One of the most alarming aspects of the situation is the precarious state of the banking
system, which has been unsettled by the inability to accurately assess the worth of exotic debt instruments on their balance sheets. As these complicated and highly leveraged securities (many of which contain shaky subprime loans) continue to go bad, banks have dramatically cut back lending to conserve critical capital. But the continuing atmosphere of fear and uncertainty has created a credit crunch that has had a direct impact on consumers, companies and, not least, major Wall Street players.

In an effort to forestall a ripple effect that could have even more dire consequences for the wider economy, the Federal Reserve intervened on a scale not seen since the Great Depression, including orchestrating the unprecedented $30 billion bailout of Bear Stearns. Other moves included opening the discount window (a place for institutions, traditionally banks, to borrow directly from the Fed) to investment banks and reducing the capital requirements for Fannie Mae and Freddie Mac to spur open lending in the mortgage market.

The Federal Reserve was also busy during the quarter sharply lowering short-term interest rates from 4.25% to 2.25% in an effort to increase liquidity during a time of crisis. However, it became clear that the benefits of this basic strategy would be limited (while at the same time shrinking the yields of money market funds, a traditional safe haven for investors in times of market turmoil). However, the willingness of the Fed and other central banks to take steps to shore up the international financial system did provide a meaningful measure of reassurance.

The worries in the market place brought down stock prices to a level going back to late 2005. The S&P 500 lost 9.45% during the quarter, one of the most volatile on record. The downturn in the market was broad-based as small-cap stocks were down roughly the same amount as their large-cap brethren. Hedge funds recorded their worse quarterly performance in almost six years with a loss of 2.83%.

Broadly, value made a comeback, outperforming growth across all capitalization categories. While we have been trending more towards growth recently, our portfolios are still largely value-oriented and benefited from this rebound.

International markets, and some Asian markets in particular, were also down, reflecting their strong reliance on U.S. trade. On the plus side, the weak dollar helped to boost U.S. exports and the foreign operations of U.S. companies.

The sell-off in equities has provided some of our managers with opportunities to pick up shares in companies that they find attractive, and at cheaper levels than just a few months ago. For patient, long-term investors events such as the current bear market are in fact often a blessing in disguise.

The fixed income markets faired well as the Lehman Brothers Bond Index returned 2.17% for the quarter. Treasuries, and specifically Treasury Inflation-Protected Securities (TIPS), enjoyed their strongest annual start since 1995. Conversely, municipal bonds saw their worst performance since 2005 as hedge funds – which use municipal bonds as collateral for their leveraged bets – were forced to sell these bonds to unwind positions and the market suffered from prevailing credit concerns. Municipal bonds now yield more than taxable bonds, which we believe may provide a good entry point for taxable investors.

Strategy Review

We haven’t deviated from our strategy laid out in last quarter’s report, except from the addition of an equity hedge as a small insurance policy against a total collapse of the credit markets. We believe that this small position may benefit clients’ portfolios in the event economic conditions worsen substantially. Another change is a slight decrease from an overweight position in flexible bond funds, the proceeds from which we are adding to an underweighted position in tax-free municipal bonds for some clients for whom this strategy is appropriate.
 

(c) R.W. Roge & Co.

www.rwroge.com