The Markets	12/31/08      Close	09/30/08    Close	4th   Qtr.  Change	12/31/07                      Close	12 Mo. Change	YTD       Change
Dow	8,776	10,851	-19.12%	13,299	-34.01%	-34.01%
NASDAQ	1,577	2,082	-24.26%	2,656	-40.63%	-40.63%
S&P 500	903	1,166	-22.56%	1,473	-38.70%	-38.70%
10-yr Treas. yield	2.24%	3.83%	-1.59%	4.04%	-1.80%	-1.80%
Fed funds rate	0 to .25%	2.00%	-1.75%	4.25%	-4.00%	-4.00%

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

2008 closed as one for the record books, and not in a good way. By some measures it was the worst year for the stock market since 1931 and overall stocks are below the levels of ten years ago. The financial and credit crises meant losses on fixed income investments that were previously considered relatively safe, and real estate and hard asset prices continued to fall. We may have indeed seen our “lost decade” for investments.

Government intervention and “bailouts” were the big development of the quarter, starting with the political drama of the $700 billion package for financial firms and ending with the administration stepping in where Congress was unable to reach a decision on a package to aid the failing automakers. Along the way, and as was widely predicted, an array of industries and political entities presented their case for some sort of government assistance, and the final tally will easily be north of $1 trillion. On top of that, the balance sheet of the Federal Reserve has grown from under $800 billion to well over $2 trillion as the Fed has taken on a variety of obligations from financial firms. All this is before any stimulus or infrastructure package from the new Obama administration.

The Fed was very active on the interest rate front as well. In October the Fed cut rates by 0.5% and was joined by the European Central Bank, the Bank of England and the central banks of China, Canada, Sweden and Switzerland in the first globally coordinated rate cut ever. The Fed cut by another 0.5% at the end of October, saying “downside risks to growth” were greater than any inflation fears. The quarter ended with the Fed cutting rates to all-time lows, with the target rate set at 0.25% to zero. The obvious fear is that having exhausted the fundamental tool of rate cuts, what other levers can the Fed pull should the economy continue to slide. (And in some poetic justice, former Fed Chairman Alan Greenspan finally admitted to some “flaws” and blunders in the Fed’s long strategy of easy money and hands-off management, which inflated the credit balloon and lead to the current crisis.)

Otherwise, all the economic news was bad and generally got worse through the quarter. The job market weakened considerably, with first-time jobless claims steadily increasing and the number of ongoing claims at record levels; unemployment increased to 6.7%. Average housing prices were down 11% and new home sales were off 35% compared to a year earlier. Consumer confidence hit all-time lows in October and again in December, and holiday retail sales were off around 4%. Manufacturing indicators hit 60-year lows and even usually reliable services indicators showed declines. Third quarter GDP was revised to a decrease of 0.5%, and the recession was determined to have actually begun in December 2007. The International Monetary Fund predicted that consolidated GDP for 31 developed countries would decline in 2009 for the first time since World War II. At least the declining activity pushed down oil prices, as they plunged to below $40 a barrel at some points despite announced production cutbacks by OPEC.

All of this panic created unprecedented volatility in the stock market. Three of four trading days in the quarter saw triple-digit changes in the Dow, for the first time ever there were three days with 1,000 point intraday swings in the Dow, and the market has registered historic daily moves both up and down. The week of October 6 presented a graphic example of how panic can disrupt markets. Each day, trading began calmly as investors hoped to see signs of stabilization. As the day went on, those signs did not materialize, and the stock market began a slow decline. In the last half hour of trading, trading volume skyrocketed as panic set in and a stampede of selling ensued. By week’s end the Dow had dropped 18%.

It may well prove that the worst has passed, and reduced volatility towards the end of the quarter may be an indicator of some sanity returning to the market.

Looking Forward

Once again the economic situation has presented us with both a short-term and a long-term uncertainty. In the foreseeable future, the big question is whether and to what extent the credit markets will begin to thaw. Despite the media version of immoral financial executives gladly taking public money, refusing to lend and even cutting off current qualified borrowers, there is a legitimate and worrisome imbalance in the availability of credit.

By no stretch of the imagination will we return to the days of credit made available on a signature, if that, and there is general agreement that restoration of reasonable lending standards will be one of the silver linings of the crisis. But available credit for qualified borrowers will be essential to halt the slide of property and hard asset values, whose decline is in large part due to the dearth of potential buyers. Likewise, credit markets such as the commercial paper market, which is crucial to supporting normal business operations for many sound companies, have irrationally dried up from overreaction to isolated problems.

The government’s many “bailout” initiatives, as easy as they are to criticize, are intended to reduce the fears of the credit markets and facilitate sound lending. Once that begins to happen, the true measure of the bailout initiatives will be the extent to which the government remains involved in ongoing operations of the financial markets. While it is reasonable for the government to expect more lending in return for taxpayer dollars being put at risk, tighter regulations are one thing, ongoing ownership is quite another.

The long-term question is how the consumer will adjust to the financial crisis. In other words, is the new austerity just a temporary adjustment that will fade as credit becomes available and the job market stabilizes, or will there be a lasting cultural shift from conspicuous consumption to a more thoughtful consumerism. As financial advisors, we continue to encourage clients to take a hard look at spending and search for cost-effective ways to enrich their lives rather than equating benefit with the amount spent; unfortunately, if everyone took that approach the impact on the economy would be long and deep. Our guess is that the dust will settle somewhere in the middle, with the consumer returning but in a bit more practical way. And there will undoubtedly be some “catch up” spending once the recession ends.

Our Portfolios

From our last report, where we lamented that there was little place to hide, our portfolios suffered with the markets this quarter. As painful as the quarter was, we elected to stay the course with some minor adjustments in specific portfolios. We expect that most of the pain is behind us, and hope that there will not be another wave of “forced selling” by market participants which contributes mightily to volatility.

This was an opportunity to harvest some tax losses to offset any gains, as well as some ordinary income, and we did take some tax losses in taxable portfolios. Another benefit of capital losses is that any excess can be carried forward to future years, further offsetting gains. Whether shifting to a similar investment or staying out of the market for the required period, we anticipate returning to previous market exposure over time.

One interesting area is inflation-protected Treasury securities, particularly for new portfolios. These Treasuries have become a bit of an afterthought as inflation has slid off the list of policy makers’ priorities, but that is precisely what makes them attractive as a classic “buy low” opportunity. These securities pay a fixed yield but also adjust their principal with inflation, making them an ideal inflation hedge. Typically the yield on inflation-protected securities is less than regular Treasuries because investors are willing to pay for the inflation protection in the form of a lower yield. Prices have declined to the point that they have the same current yield as comparable maturity regular Treasuries, meaning that the inflation protection is “free”.

The Secret

My mother is like many women of her generation. My late father’s efforts left her with resources that are not large but which provide sufficient income to meet her needs. She is concerned about the current crisis and worries that she could “lose everything” but she does not fully understand the risks and opportunities of various types of investments and markets. She has been a member of her community for many years and knows just about everyone.

So, she regularly asks why she can’t do with her money what the local doctors do with theirs. She is certain that “the doctors” have some special method of investing that regular fools don’t know about.

Enter Bernard Madoff, who used exclusivity and secrecy to run a Ponzi scheme that, by his own estimate, may ultimately total $50 billion in losses. Madoff used intermediaries with connections in country clubs, charity circles and the international jet set to generate new investors to pay off the old investors. Often the intermediary would present Madoff’s fund as one that required an “invitation” to participate. As Robert Cialdini, a psychology professor at Arizona State University, noted in the Wall Street Journal, Madoff “shifted investors’ fears from the risk that they might lose money to the risk they might lose out on making money”.

Since participation was by “invitation”, investors were reluctant to do further investigation. Asking too many questions often got investors thrown out of the fund, further inhibiting critical inquiry. And despite the failure of the regulatory authorities to follow up on red flags, there were plenty of signs of trouble that the investors should have recognized.

Madoff refused to describe his investment strategy in any detail and reported remarkably smooth returns, somehow conquering the volatility of the markets. He posted positive returns when nearly every other hedge fund was struggling. Over the years, a number of other investment professionals tried to validate his results based on reported trades and were unable to do so; in fact, the reported transactions were so large as to be impossible in the securities supposedly traded. Most telling, Madoff’s client reports came from Madoff himself rather than an unrelated, independent third party, making it easy for him to conduct the fraud for years. The fund was audited by a small firm with few other clients and no real experience in auditing funds.

The Greenwich Roundtable, a non-profit that researches alternative investments, conducted a survey in 2007 of institutional and high net worth “sophisticated” investors. Rather than a formal checklist or other analytical due diligence, one out of five follow “an informal process” of due diligence, leaving themselves open to fraud. One in four will invest without examining the fund’s financial statement and nearly one in three won’t always investigate the fund manager’s background. It is no surprise that many of Madoff’s investors didn’t even know they were invested with him; they had invested with other advisors who had in turn shipped the money to Madoff. Not only did they have no idea how their money was invested, they were paying layer upon layer of fees for the privilege.

The secret, of course, is that there is no secret. The doctors my mother knows are professionals who have invested heavily in their own education, work very hard, and have earned a relatively high income for a number of years. They have invested and taken risks and have benefited from diversification and time, the fundamental factors that are available to all. And they have undoubtedly had their share of investment failures, although those may be less public and are a little less obvious because of their ongoing income.

Somehow my mother still doesn’t seem convinced.