It’s been a while since we’ve experienced a bear market this bad. As advisors we counsel our clients to do the right thing, it’s very upsetting to see the value of our homes and portfolios depreciate as much as they have this past year. With the exception of cash, everything is down substantially. Because these downward spirals tend to feed on themselves, we’ve now reached the point where market activity is no longer rational. You’re now seeing great dividend-paying companies with solid earnings currently trading at a fraction of their real intrinsic value.

Given this situation, several of you have gotten in touch to inquire whether we’ve seen anything like this before. Every major market slide is accompanied by its own special circumstances, but the short answer to the question is yes.

Market Crash of 1973 and 1974

In 1973, I was a young man in my twenties who had purchased my first home just two years before. I was working for New York Telephone after graduating from college. I began investing with Bache & Co. and E. F. Hutton with what little discretionary money I had in those days. Here’s what that environment looked like at the time:

1. Richard Nixon was president and under threat of impeachment
2. The Vietnam War was winding down
3. Our national self-esteem was at a low point
4. Congress was in its customary disarray and had lost the public trust
5. Detroit automakers were losing business to imports as petroleum prices had escalated, for the first time
6. Business confidence was reaching new lows
7. Interest rates were on the rise

8. The markets for 1973 and 1974 were disastrous
    a. Common stocks were down 14.66% in 1973 and down 26.47% in 1974
    b. Small-cap stocks were down 30.99% in 1973 and down 19.95% in 1974
9. Inflation was on the rise:
    a. The Consumer Price Index rose 8.08% in 1973 and 12.20% in 1974
10. And to add insult to injury, we had to wait in very long lines to buy gasoline that was outrageously priced. Gasoline went from 39 cents per gallon to 55 cents per gallon due to shortages.

At the time, most of my generation felt that our financial future might not be as promising as that of our parents. The investment mood of the nation was sour and the federal budget deficit was deemed out of control, mostly due to the cost of the Vietnam War. But, as they say, it’s darkest before the dawn. The stage was set, in fact, for markets to stage strong rallies in 1975 and 1976 with gains of 37% and 23%, respectively. This helped build the base for the historic 1980-1999 bull market (with only a few bumps along the way).

Market Crash of Oct. 19, 1987 (Black Monday)

On Oct. 19, 1987, when R.W. Rogé & Co. was just a little over a year old, and I was working
from my home office. I remember watching the market (the Dow, in this case) dropping
23% in a single day. I was literally sick to my stomach. I felt helpless. How could this be? I was trained in Modern Portfolio Theory (MPT) Statistics and Portfolio Construction. I was counseling clients that a moderate-risk portfolio could be down only about 15% in any one-year time frame, 95% of the time.

Well, I got quite an education, as it became apparent that the market could be down much more and in a much shorter time frame. And there was that remaining 5%, statistically akin to a dark corner. Today it’s referred to as “tail risk”: the very end of the bell curve, where very low-probability – but high impact – events can jar a portfolio. This was one of those outlier events.

But the other lesson learned was that, despite the havoc of Black Monday, the Dow ended the year in positive territory. It took less than two years to surpass its previous high of 2722 reached on Aug. 25, 1987.

Market Crash of 2000 to 2002 (The Three-Year Bear Market)

The technology and dot-com bubble created rapid growth from 1992 to 2000. Then, from September 2000 to Jan. 1, 2001, the tech-heavy NASDQ dropped 45.9%. It eventually fell 78.4% from its all-time high, reached in March 2000. Real estate was the next focus of speculative over-exuberance, which became the first domino to fall in the current market correction. The market as measured by the S&P 500 Index produced very good positive returns in 2003, 2004, 2005, 2006 and 2007 of 28.67%, 10.87%, 4.90%, 15.79% and 5.50%, respectively.

Our Advice and Guidance

The markets have declined about 40% in the last 12 months, an over-correction to be sure. What’s worse, we may not even be at a bottom yet. At low points in stock market cycles, it is not unusual to look up and feel that years of returns have evaporated over a period of months. Under these circumstances, it is perfectly understandable that most investors
will be inclined to jump out of the market and seek the relative safety of bonds and cash. However, it’s critically important to not stay on the sidelines for any length of time or you risk locking in your losses and missing the opportunity to benefit from the inevitable recovery. Alternatively, you might consider increasing allocations to equities now (in accord with your tolerance for risk) even though, emotionally, it may seem very counterintuitive. But bear in mind that it is precisely moments like this that present the best opportunity for significant wealth accumulation over the long term.

Warren Buffett, the world-renown investor, has said recently he has a simple rule that guides his buying: “You should be fearful when others are greedy and greedy when others are fearful.” He has been buying equities lately and that could suggest a course of action for the rest of us. As it stands, his investment in those equities is now under water (trading lower than his purchase price). However, Buffett well understands you can’t time the market. He’s still happy with those investments and is confident that they will provide very nice returns in the future because he knows that he did not overpay for those companies.

A good example of how this could play out may be found in the markets of 1975 and 1976 (which had respective returns of 37% and 23%), which laid the groundwork for the unprecedented 1980-1999 bull run. Given that it’s impossible to “time the markets,” the investors who bailed out of the 1973-74 markets failed to return to the stock market until after the 1975-76 recovery. The moral of the story is that trading out of the market based on fear and nerves can decimate the gains of many years.

We remain firmly convinced that – because the markets are so dismal at the moment – it is exactly why they are presenting us with exceptional opportunities for longer term performance.

We also understand that investment opportunity is relative to your risk profile and investment horizon. Consequently, we are carefully evaluating every client account to ensure that our overall assessment of market conditions in these troubled times corresponds with your

individual needs and tolerance for risk.

Tax Strategies

For the past four months we have been harvesting tax losses in our taxable portfolios. You will notice we are placing the proceeds from these trades into Exchange Traded Funds (ETFs), such as the S&P 500 ETF, to maintain proper market exposure and avoid taxable capital-gain distributions that most mutual funds will have between now and the end of the year. The reason regular mutual funds will most likely have capital gain distributions– even though they will have negative returns for the year – is due to liquidity issues. As mutual fund shareholders sell their shares in response to market conditions, the mutual fund complexes have to sell positions they have held for years at a profit in order to meet redemption requests. This results in a taxable distribution to the remaining shareholders.

The ETF positions are temporary investments that allow us to maintain market exposure as we implement our tax strategy. We will most likely return to our regular mutual funds after the first of the year.

The Future

Based on the historical evidence, we are very confident that when we look back in three to five years at our response to the markets today, that we will be extremely pleased with our portfolios’ performance. Most bear markets bottom at a 30% loss off their previous highs. We are now at 40% off the highs reached in October 2007. So we are in a bottoming process that could take a while. I believe we are in the early stages of a recession and the late stages of a bear market. Since markets look out to the future, they usually begin to turn at the early stages of a recession.

The government bailout package and accompanying guarantees are already showing signs of providing much needed liquidity to banks and financial institutions, and will eventually restore public confidence in the financial system. The markets are now focused on the recession, the election and new financial regulation. All of this will be worked out over the next 12 months. Yes, the economy is in for some rough sledding but it too will recover as these issues are resolved. The key to a recovery is (1) stabilizing the financial system, which is well underway
and (2) working off the excess inventory of homes for sale. Once the real estate market begins to show signs of recovery, the economy will begin to regain some resilience.
Thank you for your patience and understanding in these trying times. We are extremely grateful for our good fortune to work for you and are humbled and honored in the trust you have placed in us over the years. Again, we’ve experienced difficult periods like this before and rest assured we’ll get through this market correction as we have in times past.

Market Review and Outlook

Following a brief period of tempered optimism brought on by a sudden drop in oil prices and a firming U.S. dollar, the disconcerting trends roiling the markets in the first half of the year resurged dramatically to turn the third quarter into yet another harrowing and volatile ride for anxious investors.

The unrelenting grind of bad news culminated in a record 777-point drop on the penultimate
day of the quarter (after Congress initially rejected the Treasury’s $700 billion bank rescue package). That was accompanied by a series of unprecedented government interventions
in the financial sector that have, in effect, fundamentally reshaped Wall Street and – perhaps – the structure of American capital markets themselves.

Government action (or, in one case, inaction) resulted in a number of high-profile developments:

• The demise of Lehman Brothers and fire sale of Merrill Lynch, two of Wall Street’s most storied and venerable investment banks
  
• An emergency infusion of $85 billion into American International Group (AIG), the world’s largest insurance company
  
• The massive mortgage entities Freddie Mac and Fannie Mae (which hold or guarantee
  approximately half of the nation’s mortgage debt) were taken into government conservatorship
  
• In the largest bank failure to date, Washington Mutual (WaMu), was taken over by the FDIC and its remaining assets to JPMorgan Chase, which already absorbed Bear Stearns earlier this year
  
• The two remaining major investment banks, Morgan Stanley and Goldman Sachs, moved to reregister themselves as regulated commercial banks
  

Combined with barely functioning credit markets, rising unemployment and increasing
signs of slowing economic growth, it all made for a memorably dismal quarter for domestic and foreign markets.

Equities

For the quarter, the S&P 500 lost 8.37% and the Dow Jones Industrial Average retreated 3.7%, its fourth consecutive quarterly drop but a smaller decline than the respective 7.6% and 7.4% drops in the first two quarters of the year. The Russell 2000 small-cap index was down a marginal 1.1%. As a group, hedge funds registered their worst performance on record with a drop of more than 13%. Most of those losses occurred in September.

Abroad, markets fared significantly worse as the MSCI EAFE index – which tracks large-cap stocks in 21 developed markets outside the U.S. – posted a loss of 20.5% (in dollar terms). Reflecting a steep drop in commodity prices, investor aversion to risk and perhaps some degree of overvaluation after a five-year bull run, the MSCI Emerging Markets Index lost 26.8%.

Overall, market conditions favored value over growth while small-cap stocks outperformed large caps. Positive sectors of the economy were few, but surprisingly included financials and real estate. The big losers were natural resources (oil, precious metals), utilities and technology.

Fixed Income

The deteriorating condition of the credit markets, an increase in corporate defaults and the tumult in the financial services sector led the broad bond market lower. Nervous investors sought shelter in U.S. Treasuries, which pushed down yields and raised prices. Treasury returns were also helped by a recovering U.S. dollar, which made dollar-denominated low-risk assets more appealing to foreign investors. Conversely, the Lehman Brothers bankruptcy further unsettled the corporate debt market, causing repercussions even for short-term money market funds.

For the quarter, the Lehman Brothers U.S. Aggregate Index was down 0.48%, but has still posted a 0.63% gain year-to-date. Economic uncertainty, the flight to relatively safer Treasuries and oversupply of muni’s resulted in a loss of 3.21% for the Lehman Municipal Bond Fund Index. Foreign investment-grade bonds declined approximately 5%.

Market Observations

This year is turning out to be a memorable headache for investors; this market is only the latest in a series of events – most recently the slumps in 1987 and 1990, the Asian/Russian “contagion” of 1997-98, the end of the dot-com bubble and the prolonged downturn following the events of 9/11 – from which the markets have always rebounded.

Each time the details are different, but the common denominator may be the growing interdependence of the world’s financial markets, which have been an important component
of global economic integration. There is much higher correlation among markets today then there was 20 years ago and some of the problems derive from the unexpected speed of these changes. Here are a few points about the markets generally and the third quarter in particular:

• One upside of the market’s slide is that stocks in general are undervalued, presenting some terrific opportunities. Stocks are still the real long-term engine to superior portfolio returns. The S&P 500 index has generated average annual returns of more than 9.7% over the last 40 year period.
  
• While economic fundamentals continued to be problematic, a stronger U.S. dollar combined with lower commodity prices and slowing global economic growth eased inflationary pressure as well as the nation’s trade deficit. Going forward, there are a number of plans being consideredto address the foreclosure problem that is weighing so heavily on the housing market.
  
• The extent of the shake-out and consolidation in the financial services industry and the increasingly aggressive response by the world’s central banks suggests a good deal of the problems underlying the credit crisis (mainly concerning asset quality) have been identified and are on their way to being resolved. In the view of many observers, the impact of the financial crisis has largely been factored into share prices, lessening downward potential.
  
• Based on technical and historical data, there is a growing sense that the market may have reached a bottom. Even so, stock prices may continue to bounce around for a while (a phenomenon called “testing the bottom’). However, being on the sideline can be costly because market recoveries are fitful and can occur very quickly. In the 12 bear markets since 1957, the S&P 500 recouped a third of its value within approximately 40 days of hitting bottom.

Bear markets, corrections and all manner of downturns have been a fact of life since there were markets. That’s why it’s essential to have a long-term plan, which anticipates and helps to buffer portfolios from inevitable market turmoil. While everyone’s investment profile is unique, a look back at the history of market performance strongly suggests it’s a good idea to stay invested, diversified and disciplined in order to fully benefit from market fluctuations over time.

A snapshot of the major market indices as of September 30, 2008 is presented below:

Strategy and Outlook

At this point in time, it’s impossible to know when the markets will begin to regain their footing, although we expect economic weakness to extend perhaps into the middle of next year. Despite direct governmental action of unprecedented magnitude, investors have not yet regained sufficient confidence in economic fundamentals to sustain any degree of positive momentum, although we have reason to believe the markets may be at – or nearing – a bottom. Investor behavior remains erratic, emotional and irrational.

Moving forward in this difficult and unpredictable environment, we will continue to adhere to our investment discipline which has always served us well. That means sticking to basics: looking for exceptional value and quality, maintaining broad diversification in our portfolios and remaining vigilant for shifts in market conditions.

Despite record volatility, this stock market correction (now at roughly 40% since the beginning of the year) has created compelling opportunities for patient investors. The price-to-earnings ratio (P/E) of the S&P 500 now about 16 times earnings, relatively low by historical standards and lower than in pervious bear markets of the last 20 years when P/E ratios were in the 24-30 range. Therefore, we remain cautiously invested and are taking the long view and letting previous lessons of bear market events guide us through this market turmoil.

There will be no quick fixes, but current conditions have created considerable potential for significant gains over time.

• We expect the recession to last into next year, meaning that it won’t be mild but it also won’t be all that long. Remember that past patterns suggest that stocks bottom about six months before the economy and correspondingly rebound six months before the general economy. We are endeavoring to position ourselves at this stage of the market cycle to capture as much of this rebound as possible.
  
• Sectors we think present attractive strategic opportunities include managed healthcare, consumer staples, technology and select financial services.
  
• The real estate market is showing some signs of recovery. While prices continue to drift down, sales of existing homes are either holding steady or climbing somewhat in many major metropolitan areas.
  
• We have trimmed our exposure to energy and expect this sector to largely track the broader market. The price of oil has dropped by about half since its peak last quarter, and while that has boosted the dollar and lessened inflationary pressure in the near term, it has also undercut immediate prospects for the alternative-energy (green) sector. We continue to believe, however, that for economic and political reasons the country must greatly lessen its reliance on foreign energy sources.
  
• Due to their popularity with panicked investors, Treasuries are the most overvalued asset class we’ve seen in a number of years. However, there are ample pockets of opportunity in corporate bonds – particularly of the non-financial and non-industrial variety – and municipal bonds, which are providing safe, attractive yields. We also see limited opportunity in corporate high-yield and foreign investment-grade bonds, although in this environment we’re more inclined to quality and safety above all else.
  
• By and large, our strategy will focus on large-cap, high quality stocks because of their relatively stronger balance sheets, better access to capital (such as it is) and their broader exposure to overseas markets. Accordingly, we think bigger companies will do at least as well as smaller ones as the recovery gains traction.

In short, we will continue to engage the market by applying a prudent approach of risk-appropriate diversification to the management of our client portfolios with the goal of participating in market advances while maximizing capital preservation. Efforts now under way to calm the markets and restore investor confidence will take time, but we believe they will eventually be successful. The markets have a long and unparalleled history of adaptability, recovery and – ultimately – growth.

(c) R.W. Roge & Company

www.rwroge.com