• Below, we have reproduced a chart, prepared by Citigroup and presented by Great Companies, Inc. at its annual investors’ meeting last week.  It shows how the S&P 500 performed during recessions, as well as in the 12 months before and after each one.  It is not hard to see that the greatest damage has historically occurred before, not during or after, each recession.  The exception is the last recession, which fell on the heels of the greatest stock market bubble ever.

• The first five days of the trading year set a record as the worst beginning for the markets, sending the S&P 500 down 5.3%.  The previous record was -4.7% for the first five days in 1978, but the market finished that year up 1.1%.  In 1991, the market started down 4.6% in the first five days, but finished up 26.3%.  (Source:  The Stock Traders Almanac)  Unfortunately, this year, the markets continued to tumble right up through the middle of this month.  The S&P 500 is now down 6% year-to-date through January 15, 2008.  Where it will finally bottom out remains to be seen, but it is highly unlikely that we will suffer any of the “slings of outrageous fortune” that occurred between 2000 and 2002.  Investors need to keep in mind that today’s market is very different.  For example, we don’t have the “internet bubble” valuations.  The fourth quarter earnings releases will be important to watch.  

• Gold recently jumped to an all-time high after languishing for more than 25 years.  With the dollar declining in value, as well as concerns about inflation and the potential for a weak economy, gold has become a supposed “storehouse of value”.  Similarly there is a “flight to quality” in U.S. government bonds.  Gold is up about $250 an ounce since last year. 

As big a jump as gold has made, it is nowhere near its 1980 all-time high on an inflation-adjusted basis.  To match that high on an inflation-adjusted basis, gold would have to be selling for almost $2,200 per ounce today, more than double its current price of about $900.  Back in 1980, people hoarding gold and silver created record prices for precious metals.  Some even sold their silverware to cash in on the profits, and worse, homes were being invaded with silverware being the only item stolen.

• Nothing creates bipartisanship like an election year.  On January 28th, the President will give his last State of the Union Address.  Most expect that he will have cut a deal with the Democrats for an economic stimulus package.  Although early signs show the Democrats want an increase in spending (and are likely to get it), our big concern is that both the tax cuts and the spending will spiral out of control, causing what might have been a good package to become “full of pork” for special interests.  Especially in this election year, Democratic and Republican candidates want to go home to constituents and talk about how they “did what they could for each voter’s pocketbook”.

• Speaking of the economic stimulus plan, don’t be surprised to see some type of investment tax credit plan as a part of that package.  This idea has been around since President Kennedy used it to help spur the economy in the early ‘60s.  In essence, an investment tax credit allows businesses to expense new equipment purchases faster.  As the theory goes, this causes businesses to speed up the purchase of new equipment before the expiration of the incentive plan, and since new equipment is being purchased, theoretically, this should lead to higher productivity, in turn leading to higher wages, leading to increased consumer spending, and the cycle continues. 

• Although we are still a full nine and a half months away from the Presidential election, we might know within the next thirty days who the candidates will be.  Obama pulled off a surprising victory in Iowa, followed by Clinton’s arguably even bigger surprise in New Hampshire.  On the Republican side, Huckabee, McCain, and Romney all became winners.  Giuliani is clearly placing almost everything on Florida at the end of the month.  If he’s able to win in Florida (and he must win big), this could carry over into the primaries in early February.  While, on one hand, it could be boring to know who the candidates will be eight months ahead of time (making the conventions this summer virtually useless) it could be equally as interesting if no one emerges as a clear winner and they actually have to continue to work for the nomination.  This harkens back to the “good old days” when the conventions really meant something.  Either way, expect the rhetoric from each party to continue to ratchet up as we head toward November.

• Just what does Bank of America’s proposed acquisition of Countrywide Mortgage really mean, not only to the companies’ shareholders, but to the broad economy, especially the housing industry?  Although Countrywide is recognized for mortgage lending, the savings bank also offers CDs insured by FDIC up to $100,000 per person.  If Countrywide had gone bankrupt, as was predicted just before the sale (perhaps strictly fueled by speculators), then CD holders might have lost the uninsured portion of their investments.  Thus, we might also call the government a winner in this deal, since, if Countrywide really was near bankruptcy, the FDIC was saved from having to prop up the insured investments.  Clearly, Countrywide shareholders don’t stand to benefit greatly.  A year ago, before the sub-prime mess, the stock was $45 per share, significantly more than the BOA deal at $7 per share.  Of course, it would have taken a long time for Countrywide shareholders to have recovered anything close to what their stock was worth a year ago.  How quickly one can fall from grace. 

On the other side of the deal is Bank of America.  Under Ken Lewis’ tenure, BOA has continued to make one deal after another.  First, we need to keep in mind that BOA is still in the process of completing its acquisition of US Trust, which it acquired from Schwab, and the purchase of LaSalle Bank, based primarily in Chicago.  Acquiring another large company (Countrywide) will put a real strain on BOA, although according to Mr. Lewis, everything is “nicely sequenced” so that there won’t be conflicting issues.  The proposed merger must still pass the regulators, but there is a strong likelihood that this will happen. 

Why in the world would BOA want to bail out a company like Countrywide?  First, it previously invested $2 billion into Countrywide, purchasing a stake of around 16% in August, while simultaneously securing a first right of refusal to buy the rest of the company.  A mortgage relationship with consumers is often the first step toward a banking relationship.  Although, by law, a bank can’t force a borrower to bank there, there are often enticements to do so.  Thus, Countrywide’s $79.5 billion loan portfolio offers the opportunity to expand BOA’s depositor and checking business.  Countrywide also has a very sophisticated back office for mortgage processing, including state of the art computer software.  Finally, and perhaps most importantly, Countrywide has 15,000 loan originators scattered around the country.  All of this made it too hard for BOA to walk away.

The deal, worth about $4 billion (in addition to $2 billion originally invested), is buffered by the fact that the book value of Countrywide is around $13 billion.  That’s the good news.  What many people don’t understand about Countrywide is that almost 75% of its loans are basically second mortgages in the form of home equity loans.  This means that someone else holds the first mortgage.  As long as the first mortgage is kept current, the second mortgagee cannot foreclose on the home.  This is why Countrywide and so many others like them are potentially in trouble. 

BOA’s move is either one of the most brilliant or one of the worst ever to occur.  It could signal the acquisition by stronger companies of other mortgage companies or thrifts, like Washington Mutual.  It could also signal that BOA believes that the housing slump has ended or is close to ending, and they were able to pick up a valuable asset at the bottom of the market.  Either way, this was clearly a bold move, and the brilliance or foolishness of this move will not be known for several years. 

• Is there anything rosy about a recession or a slow down in the market?  As always, for every yin there is a yang.  In this case, a slow down in the economy should lead to lower interest rates, which are especially important to the home mortgage industry since they make homes more affordable.  The average thirty year fixed mortgage rate is now down to 5.7%, according to the Mortgage Banker’s Association, about the same as it was at the height of the real estate frenzy in the fall of 2005.  Not only could this spur an interest in the purchase of homes, but it could also make it much easier for people with adjustable rate mortgages to refinance at a fixed interest rate.  A further reduction in short-term interest rates is expected later this month when the Federal Reserve Board meets, and it is possible that we will see the thirty year mortgage rate decline further.

In a speech last week, Federal Reserve Board Chairman Ben Bernanke made it clear that the Fed would take “substantive” action.  Many economists criticize the Fed for not reducing interest rates faster, although they have come down 1% since September.  The Fed is in a delicate position because inflation, especially in food and energy, has been higher than the Fed would like. 

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.

RAY, KIM, ERIC, BRUCE, and LOU

©1/16/08 ProVise Management Group, LLC

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