On second thought, maybe that wasn’t such a good idea.

Treasury Secretary Hank Paulson did an about face last week as he told Congress that the administration was backing away from the original plan of using the $700 billion bailout fund to purchase toxic mortgages. Instead, he said they would like to “consider using (the) remaining bailout funds on a second round of purchases of preferred shares in both banks and non-bank institutions that would match privately raised funds,” according to CNBC. Wall Street panned the flip-flop as the Dow Jones Industrial Average dropped 411 points on the day of Paulson’s change of heart.

To his credit, Paulson didn’t stubbornly stick to a plan that may have been less than optimal as new information became available. Like a good trader, he realized that the winds had shifted so he decided to shift, too. Wall Street took it hard because the swift change just reinforced how quickly things are changing in the economy. Wall Street doesn’t like uncertainty and this change was another example of the unpredictability of our current environment.

Glum retail sales, weak corporate earnings reports, and another jump in initial jobless claims added to the negative tone in the markets last week, according to MarketWatch. Last Thursday was the lone bright spot. After the Dow Jones Industrial Average dropped below 8,000, it staged a dramatic comeback and finished the day up a stellar 6.7%. This 11.5% intraday swing was the third biggest one-day swing in the past 46 years, according to Barron’s. Although the market finished up for the day, this stomach-turning volatility kept investors nervous and the market sold-off again the next day.

Like Paulson, we’re trying to be flexible and responsive to this ever-changing market environment.

IN 1958, A SEISMIC SHIFT OCCURRED in the relationship between dividend yields and bond yields. Fifty years later, that shift is close to reversing. If it does, what does that mean for investors?

Prior to 1958, the dividend yield on common stocks was always higher than the yield on long-term government bonds, according to Stocks for the Long Run by Jeremy Siegel. As a refresher, the dividend yield is simply the annual dividend divided by the price of a stock. For example, if a stock pays a $2 annual dividend and the price of the stock is $80, then the dividend yield is 2.5%. Fifty years ago, investors felt it was normal for stocks to yield more than bonds because stocks were riskier than bonds. Investors felt they had to be compensated for this risk by receiving a higher yield.

As 1958 unfolded, the stock market soared more than 30% and that dropped the dividend yield to below the yield on long-term government bonds and it’s been that way ever since, according to Siegel. Over the ensuing 50 years that stocks have yielded less than bonds, investors have gradually concluded that even though stocks may be riskier than bonds, the lower yield is justified because stocks may offer more growth opportunity. In other words, stocks offer the chance for a capital gain and a dividend, whereas long-term bonds bought at par and held to maturity only offer an interest payment.

Fast forward to last Friday. According to The Wall Street Journal, the dividend yield on the S&P 500 index was 3.5%, while the yield on 10-year government bonds was 3.75%. As you can see, we’re getting very close to parity after a 50-year hiatus.

In order for the dividend yield to surpass the bond yield, we would need to see stock prices continue to drop, bond prices continue to rise (remember: bond yields move opposite of bond prices), or some combination of the two. Here are some thoughts on each of those scenarios:

First, if stock prices continue to drop, the relative attractiveness of stocks may improve. With a high dividend yield, investors can take some comfort in knowing they’ll receive a payment for holding stocks, while still offering the chance for capital appreciation down the road.

Second, if bond prices rise, which leads to lower bond yields, then the economy may get some extra ammunition to spark economic growth. Lower interest rates may lead to more business investment, which could lead to higher corporate profits and, hopefully, higher stock prices.

Third, if both scenarios happen, it may set us up for a big recovery at some point in the future.

If the dividend yields end up surpassing bond yields, this reversal of a long-term trend may be a major signal that something momentous is about to happen. This “something momentous” could be a change in investor psychology that keeps stock prices low for a long period of time or it could be a sign that we’re nearing a trough in stock prices and that they’re poised to head up.

Regardless of what happens and what it may signal, we keep working diligently on your behalf to help you meet your long-term goals and objectives.

Weekly Focus - Think About It

“We don’t stop playing because we grow old; we grow old because we stop playing.”
–George Bernard Shaw

Last week’s business news underscored the severity of the current economic slowdown.

We all know October was a bad month in the financial markets. What we didn’t know until last week was how bad the economy was faring during the market meltdown. Well, on Friday, the Labor Department delivered the dreaded news that our economy shed 240,000 non-farm jobs in October. And, if that wasn’t bad enough, they significantly revised the September payroll numbers to show a decline of 284,000 jobs. The data led to a 6.5% unemployment rate in October, which is the highest rate in 14 years, according to MarketWatch.

The way the stock market responded to this news is rather instructive.

In the two days prior to the release of the employment numbers, the S&P 500 index declined a whopping 10%, according to Bespoke Investment Group. That was the largest two-day decline since the market crash of October 1987. What triggered the drop? While we’ll never know for certain, it appears that some investors were selling ahead of the anticipated bad employment numbers. According to a Reuters article, “Goldman Sachs analysts had expected up to 300,000 jobs may have been cut from non-farm payrolls in October. So, when the Labor Department reported 240,000 jobs lost last month, that did not send the stock market into a tailspin even though the figure exceeded the median forecast of 200,000.”

This is an example of how the stock market tends to anticipate what’s going to happen and, then, reacts accordingly. On the day the employment numbers were released, the S&P 500 index actually rose nearly 3%. In effect, it was a “sell on the rumor, buy on the news” strategy.

Even armed with the knowledge that markets tend to anticipate what’s going to happen, it’s still difficult to try and profit from it. There are a couple reasons why. First, one never knows exactly what news is already baked into stock prices; hence, it’s hard to predict how the market will react when the news is released. Second, at times the market may predict things that don’t actually happen. For example, there’s an old Wall Street saw that says, “The stock market has predicted nine of the last five recessions.” Clearly, Wall Street’s crystal ball is not always “crystal clear.”

Wishful thinking aside, it appears that this time the market is accurately predicting a recession.

ISN’T IT IRONIC that one of the major causes of our current financial predicament - borrowed money - is exactly what the federal government is using to try and solve the crisis? One has to look no further than the Federal Reserve’s balance sheet. The Fed has pulled out all the stops and flooded our financial system with all kinds of “new facilities” that have dramatically expanded its assets and liabilities.

As of November 5, the Fed’s balance sheet had ballooned to over $2 trillion in assets. That’s up more than 100% in less than 60 days, according to data from the Fed. And, it may not stop there. Richard Fisher, president and CEO of the Federal Reserve Bank of Dallas, said in a November 4 speech that, “I would not be surprised to see them [assets] aggregate to $3 trillion - roughly 20% of GDP - by the time we ring in the New Year.” The thought that the Fed’s balance sheet could triple to $3 trillion in the span of four months shows how serious the Fed is about trying to minimize the impact of this financial and economic crunch.

So, where does the Fed get the money to expand its balance sheet? By borrowing, of course! Last week, the Bush administration announced plans to borrow a record $550 billion between now and the end of the year, according to Associated Press. That’s necessary to help fund our federal budget deficit, which some experts predict will hit $1 trillion this fiscal year (2009). For the full year, government borrowing could total $2 trillion, according to Mark Zandi, chief economist at Moody’s Economy.com. Boy, a trillion here, a trillion there, and before you know it, we’re talking serious money.
But, just like us normal people, the government can’t continue to borrow money indefinitely without major repercussions. The government’s ability to borrow is generally limited by somebody else’s willingness to lend. And, those lenders have increasingly been countries such as Japan, China, and the United Kingdom.

At the end of August, the national debt of the U.S. was approximately $9.6 trillion, according to the Treasury Department. Of that, just three countries, Japan, China, and the United Kingdom, held about $1.4 trillion of the total. If these countries, or any of our other lenders, decide that they don’t want to own any more of our paper, then we may run into trouble financing our deficits. That, coupled with the specter of rising inflation if we juice the economy too much, may act as a governor on the government’s ability to add liquidity to the economy.

With that said, it appears that the government still has takers for our treasury securities and that inflation is not currently a big concern. Consequently, the government may continue to borrow money to help jumpstart the economy. Hopefully, they’ll borrow just enough to get us out of this economic funk, but not so much that we end up drowning in debt from which we can’t escape.

Weekly Focus - Stock Ticker
During this week in 1867, the first stock ticker was unveiled in New York City. It replaced mail and messengers and allowed investors around the country to receive up-to-the-minute stock prices. But, most importantly, the tape from the machines made for great parades!

Thank goodness, October is over.

Market historians were busy last month rewriting the record books on what seemed like a daily basis. Unfortunately, many of the new records were the type that we’d prefer to have remained unbroken. Here are a few of the new entries:

• October was the most volatile month in the S&P 500 index since November 1929, as measured by moves of at least 1% higher or lower, according to MarketWatch.
• As of October 28, this bear market represented the fourth largest decline in the S&P 500 index (on a closing basis) without a 20% rally. The only three other periods where we had deeper declines without an intervening 20% rally were in 1931, 1938, and 1974, according to Bespoke Investment Group.

•On a positive note, the Dow Jones Industrial Average rose 946 points, or 11.3%, last week. Barron’s said it was the Dow’s biggest one-week point gain on record and its largest percentage rise in 34 years. However, the end of the month heroics couldn’t overcome the early in the month carnage as the Dow still lost 14.1%t for the month, according to Barron’s.

•Crude oil prices dropped more than 32% in October, the largest one-month drop on record, according to CNBC. That’s good news for those of us who drive because the fall in oil prices has led to a dramatic drop in gas prices.

•The Conference Board Consumer Confidence Index™, fell to an all-time low of 38 (1985 = 100) in October, according to data from the Conference Board as reported by MarketWatch. This does not bode well for upcoming holiday sales.

•Gold futures prices dropped 18% in October, which was the largest one-month decline since February 1983, according to data from the Comex division of the New York Mercantile Exchange, as reported by MarketWatch.

They say records are meant to be broken. Well, we broke our fair share in October. Let’s hope the next broken record is a positive one such as, “The fastest return to an all-time high after experiencing a 40% decline in the S&P 500 index.” All in favor, say “Aye.”

HOW DO YOU DETERMINE IF THE STOCK MARKET is overvalued, fairly valued, or undervalued? On the surface, you might think that with the S&P 500 index down 35% over the past year, the market should be undervalued. Whether it is or not, we won’t know until we look back in hindsight. However, it’s helpful to look at history and see if we can place the current market in context. With the caveat that past performance is no guarantee of future results, here are some thoughts:

•Market analysts use many different measures to value the market. Some measures are quantitative in nature, while others are rather arcane, such as Kondratieff Waves and astrological cycles. We’ll just stick with the quantitative for now. One common measure is to compare the price of an index to the earnings of the underlying companies in the index. For example, if the price of the S&P 500 index is 1,000 and the underlying 500 companies in the index earned a total of $50 per share over the previous 12 months, then the index would be trading at a price-earnings ratio (P/E ratio) of 20 (1,000/50). By comparing the P/E ratio of today’s market to historical P/E ratios, we can see how this market compares to previous markets. Generally speaking, high P/E ratios are associated with high market valuations, while low P/E ratios are associated with low market valuations. Other factors may affect whether a given P/E ratio represents a high or low market valuation, but for our purposes, the above description is sufficient.

•As of last week, the S&P 500 index had a P/E ratio of 21 based on its trailing 12 months earnings, according to data from Birinyi Associates as reported by Barron’s. That’s above the index’s 60-year average P/E ratio of 17.8. So, this means the market is overvalued, right? Not necessarily.

•The stock market tends to look to the future and if it expects earnings to rise next year, then that would increase the “E” in the P/E ratio and, all other things being equal, would lower the P/E ratio as future earnings come to fruition. For example, a recent Barron’s survey of five Wall Street market strategists indicated they expect the S&P 500 companies to earn approximately $70 per share in 2009. If we apply the historical average multiple of 17.8 to the $70 earnings number, we end up with a projected S&P 500 index of 1,246 at some point in the future. That’s an increase of nearly 29% from last week’s closing S&P 500 value of 968. So, that would suggest the market may be undervalued, right? Again, not necessarily.

•Merrill Lynch’s top down estimate for 2009 S&P 500 earnings is only $60, according to Barron’s. If we apply the historical average multiple of 17.8 to Merrill’s number, then we end up with a projected S&P 500 index of 1068, which is still about 10% higher than last week’s close. So, we’re still potentially undervalued in today’s market, right? Well, you’re seeing a pattern here, so the answer is… not necessarily.

In the three examples above, we held the P/E constant at the historical average of 17.8. The bad news is, in some past economic recessions, the P/E ratio of the S&P 500 fell dramatically below the historical average. In fact, in 1975 and in 1980, the P/E ratio on the S&P 500 sank to around 7, according to Barron’s. You probably know where this is heading so, take a deep breath… if we apply a P/E of 7 to the $60 earnings estimate, that would leave us with the S&P 500 index at 420 at some point in the future. Based on last week’s closing price of 968, that means we could be in for a further decline of 56%. Ouch!

Now, before you get too worried, we think the likelihood of the S&P 500 dropping to 420 is extremely remote. We’re only showing it to you for educational purposes. And, to be fair, we should show you the other extreme, too. According to the St. Louis Federal Reserve Bank, during the bubble year of 1999, the P/E ratio on the S&P 500 hit 36. If we apply a 36 multiple to Merrill’s $60 earnings estimate, we get an S&P 500 index of 2,160. That’s a 123% increase from last week’s closing value.

Have we confused you yet? Here’s the bottom line. Whether you think the market is over, under, or fairly valued depends on many factors, two of which include future expected earnings and the multiple investors put on those earnings. Depending on where you stand, today’s market could be grossly overvalued, fairly valued, or grossly undervalued. There’s data to support pretty much any view you want. The constant tug of war among investors who think we’re overvalued, fairly valued, or undervalued may be one reason why we’re seeing so much volatility in the markets.

Weekly Focus - Think About It

“To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude, even while offering the greatest reward.”
–Sir John Templeton

Almost, but not quite.

As we awoke early last Friday morning and turned on our computers, we saw something that doesn’t happen very often. Pre-market opening indicators were suggesting a massive drop in the U.S. stock market when trading opened at 9:30 am Eastern time, according to MarketWatch. We already knew that many overseas markets had plummeted since most of them start trading well before the U.S. market opens. Japan’s main stock market index, for example, had dropped more than 9% prior to the start of trading in the U.S., according to MarketWatch. With that backdrop, investors nervously awaited the opening bell in New York. As the bell rang that morning, stocks dropped significantly in the first few minutes. But then, something surprising happened-no panic ensued. After see-sawing throughout the day, the Dow Jones finished with a disappointing 3.6% loss, but that was greeted with relief by many investors, who feared a much steeper decline.

It’s almost become a parlor game now with market pundits trying to call the bottom in the market. Many of them seemed to be waiting for the big washout-type capitulation day that takes the market down by double digits on record volume. Some people thought last Friday would be the day, but it didn’t happen.

With so many people looking for a big capitulation day, there’s a reasonable chance that it may not happen. According to an October 25 Wall Street Journal article, “Bear markets often end not in a crescendo of selling but [in] a cloud of indifference.” Ultimately, bear markets may end when stocks get so cheap that buyers step in and start bidding up prices.

Nobody knows whether this bear market will end with a record-breaking capitulation day or end unspectacularly as the selling pressure just peters out. This market has confounded so many “experts” that it’s anybody’s guess. Instead of worrying about calling a bottom, we’re trying to identify where the compelling values are and take advantage of them on your behalf.

ARE HUMAN EMOTIONS PARTLY RESPONSIBLE for the volatility we’re seeing in the financial markets? There’s no doubt that volatility is running rampant right now. The VIX, which is a widely used to measure of market risk often referred to as the “investor fear gauge,” rose to a record high last week, according to Bloomberg. But, is this fear rational? Do the fundamentals of our economy support the worldwide declines we’ve seen in the past month?

Clearly, the U.S. economy and many overseas economies are experiencing a significant slowdown. The ultimate severity of this downturn will not be known for quite some time. However, we do know that the financial markets are reacting violently to what’s happening. Could our emotions be getting in the way of sound investment judgment?

Westcore Funds/Denver Investment Advisers, LLC, developed a chart, which illustrates how volatility in the financial markets may cause us to turn off our rationality switch and replace it with some degree of either fear or greed. Below is a brief summary of what they call The Cycle of Market Emotions:

As markets rise, investors’ optimism begins to grow, excitement builds, and making money becomes thrilling. Over a period of time, the bull market finally reaches a crescendo, euphoria and greed set in and unbeknownst to most investors, this is the point of maximum financial risk. In hindsight, this could describe the first quarter of 2000, when the technology bubble reached its zenith. Inevitably, the market starts to drop, anxiety builds, and denial, fear, and desperation set in. Eventually, panic is followed by capitulation as some investors throw in the towel and say “I can’t take this anymore.” Capitulation is followed by despondency and it’s right here where you may find the point of maximum financial opportunity. Depression ensues, but then, when people realize the world is not coming to an end, the markets start to turn up. Hope turns into relief, which then leads to optimism and then the cycle starts all over again.

Since the current bear market is still unfolding, it’s not possible to say where we may be in this cycle. However, it would not be going out on a limb by saying we’re probably at least in the desperation/panic area. If true, we may see more pain before the next gain.

We need to keep in mind that successful investing takes more than just doing good research. It also takes strong emotional control and the ability to swim against the tide at times. By understanding the cycle of market emotions, and not letting fear or greed become dominant, you may be able to better tolerate and ultimately profit from market fluctuations. We do our best to embody these skills on your behalf.

Weekly Focus - Can You Solve This Puzzle?

Study this paragraph and all things in it. What is vitally wrong with it? Actually, nothing in it is wrong, but you must admit that it is most unusual. Don’t just zip through it quickly, but study it scrupulously. With luck you should spot what is so particular about it and all words found in it. Can you say what it is? Tax your brain and try again. Don’t miss a word or a symbol. It isn’t all that difficult.

What’s different about the above paragraph? There’s no E–but every other letter of the alphabet is there.

High volatility continued last week, but when the closing bell rang on Friday, investors were smiling as the Dow Jones Industrial Average recorded its biggest one-week gain in more than five years, according to The Wall Street Journal.

On Monday of last week, the Dow rose a stunning 936 points, but on Wednesday, it took a 733-point dive. And, for good measure, it popped higher by 401 points on Thursday. These dramatic daily swings suggest that investors still lack strong conviction on which direction the market is heading.

The government intervention in the financial markets continued last week and investors were left trying to figure out what it all means. At one end of the spectrum, you have people who are thrilled that the government is stepping in and preventing more firms from going under. At the other end, you have free-market champions who are furious that the government is propping up weak firms that otherwise might fail because of their bad decision-making. If nothing else, these historic times are keeping bloggers and opinion page writers busy arguing their particular point of view.

One surprising piece of news last week was the opinion page article penned by super investor Warren Buffett that was published in the New York Times. The normally tight-lipped investor went on the record as saying he was buying stocks last week for his personal portfolio, according to CNBC. Buffett also said, “Fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups as they always have. But, most major companies will be setting new profit records five, 10, and 20 years from now.”

Buffett says one rule dictates his buying: “Be fearful when others are greedy, and be greedy when others are fearful.” Right now, with these tremendous daily swings, there appears to be plenty of fear. And, if Buffett is right, then the prices we see today might look pretty attractive five or more years from now.

WHAT WILL BE THE CLOSING PRICE of the Dow Jones Industrial Average five years from now? While nobody knows the answer to that question with 100% certainty, it is worthwhile to look at several different scenarios. By understanding what might happen, we may be able to put ourselves in a better position to profit from what actually happens. Here are three possible scenarios:

Scenario 1: The stock market is significantly lower five years from now. In order for this to happen, we would likely need a severe and long-lasting recession that borders on a depression. In light of what’s happened over the past few months, this is not entirely out of the question; however, we think the likelihood of this happening is small. The U.S. government’s massive intervention in the economy and the global response to this crisis will likely prevent this type of complete meltdown.

Scenario 2: The stock market is about even five years from now. This could happen if we have a major recession that puts a multi-year crimp in corporate earnings. This wouldn’t be as bad as the meltdown in Scenario 1, but it would probably have to be on par or slightly worse than the early 1980s recession. Even if this were to happen, there could still be some profit-making opportunities in the stock market. For example, between 1929 and 1934 during the depth of the Great Depression, there were 9 bear and 8 bull markets as defined by an increase or decrease of 20% or more in the Dow Jones Industrial Average, according to data from Bespoke Investment Group. So, even though the Dow experienced an overall drop between 1929 and 1934, there were several significant rallies in between that offered potential profit-making opportunities.

Scenario 3: The stock market is higher five years from now. This might be the most likely scenario given the significant drop we’ve already experienced. Here are several pieces of information that help support the likelihood of this scenario coming to fruition:

–First, as we mentioned earlier, Warren Buffett said he’s started to buy stocks for his personal portfolio. That’s a comforting sign for many investors.
–Second, noted investment manager John Hussman mentioned in his October 13 market commentary that, “Stocks are now at the same valuations that existed at the 1990 bear market low. Relative to 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980s.” In effect, he seems to suggest that the downside risk from here may be small and that there may be some significant upside available.
–Third, noted investment manager Jeremy Grantham, who is chairman of the $120 billion money management firm GMO, wrote in an October 17 letter to clients, “At under 1,000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early.” Grantham had been bearish on the market for many years, so this is a big turnaround for him.
– Fourth, corporate insiders are buying much more stock than they are selling as of October 10, according to Vickers Weekly Insider Report as reported by Mark Hulbert at MarketWatch. This insider buying ratio was the best in nearly 10 years, which is often a bullish sign for future stock prices.

Short of getting a copy today of The Wall Street Journal that will be printed five years from now, we know that any forecast about the future is subject to error. With that said, as outlined in Scenario 3, we think there are numerous reasons to be optimistic about the future. That doesn’t mean it will all be rosy from here. We’ll likely experience more harrowing hiccups, but, eventually, the crisis should pass, the excess should be cleared out, and the market should move higher. Time tends to heal all wounds.

Weekly Focus - Think About It

“Our interviews, experience, and involvement with people at mid-life have led us to believe that nothing is more important to fulfillment in the second half of life than the willingness to ‘risk walking new ground.’” — Richard Leider and David Shapiro

“Past performance is no guarantee of future results.”

That’s a phrase you hear often in the securities business, in fact, securities regulators require that disclosure in certain written communication. It’s most common usage is to warn investors that if an investment has performed extremely well in the past, it’s no guarantee that the investment will continue to perform well in the future. Conversely, it could also mean that a poorly performing investment is not guaranteed to continue performing poorly in the future.

Here’s a third way to interpret that statement. The past performance of stock market indicators is no guarantee that those indicators will hold up in the future. What we mean by that is, historically, investment analysts have developed ratios, technical indicators, chart patterns, and various other tools to help them determine if stocks are “properly” valued. These tools help guide investors in making investment decisions. Unfortunately, the swiftness and the degree of this decline are rendering many of these indicators less useful.

With that said, this is no time to throw up your hands and cry “uncle.”

The depth and speed of this worldwide decline, coupled with the seizing up of the credit markets, is unprecedented in our lifetime and it caught many people off guard. For example, here are a few quotes that show how wrong some people in power were:

•On March 28, 2007, Fed Chairman Ben Bernanke told Congress that subprime defaults were “likely to be contained.”

•On June 20, 2007, Treasury Secretary Hank Paulson said that subprime fallout “will not affect the economy overall.”

•On June 27, 2007, Stan O’Neal, then the CEO of Merrill Lynch, called subprime defaults “reasonably well contained.”

Today, there’s no doubt that the situation we’re dealing with is serious and despite their tardiness, government and business leaders clearly understand that. They’re doing what they can to solve this problem as are we. As your advisor, it’s our job to keep digging and keep searching for better ways to manage and protect your investments. When the historical indicators no longer work, then it’s our job to find new ways to analyze the situation and respond as we think appropriate.

Please be assured that we’re not crying uncle. Instead, we realize that it’s times like these that the seeds of opportunity are sown. Major market disruptions as we’re witnessing now may lead to unprecedented opportunities down the road. We’re keeping our eye on that road and doing our best to take advantage of any opportunities we find along the way.

If you have any questions or concerns, please let us know. We are here for you.

WHAT HAS TO HAPPEN for this market to find a bottom? With an 18% decline in the Dow Jones Industrial Average last week and a 40% decline over the past 12 months, trying to call a bottom in this market has been futile. While nobody can predict exactly when we’ll hit bottom, here are a few things to monitor:

•First, a credible government action plan could help put a floor under stock prices. So far, our government’s piecemeal approach to this crisis hasn’t worked. However, if they’re able to get their act together and work in coordination with their G-7 and G-20 counterparts, then we may see some confidence return to the markets and a bottom could begin to form.

•Second, “Bottoms are made when selling becomes exhausted and long-term participants perceive value and lift stocks sharply off their lows,” according to Brett Steenbarger, Ph.D. As of last week, we still haven’t seen the long-term participants enter the market and lift stocks. Instead, we’ve seen one down day followed by another. It’s been a vicious cycle of selling that feeds on itself. At some point, though, we expect the strong selling pressure to abate and bargain buyers to emerge. Let’s hope that happens sooner rather than later.

•Third, the credit markets need to get back to some semblance of normality. Currently, banks are afraid to lend money and this constriction of credit is causing major problems for consumers and businesses. Too much credit and too little credit are both bad things. We need to strike a balance in order for commerce to function. Right now, credit constriction is putting a crimp in commerce.
One way to help determine if the credit freeze is thawing is to look at the “TED spread.” This is the difference between 3-month LIBOR (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. According to Bespoke Investment Group, “Elevated readings in the indicator indicate an increased level of risk aversion in the market, as investors flock to short term T-bills, which due to their credit quality and short time horizon, are considered risk free, while Eurodollar futures are more representative of the credit quality of corporate borrowers.” Historically, the TED spread has stayed below ½ of 1%, meaning the LIBOR interest rate has usually been less than ½ of 1% higher than the T-bill rate, according to Econbrowser. However, last Friday, the spread was a record 4.6%, according to Bloomberg. This extraordinary reading suggests banks are very leery of lending money and, when they do, they demand a significant premium. This number will likely need to come down dramatically before we see the stock market stabilize.

In summary, keep your seatbelts fastened. There may be more turbulence ahead, but we’re doing all we can to get you to your destination as safely as possible.

Weekly Focus - Think About It

“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble - i.e., to give way to hope, fear, and greed.” - Benjamin Graham

There’s only one word to describe what took place in the financial markets last week - ugly.

You probably don’t need to glance at the box score below to know that stocks dropped significantly last week. Monday’s dizzying drop of 777 points in the Dow Jones Industrial Average, attributed to the House of Representative’s failure to pass the bailout bill, set the tone. That was the largest point drop in Dow history, but in percentage terms, the 7.0% drop was not even in the top 15, according to MarketWatch. Interestingly, since the Dow was created in 1896, it has averaged a 7% or greater decline every 7 years. Coincidentally, the last time the Dow dropped more than 7% was on September 17, 2001 - just a fraction more than 7 years ago. While that offers little comfort, it does indicate that Monday’s decline was well within historical norms.

Monday’s decline was very broad based. Out of the 500 stocks in the S&P 500 index, 499 of them declined that day, according to Bespoke Investment Group. Can you guess the name of the only stock to rise that day? Here are a couple hints. First, when we’re feeling sick, our moms typically encourage us to eat the kind of food this company processes. And, second, for art lovers, Andy Warhol turned this company’s main product into pop art. You may have guessed that the company was none other than Campbell’s Soup. How ironic.

By the end of last week, lawmakers had approved a revised version of the bailout bill that included enough sweeteners to garner a few more “yes” votes. What started as a three-page treatment from Treasury Secretary Hank Paulson turned into a 451-page behemoth by the time President Bush signed the bill last Friday. Unfortunately, the added girth only weighed it down and investors sent the Dow to a 157-point loss on the day it was signed.

Where do we go from here? As much as we like to be optimists and say everything will be rosy starting this week, we know that would be disingenuous. Frankly, we cannot predict the future, but we are doing everything in our power to anticipate it and respond appropriately on your behalf.

Perhaps the best way to summarize our thoughts is to quote Admiral Jim Stockdale, the highest ranking U.S. prisoner during the height of the Vietnam War. In describing how he survived eight years of torture and imprisonment, he said, “You must never confuse faith that you will prevail in the end - which you can never afford to lose - with the discipline to confront the most brutal facts of your current reality, whatever they might be.” Simply put, having faith in the future and realism about your present situation is a good way to live and to manage money.

THIRD QUARTER REVIEW

STOCKS TOOK IT ON THE CHIN
There were few places to profitably park money in the stock market in the third quarter. The Dow Jones Industrial Average closed the quarter with a 4.4% loss while the S&P 500 ended with a 9.0% loss. In the strange way that Wall Street works, the three biggest gainers in the Dow for the quarter were bank stocks. Bank of America, J.P. Morgan Chase, and Citigroup rose 46%, 36%, and 22%, respectively, for the quarter, according to The Wall Street Journal. Moving overseas, the picture was no better as shown in the chart below.

Credit Markets Were Roiled
Credits markets tried to withstand the government seizure of Fannie and Freddie, Lehman Brother’s bankruptcy, AIG’s $85 billion lifeline, Merrill Lynch’s shotgun marriage to Bank of America, and the conversion of Morgan Stanley and Goldman Sachs into bank holding companies. Were they up to the challenge? Not quite.

Here’s how the October 1, Wall Street Journal summed up the quarter: “Credit markets came nearly to a standstill. Investors fled anything that seemed the slightest bit risky and rushed into super-safe Treasurys. Borrowing costs for companies soared, if they could borrow at all. Overnight and other short-term credit markets seized up as banks stopped lending, even to one another.”

Investors were so scared at one point during the quarter that yields on the 13-week Treasury bill essentially dropped to zero, according to data from Yahoo! Finance. Apparently, the return of principal was more important than the return on principal.

What’s really frustrating about the credit situation is that there’s no shortage of money. Banks and other financial institutions have money, but, the problem is, they’re hoarding it. They are so scared of lending money and not getting paid that they’ve decided to simply sit on some of their cash and beef up their balance sheet. Now, we’re not arguing that beefing up the balance sheet is a bad idea. The trick is to balance the need to shore up their capital base with the economy’s need for credit to grease the wheels of commerce.

An analogy might help here. The economy is like the human body with the heart representing consumers, the brain representing businesses, and the lungs representing the government (notice how the brain does not represent the government). What helps keep our human organs functioning is the circulatory system. Credit is effectively the circulatory system of our economy. With too little credit, the economy shuts down. With too much of it, the economy blows up. Finding the right balance so we can keep the economy functioning smoothly is our current struggle. Right now, banks are being too stingy and the economy is shutting down. The aim of the bailout bill is to get the bad loans off the books of the banks so they will stop hoarding cash and begin lending again.

COMMODITY MARKETS FELL BACK TO EARTH
After a tremendous run in the first half of the year, many commodity markets lost steam in the third quarter. The Wall Street Journal said it was the worst three-month stretch for the commodity sector since at least 1970 as prices dropped 29.0%. Blame it on the financial crisis and a deteriorating outlook for global growth. Here’s a list of how some prominent commodities fared during the quarter:

It’s astonishing how quickly sentiment changes in this market environment. For example, it seems like one day we’re talking about running out of oil with demand far outstripping supply, then the next day global growth cools, demand declines, and oil prices plunge. What ever happened to the so-called “rational investor?”

THE DOLLAR FOUND ITS GROOVE
An explosive rally in the dollar saw it gain about 5% for the quarter when measured against a broad range of currencies in a Federal Reserve index, according to The Wall Street Journal. The rally was even more impressive when compared to the euro, where it gained 11.8%, and the British pound, where it gained 12.0%. According to Richard Clarida, global strategic adviser at Pacific Investment Management Co. and an economics professor at Columbia University, as quoted in The Wall Street Journal, the dollar strengthened “not because the U.S. looked better, but because the rest of the world looked worse.”

The outlook for the dollar is uncertain because we have several crosscurrents coming into play. For example, the currency’s historical view as a safe haven in times of crisis may help support it, but the government’s need for hundreds of billions of dollars to support the bailout may put pressure on it. Of course, if the government starts printing money to jumpstart the “circulatory” system, then all bets for a strengthening dollar are off.

SUMMARY
We’re probably not out of the woods yet even though the bailout bill is now law. As Warren Buffett said on CNBC last Friday in reference to the bill, “This does not solve all our problems.” Hopefully, it will be a catalyst to get the financial system back on its feet. If not, the Federal Reserve, Treasury, and Congress may have to swing back into action with more goodies. No matter what happens, we remain focused on serving you. If you have any questions or concerns, please let us know. Thank you.

Weekly Focus - Think About It

“Some of the secret joys of living are not found by rushing from point A to point B, but by inventing some imaginary letters along the way.”
– Douglas Pagels

Been busy with a lot this week, especially watching Vice Presidential debates, and obviously the enormous financial crisis faced by this country. My bank, Wachovia, got swallowed up by my other bank, Wells Fargo. Some other news in the headlines:

Fannie Mae forgives loan for woman who shot herself

Bailout: Will it work?

House Passes Rescue Bill Second Time Around

Plenty of Perks for Taxpayers, Savers in Senate Rescue Plan

“Historic” is not a word we use lightly, but it seems appropriate to describe what took place in the financial markets last week.

As you look at the box score below, it masks the volatility that took place in one of the wildest weeks in Wall Street history. When the dust settled, the broad S&P 500 index finished the week with a slight gain, but it took some pain to get there. Last Monday, the Dow Jones Industrial Average dropped 504 points, followed by a gain of 141, a loss of 449, a gain of 410 and it closed the week with another gain of 368 points. Whew!

By Wednesday of last week, the world financial system was teetering on the brink of collapse. Credit markets had frozen, banks were unwilling to lend to each other and stock markets were plunging. A vicious death spiral was spinning out of control. After trying a “plug the hole” policy that had failed to stem the crisis, the U.S. government threw out the playbook and decided it was time to act decisively. By late last week, the government marshaled all its resources and created a plan to try to put the crisis behind us for good. The stock market liked what it was hearing and it staged a huge rally the last two days of the week. Let’s hope it continues.

THE PAST, THE PRESENT, AND THE FUTURE
OF THE CURRENT FINANCIAL SITUATION

In light of the recent turmoil, this week’s report will be longer than usual. We thought it would make sense to discuss the past, present, and future of the current financial situation. This may help put things in context for you.

The Past

In order to understand how we can get out of this mess, it’s necessary to figure out how we got into it. The late 1990s is a good place to start.

No doubt you remember those “good ol’ days.” The internet was changing the world, technology stocks were soaring, and the economy was humming along. It was a great time to be in the stock market as the S&P 500 index rose 220% for the five years ending December 31, 1999, according to data from Yahoo! Finance. That’s an average annualized return of 26% excluding reinvested dividends, which is simply phenomenal.

Of course, the good times didn’t last. The bubble popped and the S&P 500 declined by 49% between March 2000 and October 2002, according to data from Bespoke Investment Group. In order to limit the collateral damage to the economy from this steep decline, the Federal Reserve, under former chairman Alan Greenspan, embarked on a major interest rate cutting campaign to try and stimulate the economy. The Fed took the federal funds rate from 6.5% in May 2000 all the way down to 1% by June 2003, according to data from the Federal Reserve Bank of New York.

This precipitous decline in interest rates set the stage for the next bubble - real estate.

While the politicians fiddled, Wall Street and Main Street burned.

The financial markets eagerly awaited confirmation of a government bailout last week, but all they got by last Friday was partisan bickering and finger pointing. With no deal, traders pulled in their horns and the markets fell for the week.

It also didn’t help that last week’s economic news was mostly bleak. Here are a few of the highlights:

• The four-week average of first-time claims for unemployment insurance rose to 462,500 last week. That’s the highest since November 2001, according to MarketWatch. On the positive side, some of the spike was caused by Hurricanes Gustav and Ike as opposed to economic weakness.
• Second quarter GDP was revised down to 2.8% growth from a preliminary 3.3% rate, according to the Commerce Department. Over the past 12 months, GDP grew 2.1%, which is below the 2.75% growth rate most economists say is the economy’s long-run potential, according to MarketWatch.
• New home sales fell to a 17-year low in August, according to data from the Commerce Department. The August rate was also 34.5% below the sales number a year ago. These weak numbers are not too surprising since weakness in housing is at the root of our current financial problem.
• Orders for durable goods in August dropped a larger than expected 4.5% as demand declined in most major categories, according to data from the Commerce Department.

Now, for what we hope is some good news. Over the weekend, Washington lawmakers got serious and announced they had reached a bipartisan $700 billion agreement to bailout the financial sector. The agreement may prevent a “worst-case scenario” from unfolding in our financial markets, but it probably won’t forestall further economic weakness. As we’ve said before, it took us years to get into this mess and it could take us years to get out of it. In the meantime, we continue to work hard at preserving capital and searching for new opportunities.

THE CURRENT GLOBAL FINANCIAL MESS is a good reminder that it may pay to follow a few basic principles of good living. As a society, we’re inundated with messages that encourage us to spend, spend, spend, and buy stuff that might make us feel good in the short term, but in the long term could leave us with a migraine. For some people, the lure of easy credit and living the high life was hard to resist and they ended up getting in over their heads. By forgetting basic personal finance and life principles, some of these folks are unfortunately paying a heavy price.

As we survey the landscape, there are plenty of people and organizations who can share the blame for the situation our country finds itself in. Greedy financial institutions, hedge funds, investment banks, mortgage brokers, politicians protecting their jobs, ratings agencies, and regulators are just a few in a long list of culprits. But, at the end of the day, laying blame on other people won’t solve the problem or prevent the next one. Ultimately, we each have to be responsible for our own actions and do the best we can to make prudent decisions that protect our hard-earned assets. Here are a few basic principles that can benefit all of us:

• Live below your means. Consider saving at least 10% of your annual income. Before long, you’ll have a nice cushion that will help soften the blow if the unexpected happens.

• Buy adequate insurance. There’s no need to expose yourself to a major loss if you can insure the potential loss for a relatively small amount.

• Invest regularly. No one can predict whether the market will go up or down tomorrow, let alone next year. By investing regularly, you establish a discipline that may help smooth out some of the fluctuations.

• Don’t stress out over things you can’t control. We can’t control if there will be a thunderstorm tomorrow any more than we can control whether or not the $700 billion bailout package will be successful. What we can do though, is be proactive in preparing ourselves for whatever outcome may occur.

• Focus on what’s most important in life. We’re all given a certain amount of time on this earth and it’s in our best interest to use that time wisely. Spending time with your family, your friends, and helping others may help you stay sane in a sometimes crazy world.

Weekly Focus - From $12,000 to $30 Million in 68 Years

In 1940, surrealist artist Enrico Donati purchased a Picasso painting for a reported $12,000. Earlier this year, Donati died at age 99 and his estate is putting the painting up for auction later this year. Sotheby’s estimates the painting will fetch $30 million. What do you think is the average annual rate of return if the painting, purchased for $12,000 in 1940, sells for $30 million later this year? Would you believe about 12.2%? That’s a good example of the power of compounding!

“Historic” is not a word we use lightly, but it seems appropriate to describe what took place in the financial markets last week.

As you look at the box score below, it masks the volatility that took place in one of the wildest weeks in Wall Street history. When the dust settled, the broad S&P 500 index finished the week with a slight gain, but it took some pain to get there. Last Monday, the Dow Jones Industrial Average dropped 504 points, followed by a gain of 141, a loss of 449, a gain of 410 and it closed the week with another gain of 368 points. Whew!

By Wednesday of last week, the world financial system was teetering on the brink of collapse. Credit markets had frozen, banks were unwilling to lend to each other and stock markets were plunging. A vicious death spiral was spinning out of control. After trying a “plug the hole” policy that had failed to stem the crisis, the U.S. government threw out the playbook and decided it was time to act decisively. By late last week, the government marshaled all its resources and created a plan to try to put the crisis behind us for good. The stock market liked what it was hearing and it staged a huge rally the last two days of the week. Let’s hope it continues.

THE PAST, THE PRESENT, AND THE FUTURE
OF THE CURRENT FINANCIAL SITUATION

In light of the recent turmoil, this week’s report will be longer than usual. We thought it would make sense to discuss the past, present, and future of the current financial situation. This may help put things in context for you.

The Past

In order to understand how we can get out of this mess, it’s necessary to figure out how we got into it. The late 1990s is a good place to start.

No doubt you remember those “good ol’ days.” The internet was changing the world, technology stocks were soaring, and the economy was humming along. It was a great time to be in the stock market as the S&P 500 index rose 220% for the five years ending December 31, 1999, according to data from Yahoo! Finance. That’s an average annualized return of 26% excluding reinvested dividends, which is simply phenomenal.

Of course, the good times didn’t last. The bubble popped and the S&P 500 declined by 49% between March 2000 and October 2002, according to data from Bespoke Investment Group. In order to limit the collateral damage to the economy from this steep decline, the Federal Reserve, under former chairman Alan Greenspan, embarked on a major interest rate cutting campaign to try and stimulate the economy. The Fed took the federal funds rate from 6.5% in May 2000 all the way down to 1% by June 2003, according to data from the Federal Reserve Bank of New York.

This precipitous decline in interest rates set the stage for the next bubble - real estate.

With interest rates super low and the stock market in a funk, investors turned their attention to the previously moribund real estate market. As the economy gradually improved, people started to buy homes again in a big way. And banks, mortgage companies, and Wall Street wizards were more than happy to come up with new fangled ways of getting Americans into the home of their dreams with little to no money down.

Wall Street investment banks were thrilled with this new opportunity in real estate because they weren’t making much money on their traditional business of investment banking and buying and selling securities. By coming up with new ways to package, slice, and dice mortgage securities, Wall Street firms made a boatload of money. Unfortunately, many of these new securities, which provided capital to finance the real estate boom, were highly financed themselves. Effectively, the actual equity that underpinned some of these mortgages was negligible.

When the real estate bubble became unsustainable, just like the earlier technology bubble, it all came crashing down.

With very little equity supporting billions in outstanding mortgages, a slight decline in the value of the real estate caused a ripple effect of delinquencies and defaults. As the defaults spread, it began to feed on itself like a California wildfire inhaling dry timber. Eventually, fear took over as nobody knew when the vicious cycle would be broken. Enter last week.

Investors had weathered blowups from Countrywide, Bear Stearns, Fannie Mae, Freddie Mac, and now, they were facing major problems with Lehman Brothers, AIG, and Merrill Lynch. By week’s end, Lehman had been forced into bankruptcy, AIG had been effectively nationalized by the government, and Merrill Lynch had taken refuge in the arms of Bank of America. This tumultuous turn of events propelled the government to act swiftly and decisively.

The Present

The situation is fluid and changes are happening with lightning speed. Over the weekend, the Bush Administration sent to Congress a $700 billion proposal that would give the Treasury broad authority to purchase distressed assets from U.S. financial institutions in an effort to stem the crisis. The proposal would also raise the nation’s debt ceiling to $11.315 trillion from its current $10.615 trillion limit, according to Bloomberg. To put $700 billion in perspective, that translates into an average bill of $6,500 per U.S. family, according to a report from MarketWatch. Now, it’s possible that the Treasury will turn around and sell the assets and recoup some or all of that $700 billion, but that will not be known for perhaps years.

We also don’t know how hard of a bargain the government will drive when it tries to buy these distressed assets. If it tries to buy the assets at a very low price, then the financial institutions may have to take more write-downs and raise more capital, which could keep this vicious cycle spiraling down. Conversely, if it buys the assets at a high price, then the financial institutions benefit at the expense of the taxpayers who are on the hook for any future losses.

In a surprising twist, investment banks Goldman Sachs and Morgan Stanley announced late Sunday night that they will convert their businesses into traditional bank holding companies, according to The Wall Street Journal. This will subject the companies to new regulatory oversight and possibly significantly reduce their future profit opportunities. It may also put the companies in a better position to be acquired, to merge, or to acquire a smaller bank with insured deposits.

In other news last week, the Treasury announced that it is extending bank deposit-type insurance to money market funds. The news of a money market fund that “broke the buck” prompted the government to implement this safety net as a way to limit further damage in the $3.3 trillion money market industry, according to Bloomberg. Also, on Friday, the Securities and Exchange Commission implemented a ban on short-selling 799 companies through October 2. This may ease some of the pressure on these companies and shield them from “bear raids” that could depress their stock price.

The changes announced by the government late last week helped spark a huge rally in stocks on Thursday and Friday. Nobody knows whether this is just a temporary reprieve or the beginning of a new period of stability. What we can say with some confidence is the government is all over this situation and they are trying to do all they can to prevent a replay of the 1930s.

The Future
As the old saying goes, “Forecasting is the art of saying what will happen, and then explaining why it didn’t.” At the risk of having to explain ourselves later, we’ll offer some comments about what the future may hold.

First, capitalism as we know it may have changed dramatically. The concept of letting free markets adjust and self-correct with minimal government intervention is likely gone. The government’s actions over the past few months indicate that there are limits to laissez faire. We may see more government regulation and that may mean lower long-term returns from securities because the regulations could remove some of the risks from investing.

Second, when a financial calamity is knocking on the door, a small number of people may assume tremendous power to make decisions that put hundreds of billions of taxpayer dollars at risk. Right now, Treasury Secretary Hank Paulson is arguably the most powerful person in America. He and his coterie of trusted advisors are massively reshaping our financial system with bullet train speed and little oversight. When the history books are written, Paulson may go down as the greatest Treasury secretary of all time or we may be throwing darts at his picture. Time will tell.

Third, we live in a global society that is highly connected through commerce and instantaneous communication. What happens in the U.S. is no longer a U.S. issue and vice versa. As a global society, we may all sink or swim together - so we all better get along. The financial crisis we’re experiencing is a great example. It’s not just isolated to the U.S. It has global ramifications.

In Closing

As we wrap up this extended commentary, we need to keep in mind that it took us years to get into this mess and it may take us years to get out of it. The government’s unprecedented action last week may have stopped the bleeding, but that doesn’t necessarily mean the patient is well. We still have a glut of homes on the market, a relatively soft economy, and a host of other headwinds. With that said, new opportunities may arise and we are always on the lookout for them.

No matter what the market may throw at us, we want you to know that we are closely following the situation and we are doing all we can as professional advisors to be good stewards of your money. If you have any questions, please let us know. Thank you for the trust and confidence you’ve placed in us. We’ve worked hard to develop it and we are working hard to keep it.

Weekly Focus - Think About It

“God, grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.”
– Reinhold Niebuhr