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Capital Markets Outlook

Equity allocation has been further cut over the past quarter with equity markets turning to a true bear market and volatility reaching levels not seen since 2002.

Unwinding continues

The financial crisis continues with investors learning just how large and unruly Wall Street’s web of debt had become. It seems trillions of dollars of prime and subprime mortgages were just the beginning; the web included trillions of dollars worth of Collateralized Debt Obligations (CDOs), Structured Investment Vehicles (SIVs), Auction Rate Notes (ARNs), Credit Default Swaps (CDSs), and the other forms of packaged debt given acronyms to help Wall Street forget how risky and complex they are.

Almost a combined hundred trillion dollars of this have been issued and traded between Wall Street banks, insurers, hedge funds, and even many pension funds and retirement accounts.

With banks and other financial firms teetering on insolvency, governmental intervention has grown more substantive, albeit at a daunting cost. Tax rebates, larger loans by the Fed, and the bailout of Bear Stearns shows that the Federal Reserve and Washington are willing to do anything to avert a financial catastrophe and possible recession.

More challenges to come

While its unknown how successful the invention will be in saving banks and ultimately the markets and economy in the short run, issues beyond the current crisis in credit need to be included in today’s investment strategy.

First, by solving problems largely caused by cheapand-easy credit with more cheap-and-easy credit, policy-makers allow speculating individuals and institutions to continue excessive risk takings. This bailout approach for consumers and financial institutions alike may only serve to postpone a more severe collapse in markets.

Secondly, the willingness of both the Fed and Washington to “junk” up their balance sheets and pump money into the economy risk adverse effects on the dollar and infl ation. Clearly, the Fed has abandoned price stability in favor of doing what it can to prevent a possible fi nancial collapse. With the markets anticipating future infl ation levels of less than 2.5 percent, investors may be too confi dent consumer prices will retreat soon from current levels of 3.5 to 4 percent.

And lastly, the crisis and intervention efforts only increase the possibility of higher tax rates. Increased government spending in a slowing economy only exacerbates budget deficits and fuels the clamor for higher taxes. With presidential candidates promising payroll, income, capital gains, and dividend tax rates, investors may have to reassess the multiples they pay for equities.

Allocation Strategy

Being defensive with equity exposure will remain our game as the duel financial and fiscal storms should continue to play havoc on the markets.

Equity exposure is exclusively large cap in focus. The current flight to quality, combined with large caps’ relative valuation attractiveness, give us little reason to hold smaller caps at this time.

We’ve maintained a bias to “growth” equities. Besides trading at a historically low premium to “value” equities, growth has less reliance on economic cycles, greater exposure to foreign sales, and foreseeable tax advantages that may soon materialize.

Internationally, we remain largely ambivalent. While economic growth is still robust in many regions abroad, foreign equities have yet to decouple from U.S. equities, and further escalation in the fi nancial crisis and economic slowdown will be similarly, perhaps more profoundly, felt in foreign markets.

Shifting some fixed income exposure to Treasury Inflation Protection Securities (TIPS) is imminent given new perceived risks to inflation. Gold will continue to be held to hedge the dollar and financial markets.

Much uncertainty compels us to remain cautious and defensive with portfolios; but we are looking for opportunities to enter equities at cheaper prices.

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