TRICK OR TREAT?

October has been a month that has been jam-packed with “tricks” and horribly short on “treats”.

Let’s briefly review some of the key happenings of the last week or so:

Trick

The economy shrunk in the third quarter as consumers cut back on spending.  The GDP shrank at a negative 0.3% annual rate.  It appears GDP will probably be negative in the fourth quarter as well; this would confirm the recession.

Trick?  Treat?

The government is considering a plan that would help 3 million homeowners avoid foreclosures.  A deal is pending which would allow $50 billion from the “rescue bill” to guarantee $500 billion of mortgages.  This could help restore confidence in the market for securities backed by mortgage loans.  That is where the global credit crisis started.

Trick

GM, in an attempt to stave off possible bankruptcy, has been involved in talks to acquire Chrysler.  GM is burning through more than $1 billion per month as it deals with slowing auto sales and a global recession.  GM is pursuing $5 to $10 billion in aid from the government.  Why would the government help GM???  GM has 177,000 U.S. workers and about 500,000 receiving pensions.  It is estimated that there are an additional 7.5 jobs with parts makers and other supply companies for every automotive job.  That is a lot of jobs!

Treat

The Fed cut rates by ½% to 1% on Wednesday.  This is an attempt to revive an economy hit by the most severe financial crisis in decades.  The 1% rate is the lowest since 2003-2004.  The hope is that other countries will follow with rate cuts in the next few weeks.

Treat

Credit is beginning to free up as is evidenced by the spread between LIBOR and the Federal Funds rate.

Note: Rate cuts do matter.  It causes an injection of additional reserves into the banking system.  Many loans will have their rates adjusted downward, enabling companies to borrow at lower rates.

Treat

Gas prices declined this week to $2.59 per gallon for regular.  As Larry Kudlow, MSNBC economist states: “This is like a tax cut for Americans.”

Trick (Terrible Trick)

October, when the market closes today, will wind up being the worst October since 1987.  The markets will likely finish down between 15% and 20% for the month.  Maybe the markets should just stay closed during the month of October!

THE BIGGEST TREAT OF ALL!

The Phillies won the World Series and are world champions of baseball.  This ends the “Philadelphia curse” of 25 years without a major championship.

Happy Halloween and thank goodness October is over!

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC

Edward J. Kohlhepp, Jr., CFP^®, MBA

“Today people who hold cash equivalents feel comfortable.  They shouldn’t.  They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value”.

                Warren Buffet, NY Times 10/17/2008

I FEEL LIKE A WRESTLER

Over the last week, I have started to feel like a wrestler for the WWF (World Wrestling Federation).  I thought, here I am, a 170 pound weakling being thrown into the ring with a 300 pound guy.  After the gorilla beat me up for about 10 or 15 minutes, I realized that I had survived and I was about ready to leave the ring.  Then the 300 pound wrestler tagged up with his partner, who was a 320 pound guy, and just when I thought I was getting a reprieve, he came in and pounded me again, mercilessly.

I’m sure that is how we all feel after a few months of this market pounding.  It is like we have been pounded mercilessly by the markets with a few daily reprieves of a 900 point up day, a 700 point up day, and two 400 point up days; then without notice the market takes back almost everything it gives us.

What I would like to do at this stage is bring you up to date on a few occurrences with regard to the markets and what is happening.

Paulson Speech

Secretary of the Treasury Henry Paulson gave a speech on October 21^st, and his key points were as follows:

                               1.            The current challenges in the credit markets will continue for a number of months.

                               2.            The U.S. Government will do whatever is necessary to strengthen the banks and the financial institutions.

                               3.            World governments must continue to take individual and collective action to stabilize the financial markets.

                               4.            The 20 largest countries are supporting the stabilization process.

                               5.            The recent actions of the government and the FDIC are powerful and will unlock the credit markets.

                               6.            China (despite the slowdown) will remain an important engine of financial growth.

                               7.            The world financial markets are undergoing the most serious financial stresses in recent memory.

New stimulus package

Yes, Congress has proposed a NEW stimulus package and Fed Chairman Bernanke endorsed the package when he testified before the House Budget Committee earlier this week.  The package could cost between $150 and $300 billion and “seems appropriate” according to Bernanke.

Nancy Pelosi suggested the bill should include new spending on infrastructure, aid to cash-strapped states, extended jobless benefits and possibly a tax cut.  President Bush wants a plan that would “actually stimulate the economy.”

The Democratic leadership is considering calling lawmakers back to town after the election to vote on this package.

My note: Where is all this money coming from?  The printing press must be running overtime.

The Credit Markets

In order to understand the credit markets, you need to understand LIBOR.

LIBOR

London Inter-Bank Offered Rate.  This is the interest rate that banks charge each other for loans (usually in Eurodollars). This rate is applicable to the short-term international interbank market and applies to very large loans borrowed for anywhere from one day to five years.  This market allows banks with liquidity requirements to borrow quickly from other banks with surpluses, enabling banks to avoid holding excessively large amounts of their asset base as liquid assets.  The LIBOR is officially fixed once a day by a small group of large London banks, but the rate changes throughout the day. It is for non-collateralized loans.

This global inter-bank market provides a means for financial institutions with excess capital to earn higher rates of return by lending liquid assets to those in need of the funds.

LIBOR is important because it is often used as the base for variable-rate government and corporate loans, mortgages, and derivative-based products such as credit swaps.

The Discount Rate

The Discount Rate is the interest rate banks are charged when they borrow funds overnight directly from one of the Federal Reserve Banks.  When the cost of money increases for your bank, they are going to charge you more as a result.  This makes capital more expensive and results in less borrowing. 

The Federal Funds Rate

The Federal Funds Rate is the rate that banks charge each other for overnight loans.  These loans are backed up by the Fed; LIBOR based loans are not.  

“Why would one bank borrow cash from another?” you ask.  The Fed can require banks to keep a certain percentage of assets in the form of cash on hand or deposited in one of the Federal Reserve banks.  From time to time,  The Fed will establish a required ratio of reserves to deposits; when this ratio is increased, more cash must be kept in the vault at night, making it more difficult (and expensive) for funds to be acquired.  When the reserve requirement is lowered, the money supply is loosened; because less cash has to be kept on hand it becomes easier to acquire capital.

The Thaw

There is one positive development in the last week.  The frozen credit markets are slowly showing signs of a thaw.  The three month LIBOR rate on Wednesday the 22nd had dropped to 3.54%, while the Federal Funds Rate was 1.5%.  One week ago the three month LIBOR was 4.64% versus a 1.5% Federal Funds Rate.  This is a very important credit indicator.

 The narrowing of the credit spread between the three month LIBOR and the Federal Funds Rate shows that credit is starting to loosen.  You will hear more and more on the news stations, especially CNN and MSNBC, about the LIBOR rate.  If the LIBOR rate continues to decline, this is a very positive sign with regard to credit loosening.  It is also a very positive sign that the government’s plan is beginning to work.

~ ~ ~  

In the weeks to come, we will bring you more information with regard to what is happening in the markets, what is happening in the economy and what is happening in the credit markets.  We expect the equity markets, as well as the fixed income/bond market to continue to be bumpy for the next several months.  However, there are some positive signs developing, even though the earnings reports of corporations currently are disappointing.

~ ~ ~  

Warren Buffett of Berkshire Hathaway fame wrote in the New York Times recently that he has been buying U.S. stocks.  “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

Best Regards,

Edward J. Kohlhepp, CFP^®, ChFC

Edward J. Kohlhepp, Jr., CFP^®, MBA

Note:  Several people have been asking if we would mind if they forwarded our emails to friends and family.  Not only do we not mind, but we appreciate the fact that you value the commentary enough to do so.

TURNING AN OCEAN LINER

In the following paragraphs, I will summarize the steps being taken to stabilize the world stock markets.  However, even though these strategies are sound, I am reminded that even when the captain decides to turn the ocean liner, it takes a long time to do so.  We are in the process of turning the ship, but it will take awhile.

From October 1^st through October 10^th, the Dow dropped 2,380 points or more than 21%.  Then we had a tease on Monday the 13^th with a 936 point rally before the markets took that back in the next two days.

The major elements of the federal government’s expanded response to the financial crisis have been:

• The Treasury will use up to $250 billion from the $700 billion financial rescue package to purchase senior preferred shares in banks.  Nine major banks will participate initially.  In addition to the nine major banks, thousands of others may participate.
• FDIC will guarantee 100% of newly issued senior unsecured debt of banks, thrifts, and some holding companies for three years.  They will also provide unlimited deposit insurance for bank accounts used by small businesses through December 31, 2009.
• The Federal Reserve will buy high-quality, three month maturity commercial paper through April 30, 2009, backstopping a market used by major corporations to pay for day-to-day operations.
• The banks involved in the rescue plan will issue preferred stock to the government.  It will carry a 5% annual dividend, rising to 9% after five years.  The banks will also face caps on executive compensation, restrictions on dividend payments and more pressure to help homeowners.

A couple of additional points:

• The entire stock market’s capitalization (value) in October 2007 was $18 trillion.  It has dropped to $10 trillion in a year.  John Bogle, formerly the chairman of Vanguard, said that anyone who thinks the market is worth $8 trillion less in one year is “crazy”.  This implies that Mr. Bogle believes the market is undervalued.
• Dividend yield on the S&P 500 is up to 3%.
• The market’s book value (liquidation value) is $5 trillion.  The market is only selling at $10 trillion or twice the book value.  Fair value is considered four or five times book value.
• Abby Joseph Cohen of Goldman Sachs believes the recession will not be deep and will bottom by Spring of 2009.  She said the market typically rallies six to nine months before the recession ends.
• Henry Paulson stated the government plan is good for the country, the banks and the markets.
• The British government infused $63 billion into three leading banks.
• European central banks put $2.3 trillion on the line to protect European banks.

We will have a better sense of credit loosening when the “LIBOR” (London Interbank Offering Rate) rate declines further.  I will elaborate more on this in a future email.

It has become quite apparent that the markets are still “afraid”.  Until we can dispel the fear, there will be more rough days ahead.  It will take a while to turn this giant ocean liner.

Thank you for your patience and understanding of the environment we are experiencing.  We are extremely grateful for our good fortune to work for you.  We are constantly searching for new investment opportunities during these stressful times.

Best Regards,

Edward J. Kohlhepp, CFP^®, ChFC

Edward J. Kohlhepp, Jr., CFP^®, MBA

“No one would ever have crossed the ocean if he could have gotten off the ship in a storm” …..unknown

*Information in the above paragraphs was gathered from articles in the Wall Street Journal.

THE PATIENT IS IN RECOVERY

 The patient is very ill – let’s assume the patient (the economy) just visited the doctor (Ben Bernanke & H Paulson).  The doctor prescribes medicine (the Rescue bill) to make the patient better.  The doctor tells the patient he will get better as long as he takes the medicine.  The patient says “how long will it take”?  The doctor says “I am not sure because you are really sick.  I’ve seen illnesses like this before and I know you will get better, but it could take awhile”. 

As a patient, we always want an immediate recovery once we get the prescription.  Sometimes it takes longer than we want.  In fact, the doctor says we will have some good days and bad days during the recovery.

I know the patient (the economy and the markets) will recover.  I just can’t predict how long it will take.

There are three so-called prescriptions that have been written for the patient.

1. The 700 billion dollar bailout/Rescue plan.  This plan will probably take weeks before the first check is written and months before it has much effect.
2. The Fed will lend funds directly to companies in the form of commercial paper.  This could happen within a week, but take as long as six months to really work.
3. The recent rate cut by the Fed and many other world Central Banks is important.  However rate cuts take as long as nine to eighteen months to work through the system. *

It is also likely that we are already in a recession that will probably last six to twelve months.  So what is next?  Here are a few summary items:

• I do not believe we are on the verge of a depression
• The markets will remain volatile and choppy for some time
• We believe we have reached, or are close to the “capitulation” phase – This is when almost everyone has reached the point of panic and believes the stock market will continue to drop forever and never recover
• Many advisors believe we are getting close to a significant rally
• There will be more bank failures
• The strong companies will get stronger, the weak will get weaker

Warren Buffett invested $5 billion into Goldman Sachs and $3 billion into General Electric Co. This validates the fact that there are tremendous stock values out there.

What should you do?

1. Turn off the TV.  Yes, you should stay informed, but do not confuse that with a 24/7 onslaught on your mental health.
2. Control your spending
3. Remember that your asset allocation has about 40% of your portfolio in cash, money markets, bonds, and safe investments.  If need be, we can use all of the safer investments to generate your needed income for the next five years or so.  This will allow us to keep your stocks and equities invested until the crisis has passed.
4. Reconsider if you are considering selling your investments.  It is your money and ultimately it is your decision.  But selling into a market like this almost always turns out to be a bad decision.

Humans are herd animals.  We like to move together and think the same way, even if it means moving off a cliff, or even if the thoughts are dysfunctional.  Do not be part of the herd.

We are here to be your anchor.  This is NOT over yet.  But we want you to make the right decision.  Please continue to let us know how we can help you.

Thank you for all the confidence you have shown in us.  We cannot possibly convey to you how seriously we take it and how much it means to us.

Sincerely,

Edward J. Kohlhepp, CFP®, ChFC

Edward J Kohlhepp, Jr., CFP®, MBA

“Life isn’t about how to survive the storm, but how to dance in the rain”

…..anonymous

*Note: some of the ideas in this letter were taken from a commentary by Ali Velshi, a senior business commentator for CNN

• An increase in the FDIC insurance limit has been added to the bill, and
• The House should realize how critical this bill is after the credit markets froze up on Monday and Tuesday

TWTWTW

Back in the 60’s there was a TV show called “That Was The Week That Was” – well, we have just witnessed a week in the financial and credit markets the likes of which we never want to see again.  Although the problems are quite complicated and extensive, I will attempt to list some of them, then recap the key happenings of the last few weeks and months, then summarize the government bailout.  Finally I will address “what to do now”.

The problems:

·        Our mortgage system evolved into one where almost anyone could get a mortgage with little or no down payment and no documentation (sub-prime loans).

·        Wall Street packaged these loans in bundles where there was no transparency (you couldn’t tell the good ones from the bad) and used them as collateral for further investments.

·        The real estate bubble burst and people started to default on their loans.  Consequently, the dominoes began to fall and real estate values declined precipitously.

·        In 2004, the government changed a law which allowed banks and lenders to increase their leverage, which enabled them to borrow even more money.

·        Bear Stearns became one of the first casualties but the Fed interceded and loaned money to JP Morgan to enable them to buy Bear Stearns.

·        Fannie Mae and Freddie Mac (the two mortgage giants) were in danger of failing so the government stepped in to take them over and loaned them $200 billion.

The week that was – September 15, 2008 through September 21, 2008:

MONDAY

Ø      Lehman Brothers files for bankruptcy;  Bank of America announces it will buy Merrill Lynch

Ø      Dow Jones industrial average falls 504.48 points, or 4.42 percent

TUESDAY

Ø      Federal Reserve lends AIG $85 billion in exchange for a nearly 80 percent equity stake, averting bankruptcy by the world’s largest insurance company

Ø      The Primary Reserve Fund, hurt by Lehman holdings, becomes the second money market in history to fall below $1 per share

Ø      British bank Barclays says it will buy the good parts of Lehman for $1.75 billion

Ø    Dow rises 141.51 points, or 1.3 percent

WEDNESDAY

Ø      New rule temporarily banning an abusive type of short selling takes effect

Ø      Money market funds, facing heavy withdrawals, try to reassure investors;  Putnam Investments closes an institutional money fund

Ø      Federal Reserve leaves key interest rate unchanged

Ø      To bolster the Fed’s balance sheet, the Treasury begins selling $100 billion in short-term bills

Ø      Banks worldwide stop lending to each other

Ø      Dow falls 449.36 points, or 4.1 percent

THURSDAY

Ø      The Fed and other central banks flood money markets with overnight and short-term loans to push down commercial banks’ short-term borrowing costs and encourage lending

Ø      Treasury floats plan to create a federal agency to take over bad loans made by financial institutions

Ø     Dow gains 410.03 points, or 3.9 percent

FRIDAY

Ø      Treasury announces it will buy illiquid mortgage securities from U.S. financial institutions; it will guarantee most money market funds for one year; Fannie Mae and Freddie Mac will double the amount of mortgages it will buy this month to $10 billion

Ø      The Securities and Exchange Commission bans short selling entirely in 799 mostly financial companies until October 2, when the rule could be extended for up to 30 days

Ø      Dow rises 368.75 points, or 3.4 percent, ending the week off just 0.3 percent

SATURDAY

Ø      The Bush administration asks Congress for the power to buy $700 billion in troubled mortgage-related assets.

SUNDAY

Ø      Goldman Sachs and Morgan Stanley, the last big independent investment banks on Wall Street, will be transforming transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night.  This move fundamentally reshapes an era of high finance that defined the modern Gilded Age.

The firms requested the change themselves, even as Congress and the Bush administration are rushing to pass a $700 billion rescue of financial firms.  It was a blunt acknowledgement that their model of finance and investing had become too risky and that they needed the cushion of bank deposits which had kept big commercial banks like Bank of America and JPMorgan Chase relatively safe amid the recent turmoil.

It effectively returns Wall Street to the way it was structured before Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.

In exchange for subjecting themselves to more regulation, the companies will have access to the full array of the Federal Reserve’s lending facilities.  It should help them avoid the fate of Lehman Brothers.

The Government Bailout Plan (summary)

 Treasury Secretary Paulson and Fed Chairman Bernanke have asked Congress to pass legislation to authorize a plan to bail out the U.S. financial system.  Details of the plan are still sketchy, but essentially the Treasury department will request the authority to run auctions to borrow hundreds of billions of dollars to be used to buy illiquid assets from U.S. financial institutions.  This in turn would shore up firms and make them healthy enough to raise new capital.  A new agency will be created similar to the Resolution Trust Corporation used during the Savings & Loan crisis.  This bill will be referred to as TARP (Troubled Asset Relief Program).

What do we do now? 

Change is a fact of economic life.  Flip through a magazine from twenty or thirty years ago and you’ll see the names of many firms once considered mainstays of the American business landscape that are now gone.  And many of today’s common everyday brand names are nowhere to be seen – and in many cases had not yet even opened their doors for business.

It is useful to keep in mind that change is, in and of itself, not alarming.  But sometimes the pace of change catches us off guard and inspires overreactions.  After weeks of speculation, announcements regarding the fate of Lehman Brothers and Merrill Lynch sent the markets into turmoil.  Despite the wide anticipation of negative news regarding these two one-time giants, investors across the world are reacting now that anticipation has become reality.

I believe that you already understand the limits of emotional and (especially) fear- based decision making.  No one can say what the reshaped Wall Street landscape will look like, but experience tells us that those who remain calm and make rational decisions with an eye on the long term are those who will most likely weather the current uncertainty.

As you consider the news, keep a few things in mind:

·        The turmoil engendered by the Merrill Lynch and Lehman announcements is centered on the Financial Sector.  Financials have been weak for some time and there had been considerable speculation of further headwinds to come.  So while the timing and perhaps the scope of the announcement could not have been anticipated, further bad news was not unexpected.

·        A secondary source of weakness is Consumer Discretionary.  Since much consumer spending is financed by debt, difficulties in the financial sector are likely to extend this weakness.

·        Despite the weakness in these two sectors and across the S&P 500 at large, history shows that the capital markets often respond creatively, finding opportunities in the midst of challenges.

Last Thursday I attended a conference and met with officers and strategists from Goldman Sachs, UBS, and Litman Gregory, among others, as well as 100 other independent investment advisors from around the country.  My conclusion is that we are still in for a bumpy ride.  The move by the Federal Reserve and the Treasury was needed in order to prevent a collapse of our financial systems.  I do not expect an immediate recovery or a fast market upswing (although one firm predicted just that).

 As you know, we have had concerns for some time that we are in a secular bear market (a long term period of flat or declining stock prices).  We have designed your portfolios with this in mind and have implemented different strategies for portions of your portfolio.  This will enable us to weather this storm.  If we haven’t met with you in the last few months, our plan is to schedule a meeting or a phone conversation in the near future.

We wish we could assure you that the market will stabilize and never go down again.  However, our basic role is to help you attain your lifetime goals.  It is still possible to attain your goals even when the market staggers through these declines.  We hope we can relieve you of some of the stress during these tumultuous times. 

Please call us at anytime to discuss the markets or your portfolio.

Best regards,

Edward J. Kohlhepp, CFP^®, ChFC  &

Edward J. Kohlhepp, Jr., CFP^®, MBA

Kohlhepp Investment Advisors, Ltd. 

Certain information included in the above article compiled from The San Francisco Chronicle and The New York Times.