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First Quarter, 2008

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The epic battle between the forces of deflation and inflation continue at home and abroad.  Deflationary forces originate in things such as declining home prices, high default rates in mortgage securities and other forms of debt and a rising unemployment rate resulting in a general pullback in consumer spending.  Inflationary forces have their genesis in the actions of the Federal Reserve as it lowers short-term interest rates below the level of inflation and accelerates growth in the money supply well above the amount needed to sustain current economic growth.


For reasons cited below, we are of the opinion that the many and varied efforts to re-inflate the economy and bring to a close the current financial contagion are beginning to show signs of success.  This means that the economy may begin to demonstrate a turnaround later in the year.  Our cheery forecast however should not be interpreted as an “all-clear” signal on the economic front.  To the contrary, we expect the economic news to become even more grim during the next three to six months:

  • mortgage default rates will continue to rise; home prices should continue to drop;
  • unemployment will probably rise;
  • consumer and business sentiment may worsen from today’s depressed levels;
  • financial institutions will continue writing off or writing down their bad debt as their earnings continue to suffer;
  • domestic and global GDP growth will continue to decline, or at best stay weak.


With the forced acquisition of the once mighty Bear Stearns, the various arms of government have now swung into concerted action with a new sense of urgency:

  • The Federal Reserve has:
  • engineered a dramatic decline in the Federal Funds rate;
  • allowed major brokerage firms to borrow from it for the first time;
  • accepted lower quality collateral (including mortgage backed securities) for loans to financial institutions;
  • allowed extraordinary monetary stimulus, pushing the growth rate of one measure of the money supply to a 20.7% annual rate.
  • The Department of the Treasury has authorized the two quasi-government mortgage finance entities, Fannie Mae and Freddie Mac, to expand their lending activities by approximately $200-300 billion.  The ceiling for FHA conforming loans has been raised to $ 729,000 from $417,000 (the details have yet to be worked out).  Congress has enacted and the President has signed, legislation giving cash payments to most Americans who file tax returns.
  • Both the President and Congress are floating plans to help distressed homeowners whose mortgage balances now exceed the current market value of their homes.  Based upon current estimates, approximately 9 million homeowners are “under water” with their home mortgages at the present time.  Further declines in home prices will raise the “under water” figure as the year progresses.  The Democrats are advocating various taxpayer funded bailouts for 1-2 million of these people.  The Republicans want nothing to do with taxpayer bailout schemes.  Presidential candidate McCain has a plan to help 200-400,000 borrowers without taxpayer support, and President Bush has proposed a plan that is projected to help approximately 100,000 homeowners.


Banks and brokerage firms have not been sitting by idly waiting for the markets to self correct.  Recently, major financial institutions have begun placing much of their subprime mortgage paper and other high risk financial instruments into affiliated entities with the intention of either selling a large share of that entity to private equity investors or spinning off the entity to their shareholders.  By doing so, these assets will come off the institutions’ books, eliminating future hits to their earnings.  Then it can be back to business as usual. 


The bad economic news which we listed earlier in this letter is one thing, and the markets’ reaction to the news is something else entirely.  It’s common knowledge in our industry that one must separate economic news from market action.  News is backward looking while market action represents investors’ collective judgment about the future.

Today, stock and bond markets are disregarding the avalanche of bad news and looking forward to an anticipated economic recovery.  Presented below are a few observations from various market indicators:

  • Many broad U.S. stock indices continue in a fitful, but positive, way to edge higher from their January 22 intra-day lows.
  • Yield spreads between higher risk and lower risk bonds have begun to decline.
  • The cost of mortgage default insurance has begun to experience a dramatic decline.
  • The VIX, a measure of stock market volatility, is beginning to decline. A drop in the VIX indicates that investor confidence is being restored.
  • The U.S. yield curve is steeply positive indicating good growth potential ahead and a profitable lending environment for banks.

Markets are beginning to show confidence in Federal Reserve Chairman Bernanke’s policies, with a growing belief that government actions are pulling the U.S. economy back from the brink of a deflationary disaster.  The coast is not clear by any means and there are many possible events which may undo today’s budding market recovery.  (We will spare you from the scary possibilities).  In spite of all of today’s bad news, which remains the principal focus of the media, large sums of money are now being invested by big money investors.  For example, the Blackstone Group, a global asset manager has just announced that it raised $10.9 billion for real estate investments made attractive by capital market dislocations.  Sovereign funds from around the world continue to invest tens of billions of dollars in major banks, brokers and other companies that have been significant contributors to, or victims of, the current financial malaise.


At the same time, consumer confidence figures are registering their lowest readings since the dot-com implosion of 2000-2003 and other business confidence indices are at all-time lows.  Bloomberg reports that investor fear of stocks and bonds has caused U.S. money market funds to balloon upward to a record $3.5 trillion in spite of continuing declines in current yields.  The consumer always gets it wrong at economic turning points.  There is no shortage of liquidity at home or abroad, and when consumer confidence returns, as a result of stabilizing credit markets or perhaps an improving economy, equity prices may move substantially higher. 


Here at SIMI we have taken the position that the Federal Reserve’s reflationary actions will be successful and that market indicators are signaling a more aggressive approach to clients’ equity positions.  We are near or at the top of our equity ranges for client portfolios for all risk levels.


Furthermore, we have taken the position that Fed actions will have a continuing negative impact on the dollar vis-à-vis other currencies and commodities.  There are now an increasing number of exchange traded fund vehicles representing ownership in a variety of currencies and commodities, and we have begun investing a small portion of client cash in some of these vehicles.  Currencies have low, and from time to time negative, correlation to stocks and bonds causing them to enhance portfolio diversification while reducing portfolio volatility.


Similar comments apply to exchange traded commodity-linked funds.  While there have been mutual funds offering commodity-linked investments for some time now, it is only recently that such vehicles have been created in the form of exchange traded funds and exchange traded notes which provide liquidity throughout the trading day. 


Beyond the portfolio diversifying effect there is a second, more fundamental reason for our interest: emerging markets around the world are contributing to global commodity consumption at accelerating rates.  We believe this trend will continue for the indefinite future, resulting in generally rising prices for energy, industrial metals and agricultural products.  Over time, we anticipate building the commodity and currency components of client portfolios to between 5-10% of total portfolio assets.


Various economic indicators and governmental organizations are presenting a consensus view that the economic slowdown which began in the U.S. has expanded to encompass many areas of the world.  Pullbacks in the markets of fast growing regions represent to us an opportunity to increase our foreign investment exposure.  Attractive investment opportunities abound at the present time.


Three-Month Treasury Bill                                    .7%

Russell 3000 Index (U.S. Stocks)                      -9.5%

S&P 500                                                           -9.4%

MSCI EAFE Index (Non-U.S. Stocks)             -8.9%

MSCI Emerging Market Index                         -11.0%

Lehman Aggregate Bond Market Index               2.2%

MSCI REIT Index (Real-Estate Trusts)               2.1%

Gold (Commodity)                                              9.9%

Philadelphia Gold/Silver Index (Mining cos.)        2.1%

CPI Inflation 12 months                                       4.0%


The Fed-engineered decline in interest rates during the first quarter has caused the yield on money market accounts to drop to very low levels – between 1-2% on an annualized basis.  It now appears that money market rates will stay low for an extended period of time – perhaps until the housing market begins to turn positive and confidence returns to the financial sector of the economy.


The stock portion of your portfolio had a negative return for the quarter, but the broad domestic and foreign stock markets declined by a greater degree than the equity results of your portfolio.  We aren’t happy about the first quarter’s returns, but compared to the indices, your stock portfolio performed well.


We commented in our fourth quarter, 2007 report that the bond markets had ceased to function in a normal manner and that we believed the situation would correct itself when credit markets returned to a more normal state.  This correction has indeed begun to occur during this year’s first quarter.  Interest rates declined all along the yield curve, which contributed to the positive return of the aggregate bond market index and the bond portion of your portfolio.

Within the “other” category, gold, REITs and other precious metals all had positive returns during the first quarter.  These investments offset your stock market declines, once again illustrating the benefit of diversification.


Please recall that we invite you to call us to discuss any aspect of your portfolio or the views expressed in this quarterly report.






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