Feds, Recessions and Bears

Posted on April 8, 2008 by David Laidlaw 

Turmoil within the credit and equity markets continued during the first quarter of the year. The fragility of our financial system was highlighted by the failure of Bear Stearns and subsequent acquisition by JP Morgan with the Federal Reserve’s help.

The majority of the economic trends are negative. Lower housing values have restricted the supply of credit. Less credit in turn has caused the consumer to reduce spending and slow the economy. Unemployment rates have increased further depressing growth during the first few months of the year. Finally, high energy and food prices are keeping inflation levels higher than we have seen in a generation.

We do not have any unique insights into how deep or long this volatility will persist. Equities will not recover until the banking system becomes cleared of its bad debt and is able to lend freely. Ironically, UBS’s $19 billion write-down was one of the positive catalysts that sparked the market to rebound strongly on April 1st. The government has also acted very aggressively to address these problems as we will discuss later in our commentary.

Our strategy in client accounts has been to try to preserve capital by avoiding the highly leveraged firms that are bearing the brunt of the market correction. We are also opportunistically buying positions that appear to be good values. On the equity side, we have added companies such as Noble Corporation and Danaher that are trading near historical lows relative to their earnings and cash flow multiples. With the fixed-income portion of portfolios we have reduced our allocation to Treasuries since the panic has pushed up prices to unsustainable levels. The two-year Treasury Note is only yielding 1.8% and the ten-year Note is yielding about 3.5%. These yields are incredibly low since inflation is roughly 4% year over year.

We continue to believe that much of the bad news is already factored into the current depressed prices for common stocks. We do not recommend reducing equity allocations now since stocks are more attractive than bonds and commodities based on their respective long-term potential.