The Markets	03/31/08      Close	12/31/07    Close	1st Qtr.  Change	03/31/07 Close	12 Mo. Change	YTD       Change
Dow	12,263	13,299	-7.79%	12,354	-0.74%	-7.79%
NASDAQ	2,279	2,656	-14.19%	2,422	-5.90%	-14.19%
S&P 500	1,323	1,473	-10.18%	1,421	-6.90%	-10.18%
10-yr Treas. yield	3.43%	4.04%	-0.61%	4.65%	-1.22%	-0.61%
Fed funds rate	2.25%	4.25%	-2.00%	5.25%	-3.00%	-2.00%

(stock indices are before dividends; yield and rate changes are absolute changes)

Forget about market performance and economic data, this quarter was one of historic high drama. It began with the purchase of Countrywide, the poster boy for rah-rah mortgage lending, being purchased by Bank of America. Next, the sovereign investment funds of Korea, Singapore, Kuwait and others invested in Merrill Lynch and Citigroup, which shored up the firms’ capital structure but which generated hand-wringing over ceding control of our financial system to foreign governments. Then it got real interesting over the Martin Luther King weekend as world markets plunged for two consecutive days and the Fed made an emergency rate cut of .75%. The plunge was exacerbated by a $7 billion trading loss by a “rogue trader” at Societe Generale, the second-largest French bank.

The Fed continued to pump money into the banking system in attempts to ease the credit crunch as some areas of the credit market nearly dried up. Next the White House announced its tax rebate program, a band-aid which will likely go to paying down debt rather than spending by consumers. The Fed cut rates .50% at the end of January, fears that municipal bond insurers would fail caused havoc in bond markets, gold hit $1000 an ounce and oil hit $110 a barrel, confidence was steadily eroding, and home sales and prices continued to slide.

As the quarter neared its end, we were treated to what the Wall Street Journal referred to as “ten days that changed capitalism”. The Fed and the Treasury department orchestrated the rescue of Bear Stearns by JP Morgan by taking $29 billion of Bear securities onto the Fed’s books. Even more significantly, the Fed opened their discount lending window to investment banks for the first time and accepted mortgage and other securities as collateral. Barely catching its breath, the Fed cut rates another .75% in late March and reduced the spread between the target Fed funds rate and the discount rate at which the investment banks were borrowing. Finally, on March 31, Treasury Secretary Paulson proposed a sweeping overhaul of the financial regulatory system. While the proposal was intended to recognize the intertwined nature of today’s markets, he emphasized that it was not realistic to create a system that could fully predict, recognize or prevent disruptive financial bubbles in the future. Whew!

Through it all, the economy managed to chug along and only the Nasdaq hit bear market territory, defined as a 20% drop from the market high. The “spreads” between safe Treasury securities and nearly all other fixed income securities widened dramatically as investors flocked to safe haven; this drove Treasury prices up and other prices down. New jobless claims remained fairly steady, worker productivity gains continued and fourth quarter GDP eked out a 0.6% increase. Rising energy prices, crumbling confidence, declining leading economic indicators and weakening in both manufacturing and services led to fears of recession or worse despite small increases in personal incomes and consumer spending. A positive development was a 9% drop in the 2007 trade deficit led by a nearly 13% increase in exports.

Looking Forward

At this point, whether we are now in or are heading into a recession is academic and of little consequence. Confidence is already so low that only time will fully heal the wound, and like recession, recovery will only be recognized after the fact.

The real question is whether that healing has begun as a result of the Fed’s actions or is there still a financial tsunami lurking out there that will simply overwhelm all possible efforts to stop it. The markets appear to be slowly taking the position that the system will not fail, that the major players will survive and that any losses will ultimately be absorbed. Since lack of confidence has been the nagging cause of the credit crunch, rather than money supply or interest rates, this could signal a turning point. That does not necessarily mean that either the economy or the markets will come roaring back, and a quick recovery would probably diminish the impact of the painful lessons learned. A better scenario would be a longer, gradual recovery which would restore the proper respect for risk and prudence.

It would be impossible to avoid the effects of a financial tsunami without completely withdrawing from the financial system, a disruption which very few would be willing to undertake. Even then there would be no guarantee that one cold escape unscathed. So, if it hits, we will all simply have to work together to rebuild, and let’s hope we still have the strength and character to do so.

Our Portfolios

We completed the reduction of international core holdings to a “neutral” position, based primarily on the dollar hitting a 13-year low against a trade-weighted basket of 26 major currencies. While the dollar remains weak and further rate cuts by the Fed will weaken it further, it has already fallen nearly 40%. Besides, we do not subscribe to the doomsday opinion that the dollar will completely collapse, and by the same logic, other economies that have sustained their growth face greater risk of a slowdown. In other words, the dollar and the US market have less far to fall and more room to recover, which seems like a reasonable contrarian bet to make.

We have been tempted to take gains in some of the few areas that have performed well. The commodities fever cooled a bit as institutional traders took gains to compensate for losses in other areas, and an opportunity was missed. Still, it does not look like the commodities boom is done, so at the next spike we hope to take some gains while retaining some exposure. The flight to quality has pushed up prices for Treasuries, to the point where inflation-protected securities (TIPS) now have a negative real yield, which is contrary to their very design. Since our TIPS positions were established a while ago we have benefited from this fear. Unfortunately, there are no real alternatives to serve TIPS’ purpose of a long-term hedge against inflation, so we will maintain the positions to do just that. (Gold and other real assets do not offer the same low risk profile as TIPS.)

Tough Love

While many voices are calling for much more regulation, the Fed and the Treasury have been trying their version of “tough love” in dealing with the financial markets. Rather than being distracted by the many symptoms, they are trying to allow the free market to deal with the real problems. Hopefully they have not given up on the idea that giving in to short term pain would result in deeper and more serious problems down the road. They face the difficult balancing act of allowing the various market participants to learn from their mistakes and to suffer the consequences while intervening to prevent irreparable harm.

Of course, this all begs the question of why a corporation should warrant government intervention – call it a bailout if you will – while homeowners are largely left to fend for themselves. First, mortgages for qualified homebuyers are still available, albeit under tighter criteria, so the market is still functioning. The fear was that a Bear Stearns collapse would cause a downward spiral that would cripple the entire financial system and could not be contained. Second, the Bear Stearns deal did not make the company whole by any standard, and the shareholders lost over $20 billion of value (this point was admittedly weakened by the increase to $10 a share from $2, but it was still a long cry from the high of $170). If a home is lost to foreclosure or returned to the lender, the homeowner has lost only his equity, and in the last few years homeowners have unwisely either purchased homes with little or no down payment or refinanced to extract all the equity. Third, the deal came with other strings attached, and in return for the Fed taking the risk on $29 billion in securities JP Morgan also gave up any opportunity to profit from those same securities should the markets recover. Finally, even losing a home leaves intact the individual’s ability to earn a living and there are a host of social programs and safety nets in case of further distress.

We have worked with a number of individuals and families in financial distress, and at the risk of appearing heartless, our conclusion is that none of them were victims of uncontrollable circumstances such as losing a job, medical problems or illness or family breakup. They were unfortunately victims of their own speculative investing, excessive use of debt and impulsive spending, and are only now learning the risks and feeling the consequences of their poor judgment. As long as the safety net is in place and working, tough love won’t spread the pain and cost to everyone else.