Economic Environment

Previous quarterly reports indicated that the valuation of equity markets were reflective of a generally moderate economic slowing that, although not borne out by GDP statistics, was likely in process. The nature and magnitude of that slowdown was unanswered, but the sentiment is apparent now without question. The rapid onslaught of the banking and liquidity crisis has convinced equity markets that a deep and severe recessionary environment will unfold over the next few quarters at least. Indeed, the crash in global equity valuations and the flight to quality in the fixed income markets along with a server credit squeeze, have resulted in arguably a panicked sell off representative of pending economic depression.

Although the markets' valuations arguably reflect a severe recession, this is no guarantee of what will actually happen and when. Although it appears that any perception of even remote optimism has been deemed politically incorrect and socially unacceptable, a few will be offered here. First, there appears to be some thawing in the very chily global credit markets. This may not impact consumer lending in the near term (and probably should not be the goal in any event), however, the corporate money markets may likely continue to improve, helping with near-term corporate financing needs. Second, the sub prime mortgage situation has been significantly addressed. One can argue as to its effectiveness, timeliness and eventual cost, but it has hardly been left as an issue for time alone to take care of. Perhaps also, there are some signs of stabilization in the housing market as inventories are down 29% since July 2006, partially due to housing starts being at a 17-year low. Lastly, global fiscal and monetary policy is addressing the potential of severe recession in an unprecedented and coordinated fashion. Although there is a liquidity crisis, there is also an enormous amount of liquidity in the system which will find its way into world economies over time.

I do not mean to downplay or ignore the fact that an economic contraction is most likely ahead of us. Indeed, as we have previously indicated, we were probably already in the midst of such a recessionary environment. It further appears this will not be the type of recession that is over before we knew it began. But, we have confronted economic recessions before and to no surprise to us, this one may be on a more global scale as economies have become more interdependent. There will likely be increases in unemployment and decreases in consumer spending, but significant actions are already in place attempting to reverse these trends.

It is unlikely that the markets will continue to reflect significant volatility as the global economies adjust. There will likely be additional bankruptcies and deteriorating economic statistics yet to be announced which could result in significant market declines. Just as quickly, any favorable news (or at this point, even the lack of negative news) may likely result in sudden jumps in market valuation as we have already seen. The best manner in dealing with these uncertainties continues to be in maintaining an orientation which is long term. Living through these periods of volatility with funds you can identify as longer term will ensure that you participate in the eventual recoveries which continue to come in a concentrated and inexplicable fashion.

For additional comments on the current environment, click here to view our Interim Third Quarter, 2008 Portfolio Report.

Equity Markets

The conditions within the economic environment were reflected in domestic and international equity returns seen during the quarter. For the quarter, domestic small cap value and real estate were the only asset classes to post positive returns of 5.0% and 5.6% respectively. Outside of these areas, returns were down substantially with emerging markets off the most significantly (-26.9%), developed international next (-20.5%) and domestic mid-cap growth thereafter (-17.7%). After the very strong returns seen in international equity markets over the five-year period ending last year, it is no surprise that some correction was inevitable. However, this has clearly, been exasperated by the current financial crisis. The global nature of this crisis has also muted the usual beneficial impact of diversification. As we do not interpret what we have recently seen as the norm, but rather of an extreme nature, we still believe diversification between domestic and international equities will prove beneficial over the longer term.

You may have heard this decade referred to as a "lost decade" in terms of investment returns as the S&P 500 basically has a total return of 0% so far this decade. While this is true, it is important to remember that the S&P 500, while the most widely quoted benchmark, is just one benchmark and accounts for a little less than 1/3 of our model growth component. The remaining asset classes in our model growth component, even after the big losses suffered last quarter and in to October, have all produced positive returns for the decade. This should underscore to a degree the importance of diversification within the growth component of your portfolio, even in years like the current one when everything appears to be down.

As we have mentioned, it is impossible to determine when equity markets will make their adjustments upward and downward. However, relative valuations based on trailing earnings appear to be reaching historically low levels. For example, on March 24, 2000, the peak of the internet bubble, the trailing P/E ratio for the S&P 500 Index was 30.9. In contrast, the trailing P/E ratio on October 9, 2007, the peak of the market before our current sell off, was 19.5 and as of September 30, 2008 stood at 18.8. With October performance it has fallen to about 12.0. More broadly, current P/E ratios for virutally all domestic asset classes are below their 20-year averages. The same holds true for foreign stock valuations where developed-country stocks traded at a P/E of about 11.0 and emerging-market stocks traded at a P/E of less than 11.0 at the end of the third quarter, well below their respective long-term averages of 19.7 and 16.5. Clearly, the outlook for earnings improvement is quite weak and although this may be true, the market has discounted the potential significantly.

Losses were not limited to equities as fixed income returns also suffered during the quarter. Corporate (-7.8%), high yield (-8.9%) and municipals (-3.2%) all fell sharply during the quarter. Not surprisingly treasuries rose 2.3% as the spread between treasuries (safer) and high yield (riskier) issues widened to levels seen in typical recessionary environments as principal protection took center stage over yield. At one point during the quarter, Treasury bond yields sank to zero, illustrating the unprecedented level of fear seen in the markets during the quarter. As fear and uncertainty ripple though this market, there has been a general reluctance to invest in even investment grade corporate bonds, as evidenced by average yields on A-rated corporate bonds jumping from 6% to 8% during the quarter. Should there be continued improvement in the global liquidity situation, we expect to see corporate yields fall and treasury yields increase to more normal spreads. Although this may take a time frame beyond days or weeks, we would not anticipate the process to take years either. As the yield spread normalizes, we believe non-treasury bond prices will substantially recover.