The Sky is Falling....

On days like this when the market dives 400 pts and then recovers all of it in a matter of minutes, brewing a cup of herbal tea is as good a response as any. It gives us a calmer set of nerves when they are anything but.

Looking back over the past few months I can say we've been both right and wrong on a few things. Below are excerpts from last quarters letter to clients written at the beginning of July.

The money center banks and investment banks have created their own demise by retaining highly leveraged, illiquid low quality assets from the subprime mortgage market boom. Even worse, these investments are often off balance sheet and provide shareholders very little in the way of visibility regarding their value. As far as I am concerned these assets are marked to myth. In other words the banks are still unwilling write off the assets to the full extent necessary to reflect an accurate market valuation.

This head in the sand approach is understandable. It is likely that if the valuations were accurate, a number of large and important banks could fail. (Indymac following within days)

There are various signs that the stock market is entering a bottoming phase, but how long it will take is anyone's guess. I believe that a 50% retracement of the past five year bull market will be a technical support level worth considering. (that level is about 5% lower than today's low) We are seeing even shares of companies in leading sectors such as steel, coal and materials being sold agressively. (US Steel -40%; Consol coal -46% since July 1) Bear markets begin to find their bottoms when, "they start shooting the generals." The erosion of leading sectors is indicative of market capitulation when nothing is immune to sale. Unfortunately, the fundamental seeds of the next bull market such as seen in July 2002 are not yet apparent.

Having spent nearly twenty years in the commodities markets the current conditions have the scent of a last hurrah. In jargon terms it feels like everyone is, "talking their book." That means all those making their views known have already taken their positions and are now vigorously arguing to support them. Goldman Sachs calling for $200 oil logically means they have made their bets already and hope all the latecomers will help them make their earlier investments profitable. Those calling for higher prices likely long ago made their buys. In my time in commodities I never saw a recession that did not take commodity prices considerably lower. As such I will be reducing commodity allocations in portfolios. It is entirely likely there is still more upside left, but the risk has risen out of balance with the reward. (Crude Oil since early July -28%)

Where have we gone wrong? In mid July we began buying Index Funds which followed with about a 8% bounce, that has now largely been given back. In general our error has been largely one of sentiment as July technical indicators became extremely oversold. I admit to an uncharacteristic burst of optimism in this market which has been whittled away. The primary question now is no longer how bad is it, but rather have the markets priced in the remaining bad news.

One of the caveats I see in my moments of irrational exhuberance is that the market has never performed well during a recession. If indeed we are heading into a recession it seems at best we have priced in the recession but still no recovery in sight on the other side.

The outlook as far as I can see is for continued malaise. The fundamental issues that buoy markets and economies are reeling because of the credit crisis. Digging out of the problems will be neither easy or quick and I expect alternating moments of despair and hope as new shoes drop and new solutions are rolled out. It is not a standard cyclical economy when it looks likely that central banks actions of two decades may well have to be unwound without causing a global meltdown. I have faith that it can be done, but not painlessly.

John Barnyak
President