Fourth Quarterly Letter to All Clients

Published: January 1st, 2009

This quarter’s letter has a dual purpose. One is to offer a review of the markets and our expectations going forward and the other to discuss the security of your assets given the recent news of the Bernard Madoff scam.

Market Review

2008 brought about many changes, many of them unforeseen. We are facing a new regime in Washington, living with the aftermath of the Lehman collapse, dealing with the credit markets’ collapse and coming out of one of the worst quarters for index returns in history that we would soon like to put behind us. On the economic front, we were facing little or no credit availability because of defaults and a sharp contraction in economic activity. We are now witnessing high levels of unemployment, possibly some corporate default, illiquidity, high volatility, and tremendous lurches in the market. We have seen a fall in both world production and consumption and this will most likely continue for the short term.

The biggest question you may be asking yourself at this time is, “Have the markets priced in the deepening economic weakness and where do we go from here?” The answer is that markets usually tend to see forward. 2008 was the third worst annual return for the broad index, topped only by 1937 and 1931. The 2009 economic outlook for the U.S. remains mired in a recession, and a broad, robust recovery this year is unlikely. That being said, we believe we are moving past the worst of the financial crisis, and that 2009 may be a year of stabilization.

We don’t believe that the decline is commensurate with 1929 and we feel the markets have discounted much of the pain already. Going forward, here is what we think we can expect on the economic front. The first quarter of 2009 will probably be dismal, as we are faced with higher unemployment and lower consumption. We see this in the sales from manufacturing and production around the world. This is not preordained to last forever and not on the order of 1929. The reality of it is that markets do anticipate this and have priced in losses. Corporate America will have a strict focus on cutting costs. That will inevitably bring more layoffs and slowed production.

The federal government will continue to act to halt this cycle by seeking to recapitalize banks, sustain credit availability for quality borrowers, cushion lower income citizens through a stimulus program and facilitate the creation of new jobs. Given the scale of the problems at hand, the recovery process will be a slow one.

We are starting to see the credit markets easing across the board. Libor (London Interbank Offered rate) is the rate that banks lend to one another outside the United States. The borrowing costs were high for LIBOR but have dropped to 130 basis points (1.3%) from a high of 300 basis points (3%). The Federal Reserve has started to engage on a broad scale purchase of Fannie Mae (FNMA) and Freddie MAC (FHLMC) mortgages and we are seeing the average conventional thirty year mortgage reach below 5%. There is rumor of an effort to bring the mortgage rate down closer to 4% making housing even more affordable and reducing the conventional mortgage monthly payments. Affordability is now at the 25 year average after going through a bubble in pricing. Nationally, we have seen an average 20% decline in housing prices and that combined with lower rates makes housing more affordable.

On the political horizon, we have a new administration taking control on January 20, 2009. New stimulus programs will be introduced in an effort to lower tax rates for middle income taxpayers and we will witness an infusion toward infrastructure spending and hiring programs by the US government. President Obama has changed his position on taxation with his number one priority being the economy. We believe for his long term agenda that he will put capital gains back on the table. During his campaign, he discussed increasing capital gains taxes but for the short term, we don’t think raising rates is a likely option.

The debate for 2009 is should you be positioned for further volatility or a cyclical recovery? Corporate earnings have been in a decline and will continue into the first quarter. However, markets are interestingly in a very, very cheap position. The dividend yield on the S&P 500 is a record high of 3.2%.

Source of chart data: Compustat and Goldman Sachs Research estimates, as of November 2008.

There is an excess amount of liquidity around the world and it will eventually be put back into the market. With infrastructure spending, and emerging market activity, there may be a revival in commodity prices and emerging markets. Dividends are more stable than earnings with a gravitation toward dividend paying companies during this period. Small cap stocks are poised for growth and typically outperform after periods of market decline. The key, as we always advise, is to continue to maintain a sound asset allocation strategy. The markets tend to turn around before we begin to see improvement in the economy after times like this. There is much action ahead of us to help stimulate our economy with another possible reduction in the Fed funds rate, continued easing through global cuts in interest rates, stimulus and aggressive action by the FED.

Although it is difficult, if not impossible, for anyone to predict the direction of the markets, we’d like to provide you with some optimism with the following chart:

*US Market Recovery after Financial Crises

4th Quarter Chart (PDF Download)

The enclosed chart referenced above is a 60/40 portfolio with 60% exposure to stocks and 40% exposure to bonds. It depicts the cumulative return of a balanced portfolio after various events. Fear and uncertainty might lead investors to sell their investments during tough times, putting downward pressure on prices. Trading as a result of these emotions can be detrimental to a portfolio’s value. By selling during downward price pressures, investors might realize short-term losses. This is compounded as investors wait and hesitate to get back into the market, possibly missing some or all of the potential recovery. The lesson here is that patience can pay dividends.

Diversification can also limit losses during turbulent market conditions. The dot-com crash in 2000 resulted in rather large losses for those invested entirely in stocks. In fact, every period analyzed actually produced a loss. On the other hand, the balanced portfolio’s losses were less severe, and after five years it actually generated a gain. One of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run. While stocks offer the potential for higher returns, the downside risk can also be extreme. A diversified portfolio can help mitigate such extreme swings in value.

*Source: Morningstar

Asset Security with Charles Schwab & Co. Inc.

In the most recent bad news from Wall Street, Bernard Madoff, former NASDAQ Stock Market chairman and founder of Bernard L. Madoff Investment Securities LLC, was arrested for securities fraud.

What did he do? He allegedly collected money to invest from clients, made up false statements to show that they were doing well, and used new clients’ money to pay interest and withdrawals to existing clients. This is known as a Ponzi scheme and is estimated to involve more than a $50 billion loss for his investors.

A valid question at this time is how are your assets protected? The primary line of protection is the fact that we use an independent custodian to hold client funds. Clients have an independent third party with Schwab Institutional pricing each investment they own. We have no input on investment pricing, and that separation is a very good thing. Clients also get an independent statement directly from Schwab. It is the custodian’s responsibility to keep client funds safe. The only power we have over those accounts is as follows:

To manage and make trades in the account, to receive copies of monthly statements, tax documents and trade confirmations and to deduct our fees directly from the account.

Our clients also benefit from fraud insurance. The first part is Securities Investor Protection Corporation (SIPC) coverage for $500,000 per account. At Schwab Institutional, there is also an additional $149.5 million of excess SIPC insurance per account from London insurers.

Fraud insurance does not protect against market declines; but it does protect against theft of securities and/or related fraudulent transactions.

We have worked for over 20 years to build the trust and confidence of our clients. We have communicated time and again that this isn’t something we take for granted. One of the ways that we can demonstrate this is to structure the relationship so that your assets are protected from theft. We are confident that we have taken the necessary steps to assure this.

Reportedly Madoff claimed consistent annual returns of 10-12% with little volatility and no annual losses. Can you name any legitimate investor who can make that claim in recent years? If an investment sounds too good to be true, it probably is.

Points of Interest:

• As already mentioned, mortgage rates are at an all time low with 30 year fixed rates hovering around 5% and just below. For those of you carrying mortgages at higher rates, it may be a great time to explore refinancing for lower costs. We would be happy to offer advice in this area if you feel this is an option you would like to consider.
• Typically, Charles Schwab, Inc. mails year end tax reports no later than January 31st. This year, the reports are expected to be mailed out in early February.
• Required Minimum Distributions from IRA and Pension Plans have been waived for 2009 only. Please call us and let us know if you would like to suspend your distributions this year.

A final thought to leave you with directly from Oppenheimer Funds:

“History has also taught us that the biggest gains in the market are had when pessimism runs highest.”

We always appreciate your feedback and look forward to hearing any questions or comments you may have.

Sincerely,

ARISTA WEALTH ADVISORS

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