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August in the Rear View Mirror


It is important to remain focused. Discipline and calm will out-perform bravado and emotion.

The markets in August provided more thrills than a trip to Six Flags. With increased volatility becoming the norm, confusion, fear and greed has gripped the markets stretching the already frayed nerves of investors. Despite the roller coaster ride most investors were rewarded with modest returns for August. It is important to remain focused. Discipline and calm will out-perform bravado and emotion.

Headlines of sub-prime fallout and hedge fund losses rattled investors causing panic selling. Let's take these points one at a time.

First, the sub-prime problem is well documented. Yes I know it is only a small part of the overall market but that misses the point. The issues within sub-prime trickle down to other aspects of the market and the economy. Bubbles take time to unwind whether it is tulips, gold, internet stocks or houses. I suspect this bubble still has a way to go as home prices have not fallen enough to unwind the excess. Many home sellers are hanging on to the unrealistic belief that their home prices will rebound quickly. Unlikely, in my view.

As we head into a political year politicians will rant and rave as they try to score political brownie points. You place voters in a room who remember a better time and give them someone to blame for their lot in life your poll numbers go up. That is how elections are won and lost in this country. Who should we blame for the bubble? Of course Greenspan... No, the mortgage brokers, maybe the ratings agencies. In the end bubbles are caused by one thing. Greed! They unwind over time through fear.

Falling home prices inhibits the wealth effect. The American consumer has always been pretty resilient and how deep the cut in consumer spending will be is still an unknown.

Despite these negatives there are still many bright spots in the economy. Fundamentals for the industrial, energy and tech sectors still appear quite strong. Lots of cash on the balance sheet and strong international demand are driving profits. We need to carefully monitor corporate spending. They are watching the consumer just like we are and will adjust their business plans if the consumer pull back is larger than currently expected.

Let's take a moment and examine the turbulence at Goldman's (GS) and other quant hedge funds. Quant funds using factor analysis were tested in August with significant draw-downs at some. Yes it is true that many of these funds were in similar securities but I do not believe this to be the root of the problem. They were in similar securities because these stocks have the best fundamentals an in the end stocks with these characteristics are rewarded. It appears that the biggest problem was the extent of the leverage. If you have a $5 bln Hedge Fund that is levered up even 5 to 1 (some were levered 9 to 1) it may be long $25 bln in securities and perhaps short the same amount. Even if you love your portfolio but are forced to eliminate the leverage you have to sell $20 bln worth of your longs and cover $20 bln of your shorts. Multiply that by many funds in the same predicament and you have significant market disruption. For a few weeks this month many stocks with the best fundamentals were being hit the hardest one day only to recover from significant losses the next. The problem isn't the models but the leverage. Goldman seems to be in agreement with this view and has gone to investors to add capital to their troubled fund rather than shut it down.

Despite the headwinds, those with a global view should still find plenty of opportunities in equities. As we have said before, if your strategy and success of your portfolio is dependent on Uncle Ben you may be in for a rough ride.
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