What a difference a quarter makes!

When an investor sees their quarterly statement for the 3rd quarter, they probably could not be faulted if they let out a big yawn. Most major U.S. stock indices rallied slightly with the S & P increasing by 2%. This does not sound exciting, but in actuality the 3rd quarter was one of the most volatile we have seen in many years.

From the July highs, the S&P 500 dropped nearly 12% in 30 days, only to reverse course and rally back almost all the way to new highs over the next 45 days. Other market indices had even larger swings, with small cap stocks tumbling by more than 14% over the same period. Several international markets declined by more than 15% in a 30 day period of time.

What is really amazing is how the same pattern that has been prevalent for the last 5 years held true again. The market promptly bounced back and seems to be giving the “all clear” signal. As we write this letter, the market rally has continued and, we are now trading at all time highs in several markets.

To recap, the sell off in July was triggered by news that the sub-prime crises was indeed a crises and that it was spilling over into all forms of credit. In essence we saw a complete freeze of liquidity in the market place. In the U.S., England and many other developed markets there was a virtual dearth of liquidity for banks and short term borrowers. The Federal Reserve System in the U.S provided banks with emergency short term financing. The amount of short term liquidity pumped into the system was at a level that had not been seen since September of 2001, in wake of the World Trade Center attacks.

Additionally, we heard that two hedge funds that are run by a very large, well respected investment bank were closing down. They had lost the majority of their clients’ capital by investing in sub-prime mortgage securities using high levels of leverage. This news was followed by the revelation that several even larger hedge funds that specialize in statistical arbitrage needed multi-billion dollar bailouts, because they had lost more than 15% of their capital in a few days.

Corporate borrowing was virtually impossible to find, and the many high profile acquisition transactions that involved private equity firms were rumored to be in danger because the financing could not be secured. We heard that the major commercial and investment banks were going to have multi-billion dollar losses from their financing commitments that they had made.

The news flow was one directional, bad to worse. Fear was rampant. It was estimated that thousands upon thousands of homeowners were going to suffer foreclosure of their homes. It was stated that the private equity bubble was finished and the underlying “private equity bid” that had helped prop up stock prices was gone for good. The U.S. dollar was viewed as being in serious jeopardy, and people projected that the U.S. economy was headed for a recession.

Hearing all of that, it is not hard to understand why the market sold off by 12% in 30 days. Remember our last letter when we said, “Suffice it to say, we are not even close to seeing the final chapter in this sub-prime saga.” Well, the market realized over the next few weeks that the saga was not over, and pain was felt by market participants in a way that has not existed in more than 5 years. Never forget how quickly perception can change and fear can enter the market. That, of course, leads us to… “the rest of the story.”

The Fed to the rescue

Hold on a minute, didn’t we say that the markets quickly reversed course and finished the quarter with a marginal gain? With all that negative news, how in the world did that happen? Enter from stage right, The Federal Reserve.

We all know the Fed is powerful, and they set the short term borrowing rates in the U.S. What many people do not realize is how important the DIRECTION of their rate bias is on the assumptions people make about the future. Always remember that markets move based on future expectations for economic strength and, as a result, future profits of companies.

In a very rare surprise move the Federal Reserve lowered the discount rate, by ½ of 1% in mid August. This is a HUGE move by the Fed, and they gave no warning that they were going to take this action. The Fed did this in response to the massive dislocation that was occurring in the banking and borrowing system. There was an immediate sigh of relief in the market, and they began to stabilize. Furthermore, later in the quarter the Fed slashed the Fed Funds rate and the discount rate by ½ of 1%. On this action, market participants felt that much of the risk in the economy was now less of a concern because the “Fed is on our side” and markets took off to the upside.

If you were wondering if the market can really be this psychotic, the answer is yes!

So where do we go from here?

That, of course, is the trillion dollar question. We are now in the early stages of earnings season, and as usual the market will be volatile and get its direction from these announcements. More importantly, the outlook given by management about the future will create substantial swings in earnings estimates.

We expect earnings to be decent this quarter, but we are concerned about the outlook we are going to hear from companies. The economy is obviously weakening, and the impact on corporate America is not totally clear. We have heard horror stories from the homebuilders and investment banks concerning their losses. Those are the front line players in the sub-prime story. The question is how much damage has the consumer suffered in relation to their spending habits.

Make no mistake, the direction of this market will be driven from this point by corporate profits which will be dictated by the severity of the economic slowdown. The question that everyone is trying to determine is whether the U.S. economy will dip all the way into a recession or if the Fed is once again able to manufacture a “soft landing”. The interest rate question has now totally shifted from, “when will the Fed stop raising interest rates” to “when will the Fed lower interest rates again and how low will they go”. Therefore, all eyes will be on the economic metrics.

We still believe the sub-prime saga has at least another year to play out, and we do believe it will have an impact in most areas of borrowing. This includes consumer, corporate and private equity. We also believe that the U.S. economy is going to continue to weaken materially. We are not convinced that we are going to have a recession, but we do believe that the slowdown will be enough to have a major impact on corporate profits.

It is for this reason that we continue to focus our portfolio on those companies that we believe are going to create cash flow growth in a tough environment. It is also for this reason that we are being very disciplined about the valuations that we are willing to pay for securities.

The hidden hole in the earnings story

One other major trend that we are watching with a cautious eye relates to corporate stock buy backs. These buy backs, which are always a good thing, are clouding the earnings picture more than many people realize. We have recently written a paper that discusses this issue at length. Instead of us giving a brief synopsis in this letter, we have chosen to send you the full paper for your review. This stock buyback issue is one that we don’t hear many people talking about, but we feel it has the potential to have a dramatic effect on P/E multiples, and therefore stock prices, in the near future.

Please let us know if you have any questions about the paper, or anything else in this letter. As always, we appreciate your confidence in us, and please contact us if there is anything we can do for you.

All our best,

CAZ Investments