed) that we are circulating titled "The 5 biggest 401(k) mistakes", the number one mistake participants make is selling their investments when they should be buying.  Now is the time to buy your mutual funds when they are discounted or on sale.

At a recent education meeting, a participant, after hearing my thoughts on the Market getting worse before it gets better, questioned whether he should move his assets into cash until things calmed down and then buy back once the Market comes back.  My answer, with the first quarter supporting it, is that we never know when the great days are going to be.  As bad as the first quarter was, we had four days that were among the best in the Market’s history.  Imagine how your Portfolio would of performed if you attempted to time the market and missed out on one or more of those days. 

To further illustrate, over the last 20 calendar years (1998-2007), the S&P 500 was up +9.3% per year, excluding dividends.  If you had missed the 20 best performing days over those 20 years, your average return would have been +4.8%.  If you had missed the best 1% of all those days, or 51 days, your average annual return would have been NEGATIVE.   

So, where are we headed for the remainder of the year?  We remain optimistic about the Market’s ability to rebound.  As we mentioned, the Fed is reacting, and with the Fed’s lowering of interest rates, money will be easier to come by.  The main problem right now is the Credit Crunch.  Once the lending institutions find a middle ground between 2002 and today, we believe the Real Estate market will start to recover and the Market will begin to move in the right direction. 

Patience is always a virtue; right now it’s crucial.  Losses incurred in the Market today remain “paper losses” only until we change our investment choices and make those losses permanent. For the participants who are in our AdviseMe! Program, we are able to say that we are more than holding our own.  Our objective has always been to do well in good markets and to do extremely well in bad markets.  At this time, extremely well means controlling the losses, and we have done so.  While some of our Portfolios are down year-to-date, they are out-performing the Market indices while also having less risk.

As we are enter spring, we see the grass turning green, and the trees blooming.  Let's remain optimistic that the bloom of the Market is not far behind.  We want to stress to all of you as Participants that you are not alone in this Market.  We are here for you and available at anytime either via email, phone or in person to review your account, and to make sure you are well positioned for wherever the Market goes.  Again, if we can help, please do not hesitate to contact us.

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