Third Quarterly Letter to All Clients

Published: October 10th, 2008

Autumn is here and we are in the midst of unprecedented times with the most turbulent market ever experienced. This market is the result of a financial crisis that began with a perfect storm of a global savings glut, a shift away from mortgages being held on banks’ books and low rates for an extended period of time. There is now a disconnect between Wall Street and Main Street regarding who is at fault here. However, there is certainly enough blame to go around.

We have been in a period of underregulation. Even if one believes in deregulation, certainly Congress should have regulated leveraging. Banks such as Fannie Mae are leveraged 50 to 1. Banks have been going off of their balance sheet to avoid regulation, thereby creating the toxic mortgage positions that have been discussed so much during the past year. Banks leveraged up their balance sheets, which hurt no one until they had to start writing them down. As a result of writing down the toxic mortgage positions, banks were unable to satisfy their lines of credit and had to sell to meet them. This resulted in a vicious cycle as prices on these positions spiraled downwards, which led to a further need for lines of credit to be satisfied, more sales and on and on. The Fed has now become the lender of last resort to these banks.

During the Great Depression, the Secretary of the Treasury, Andrew Mellon said, “The government must keep its hands off and let the slump liquidate itself…It will purge the rottenness out of the system.” We learned later that this was not the answer to fixing the economy then. During our current credit crisis, the US government has taken many actions to remedy the situation, such as cutting rates, setting policies to enhance liquidity, coordinating central bank actions, supporting housing, tax rebates and facilitating the sale of banks. So far, it has not been enough to reverse the cycle we are in.

High quality banks are pumping money into Treasuries causing the TED spread, the difference between the interest rates on inter-bank loans and Treasury bills, to rise. Historically, the risk to lending overnight is very low and therefore, rates had been lower. This is the real problem in the marketplace. Bernanke’s actions have not worked because there IS enough liquidity. The Fed can continue to pump money into the money system but the money is not finding its way to banks that need to be recapitalized.

The Fed has had to respond so quickly to all of the crises that they have not been able to think all of them through. For example, Lehman should have been bailed out rather than sacrificed because the failure of this company led to banks “breaking the buck” in money market holdings. The unintended consequences of the Fed’s actions are that the Fed is eroding the quality of its balance sheet, which is usually composed of 90% US Treasuries. As a result, they have expanded their balance sheet from $850 billion to $1.4 trillion. This will lead to rising monetary inflation. Although so much noise has been made about inflation in the press, it has not been an issue, in general, so far because there has not been an indiscriminate rise in prices.

The $700 billion that was asked of Congress is small compared to the amount of toxic debt outstanding, roughly 6.5% of it. It will not be sufficient in and of itself, for the government to buy these assets. It will set a floor for pricing and hopefully, give others confidence to step in and start buying these assets. However, the government will probably have to ask for more money, these actions may not be enough to build consumer confidence and they don’t help home prices. So this is certainly not an all clear signal, which has been reflected in market movements this week.

The stimulus for market recovery as a percentage of GDP, as shown in the 2003 recovery, is as follows:

71.3% personal consumption
17.6% government spending
-3.4% net exports
12.2% business investments
3.1% residential investments

Obviously, personal consumption is a very important piece of this picture and is the key to recovery. This is the reason why so much attention is paid to consumer confidence. Despite all of the government’s best efforts, if they cannot get people to start spending, the recovery will not take place.

Americans as a whole are spending less now. 60-70% of banks are tightening lending standards. Consumers are losing their appetite for debt, which has decreased to roughly 1.5 times disposable personal income. Homes have been the biggest asset to borrow against, but they are falling, something that has not happened as a whole since the Great Depression. In housing, inventories are too high. There are 4.5 million homes for sale with 1.5 million empty. With unemployment rising, people are spending only as they earn money. The upside to this is that Americans are finally saving more.

We are in a period of a declining dollar and rising gold prices. It is true that the dollar has rallied vs. the Euro since the announcement of the bailout plan. However, this is more a knock on the European economy than a positive sign for the US economy. It has been said that when the US sneezes, the world catches a cold. This has not happened so much, but they certainly have been out sick for a few days. International markets, including emerging markets, have declined considerably in value.

Most economists would agree that we are in a recession or heading into one. The market is in a massive sell-off period. As hedge funds and mutual funds are forced to generate liquidity to satisfy redemptions, this is not the time to sell. Some investors are probably concerned enough about the markets to think about moving all of their holdings to cash, the idea being that at least they will not lose money. With money market rates at approximately 2% and inflation at approximately 5%, that is not the case. Reacting in a down market is usually a poor decision because it subjects you to market losses that can not be reversed when the market recovers.

These are deeply unsettling times for investors but there are positive events that have already begun to take place to help restore our economy:

• Lower oil prices should help restore consumer purchasing power on many levels and not just at the pumps
• Lower mortgage rates combined with lower home prices are dramatically improving housing affordability in the US
• Various initiatives have been launched to deal with the surge in foreclosures; and
• The world’s central banks are moving to lower interest rates and/or to enhance liquidity to combat slowing economic growth

The Fed is capable of ramping up economic activity. Over time, all of the money that has been poured into the system will create an upswing in the global economy, especially in Asia. We are very confident about the long-term prospects for the market. Over the short-term, it is important to stick to your investment plan and remain invested. After all, if you are not in the stock market, you are betting against human capital and innovation in the United States.

Our response to this market volatility has not changed from discussions that we have had with you recently and during our annual reviews. We encourage you to think about how you are invested and remember your initial investment strategy. Review your portfolio and make sure that the asset allocation is in line with your risk tolerance and time horizon. It is important, now more than ever, to be properly diversified. We view this market environment as a buying opportunity for long term positions at depressed prices. We have been and remain focused on the long term. We believe it is about time in the market not timing the market.

We encourage you to meet with us for an annual review if you have not done so already. If you have questions or concerns, please remember that we are only a phone call away.

Sincerely,

ARISTA WEALTH ADVISORS

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