Evergreen Virtual Advisor – Investment Newsletter by David Hay

Stock markets around the world remain under extraordinary pressure as do credit market such as corporate bonds and preferred stocks. The S&P 500 has now experienced its worst 10 year return in history. The odds are increasing that governments worldwide will more forcefully intervene to stabilize financial markets.

Points to Ponder

In this regard, the Fed announced it will begin buying commercial paper directly from corporations. This is a dramatic and much-needed step that should alleviate a considerable amount of funding pressures for corporate America. Direct purchase of high-grade corporate bonds at very elevated yields and depressed prices might occur in the near future.

Generally, as the economy slows, high-grade corporate bonds provide excellent returns, especially if a recession actually occurs. Thus far in 2008, though, even these defensive securities have produced a decidedly negative return, down 12% through September 30th. BBB-rated corporate bonds (i..e, still investment grade) are at their highest yield differentials versus treasuries since the Great Depression.

Indicating the remarkable level of pessimism, CNN recently reported that 60% of Americans think we will have a Depression. Once these fears are disproven, financial markets are likely to stage a powerful recovery.

Commodity prices have dropped by the sharpest amount in one quarter in the last 50 years and are still declining. This, combined with growing clarity of a global recession, is giving central banks around the world an excuse to begin cutting interest rates. Such reductions are likely to be rapid and deep.

EVAluating the Environment

Fear runs wild. By almost every measure I look at (exemplified by the volatility chart shown below), the current distress is at levels that, in the past, have corresponded with stock market troughs. Yet stocks continue to plummet, notwithstanding the recent mortgage stabilization program and the suspension of the highly problematic mark-to-market accounting standard. One of the most unfortunate developments of the last decade or so is the tendency of a rising number of market participants to be trend followers, buying on upward momentum regardless of valuation (e.g., late 1990s) and selling when stocks are falling, also regardless of intrinsic value (summer of 2002 and right now). This creates a situation where markets overshoot on the up- and downside. When you mix in a monstrous deleveraging cycle and a spreading recession, the results are about as pleasant as a root canal sans Novocain. The carnage has engulfed almost every investment sector, reminding me of an old saying by the Oracle of Omaha.

Mad dash to cash. Warren Buffett once said that in a crisis all correlations move toward one. It’s not often I have the chance to clarify the plainspoken Mr. Buffett, but what he meant was that when things get really bad almost every investment goes down the tube at the same time. All the elaborate asset allocation strategies that were devised to insulate investors from adverse market conditions tend to come a cropper, leaving the underlying clients angry, scared, and prone to bail out. Believe me, I’m not writing these words with academic detachment—I have suffered mightily (mostly agonizing for my clients rather than over my own losses) as the grim reaper of deleveraging has swung his scythe far and wide. I’ve watched in dismay as solid securities have been decimated and increasing numbers of investors flee to the sanctuary of cash (though even that doesn’t feel too safe these days). In this particular down cycle, not even the bulwark of a generous (or even double digit) yield has withstood the fury of the selling tsunami. Is cash the only rational option at this point?

The crisis to end all crises. One thing I’ve learned from living through so many past convulsions is that every one feels like the worst ever at the time. As you can see below, the fall of 1990 was another harrowing episode when we were faced the multiple threats of recession, governmental ineffectiveness, and a looming war (as well as more than 1,000 bank failures). As we all know now, that was an exceptional time to move out of cash and into higher return vehicles like stocks, corporate bonds, and preferreds. But is this crisis a different, much more dangerous animal? Is this more like the early 1930s than the early 1990s? Those are reasonable questions, worthy of serious examination.

Confessions of an economic conservative. There is no question that I’m a believer in capitalism, free markets, and the benefits of low taxes. However, I’ve also long felt that if we didn’t have the Fed and other safeguards like FDIC insurance, we would already have experienced several Great Depression replays. I’m further convinced that markets are much like sports: They not only need competing participants, all trying to best their opponents, they also require referees to make sure the game is played fairly; otherwise, anarchy and chaos ensue. Back in the late 1920s and early 1930s, we didn’t have regulatory referees, and we certainly didn’t have a support system to deal with the immense deleveraging that occurred when a massive bubble in stocks, bought on margin, exploded with volcanic force. But, today is a very different story even though it has seemed, for most of the last 15 months, that both the referees and the cleanup crew were retired in place.

Far stronger now than then. One huge variation today versus the 1930s, in addition to the Fed, the FDIC, and other safeguards, is that the troubled and overly leveraged assets (i.e., mortgages) actually produce substantial cash flow. While it’s certainly true that a lot of them are defaulting, with many more to come, the fact is that some 95% are not delinquent. In fact, 75% of sub-prime mortgages are still paying. That’s why the government can buy mortgages, particularly when they are priced as though an impossibly high number will default, and come out with a decent, if not substantial, profit. There was no attempt by the government back in the 1930s to halt the horrific slide in stock prices and immense amounts of wealth were simply wiped out by the market crash and the rampant bank failures (with no deposit insurance). Essentially, there was not much money left with which to buy anything. Today, by contrast, U.S. households have both enormous assets and liquidity as indicated below.

Weighing the debits and credits. Please allow me to do some simple balance sheet analysis:

Assets	Liabilities
US households possess nearly $8 trillion in money funds and bank deposits	They also have roughly $10 trillion in mortgage debt (note they almost offset)
US households hold another $25 trillion in stocks, bonds and other financial assets	Besides mortgage debt, US consumers owe another $4 trillion on credit cards, etc.
Total assets amount to around $70 trillion	Recent declines in almost everything has reduced this

The net effect is that US households have an astounding $56 trillion in net worth (i.e., assets, less liabilities). Even if we assume that has fallen to $50 trillion due to recent declines, it is still a monumental sum. There are other positives to consider as well.

The Malevolent Media. Lately, there’s been more finger-pointing going on in the press and in D.C. than after another typically disastrous season by the Seattle Mariners. But, of course, the media have given themselves a free pass in the whole affair. Yet, I’m becoming more convinced as the years pass that they have cost investors far more money than the most nefarious rogues who ever occupied Wall Street’s executive suites. In the late 1990s, their sensational coverage of the tech bubble helped incite millions to get sucked into that vortex. Similarly, the media’s breathless tales of soaring housing prices, with rare words of caution, played a big role in leading to where we are today. And now they are bombarding the American public with relentless waves of depressing news, with hardly a mention of how often in the past they have trumpeted Armageddon and each time the world has managed to avert it. Just think about earlier this year.

Sensation nation. It was mere months ago that the media were howling about soaring energy prices and inflation. However, as both of these have receded with lightening speed, the media have almost ignored them, except to note that they are symptomatic of our economic distress. In fact it’s looking more likely that my once absurd forecast about deflation becoming the real “flation” worry is growing more plausible by the day. Of course, the media will spin that into another reason why we are headed for a modern-day depression. Right now, they are so fixated on blaming Wall Street for the financial crisis, as well as the sick state of the economy, that they are once again doing a huge disservice to investors by exacerbating already extreme levels of fear. Believe me, loyal reader, it’s not nearly as bleak as the media make it sound.

Reality doesn’t always bite. In all the hoopla over the “Wall Street bailout” and the utterly apocalyptic coverage of the financial crisis, have you seen any stories stating that non-financial U.S. corporations have record amounts of cash? Or that their debt levels are far lower than they were prior to the last two recessions? Or that the US GDP per capita is the highest in the world, 35% greater than Germany’s? Or that the percentage of income the average household spends on a mortgage payment for a new home purchase is at a 35-year low? Or that interest payments on the federal debt as a percentage of GDP are only 60% of what they were in 1994? Or that U.S. spending on research and development is 40% of the world’s total? Of course, there’s nary a mention of any of these positives with all the “end-is-nigh” media coverage. Yes, it’s very scary right now but to give into fear at this point is to believe the system will fail and that’s never been a good bet. A more likely outcome is a surge of government capital into the unbelievably depressed credit markets, turning an utter rout into a powerful rally. In next week’s issue I’ll discuss in more detail why the corporate bond market holds the key to stopping this horrific meltdown. Hopefully, by then, I’ll be discussing how successful the Fed’s intervention has been.