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2008 Year in Review: Where We Are and Where We're Going


As the Street gears up for '09, a little perspective is in order.


"A year has passed since I wrote my note. I should have known this right from the start."
--The Police

2008 has been unlike anything ever witnessed in the storied history of Wall Street.

Martial Law was declared on the capital market construct, a multitude of institutions were laid to rest or forced to merge and the government socialized markets and nationalized industries in a desperate attempt to combat the cumulative imbalances that have built through the years.

In the coming weeks, we'll offer fresh foresight as we cast our eyes towards 2009. In the interim, it's time for some honest reflection as we revisit our 2008 themes with hopes that mistakes morph into lessons as we together find our way.

Theme 1: Hedge Funds Buying Brokers

January thought: The critical issue facing financial institutions after years of engineering and risk recreation is the solvency of their balance sheets, particularly if they're forced to move Level III assets back onto their books.

Look for large, well-capitalized hedge funds to take selective stakes in troubled brokers as the financial continuum comes full circle.

Update: The solvency of financial institutions has been the single biggest story in a year full of front-page financial news. The combination of toxic off-balance sheet positions, interwoven derivative exposure, complex counter-party risk and the dearth of regulatory oversight brought Wall Street to its knees and threatened the very existence of the finance-based global economy.

While we've seen selective investment attempts by private equity and hedge funds-the $7 billion stake in Washington Mutual (WM) by TPG comes to mind-the credit cancer that consumed the hunted hampered would-be hunters who might otherwise have added capacity into the downturn. Once socialist agendas began to manifest, the motivation to assume incremental risk abated in kind.

Theme 2: Migration Toward a Middle-Class Mindset

January thought: As Kevin Depew wrote on Minyanville, "If the '90s were about wealth, accumulation and consumption, 2008 will continue the mean reversion toward something altogether more austere, if not more sensible. Debt reduction and the rejection of (and guilt projection toward) materialism will continue what began in 2006 and 2007 as meditations on not just doing more with less, but doing less... period."

Update: It's long been my belief that a stealth recession has existed for many years, masked by the lower dollar and skewed by the spending habits of a slimming margin of society. That created a de-facto two-class society of "haves" and "have nots" that persisted until the age of austerity arrived this year.

The combination of involuntary thrift (when people can't afford basic necessities) and voluntary thrift (when folks with money choose not to spend) created a perfect storm for the consumer and industries dependent on them.

The conspicuous consumption that once defined our immediate gratification society has passed as flashy rides and outrageous lifestyles now serve as hollow reminders of misplaced priorities.

Theme 3: Return of the Dollar

January thought: While risk remains -- for instance, if OPEC decides to denominate crude in Euros -- it's important to remember that the dollar "crash" already occurred. The greenback is off 37% since 2002 and spending power is down 97% since 1913. Factor in the widespread negativity of money managers, rappers and supermodels, and a counter-trend bounce doesn't seem so strange.

Update: After losing 8% the first half of the year, the dollar sprinted 24% higher from the middle of July to the end of November before pulling back last week.

Our longstanding view has been that all roads lead to deflation (as a byproduct of debt destruction) and the greenback would appreciate as asset classes deflated in sync. That natural progression played through until the U.S. government changed the rules of engagement.

We're now at fork in the road, with watershed deflation on one side and hyperinflation on the other. We must respect the possibility that capital preservation could conceivably mean capital conversion into alternative currencies such as the Japanese yen, Australian dollar or gold, at least until such time that it's confiscated.

Theme 4: Relative Performance of Pharmaceuticals and Consumer Non-Durables

January thought: I foresee the energy sector reassuming the top weighting in the S&P (as first shared in 2003). As our financial destination isn't as important as the path that we take to get there, however, defensive sectors such as pharmaceuticals and consumer non-durables will likely outperform on a relative basis as global slowdown fears permeate.

Update: Two tidbits warrant a mention as we tie together 2008. The first is that the energy sector did, in fact, leap-frog the financial complex for a brief spell-both behind information technology-before the devil of deflation arrived and demand destruction snuffed out those hiding spots.

The second derivative was that the consumer non-durables would benefit from said deflation by not passing along input cost savings to the consumer. That proved true as General Mills (GIS), Johnson & Johnson (JNJ) and Campbell Soup (CPB) tickled 52-week highs this summer despite double-digit declines in the mainstay averages.

It should be noted that, as discussed at the time, I tempered my enthusiasm on the consumer non-durables when the government unleashed the monetary spigots and the specter of higher input prices (as an unintended consequence of their efforts) began to crystallize.

I will also note that the DRG (drug index) is down 20% to date, or about half as much as the general market. You can't spend relative performance, we know, but it's worthy of a mention as we revisit our themes.

Theme 5: The Other Side of Zero-Percent Financing

January thought: While subprime was the first domino to fall, more ominous issues loom. The other side of zero-percent financing will manifest through credit-card delinquencies, auto loans and other forms of consumer-credit deterioration.

Update: After years of bellying up to the "consume now and pay later" bar, the cumulative bill came due in 2008. Corporate America, the bartender in this analogy, hoped patrons would pay up before passing out.

What became clear this year is that the burden was simply too much to bear. The government spread that risk to the taxpayer, attempting to buy the cancer and avoid a credit car crash. What we've witnessed is an unhealthy dose of both.

In my humble view, the only true solution for what ails us is the medicine of time and price. Protect savers by backing deposits and assign culpability for those who digressed, from consumers who over-extended on credit to institutions responsible for financial engineering and policy makers complicit by acceptance.

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