Investment Outlook - Special Comment

Almost Over, More to Come, or Soon-coming Opportunity?

Virtually all financial markets around the world have recently experienced the highest volatility levels in over 4 years. Equity markets have fallen, and bond markets have gyrated. The most significant losses have occurred in more exotic investment categories which are not as visible to most investors. (We are not active in any of the latter-type investments.)

From equity market peaks in mid July, the Canadian stock market has declined 10.1% (TSX Comp) and the US market 8.7% (S&P500).

As such, it is timely for us to provide a brief assessment of the current situation as well as an indication of our expected strategies looking ahead.

Firstly, recent markets do not catch us by surprise. We have been prepared. If anything, we have been much too early in our defensive posturing ... a year too early. We were extremely surprised at the extent and recklessness of a global financial mania that extended another full year. But now that this period has passed, we are certainly gratified for holding to a cautious stance.

However, as pessimistic as news reports and market actions may seem, the jury is still out. Events from here can still unfold a number of ways. Yet, we can at least attempt an accurate assessment of the probabilities and make our decisions accordingly.

Markets, in time, usually recover from short-term declines. In fact, in recent years, they have done so very quickly. This year, February's tremors (triggered by a China sell-off) was quickly overcome with a rapid and unprecedented shift back to "high risk appetite." Massive leveraging, "maniacal liquidity," and sheer chutzpah soon contributed to new market highs virtually everywhere around the globe.

Then, a wave of "liquidity" -- which, in this sense, is really more a psychological phenomenon than anything else -- pumped confidence and recklessness as high as perhaps 1987 (the year of the legendary October crash).

But what of this latest tremor?

This one is different in several ways.

While there assuredly have been some sharp declines peak-to-date, consider that the major stock markets are still showing positive returns year-to-date. Yet, central banks around the globe have already jumped to the rescue, infusing liquidity where needed. Why? Though not necessarily visible, there are serious problems on the balance sheets of major financial institutions -- from banks, to finance companies, to fund companies. Evidently, serious financial problems have emerged in the credit sphere.

Bad Things Come in Three

What is unfolding currently is a liquidity crisis that is an extension of a credit crisis as well as partly an insolvency crisis in some key sectors. These are all technical terms with very specific meanings. Suffice it to say that there exist many more sellers than there are buyers of most financial assets at present. And this, given pockets of high leverage and shoddy financial quality, has quickly cascaded into some significant losses in a number of financial companies. (The extent of this damage is still unknown). In turn, lenders have become more reluctant to lend, becoming much more discriminating about risk and voila ... a credit crisis. Add to that also the fact that a contagion of insolvency also exists. Millions of mortgages are going into default, portions of which will never be paid back.

The problem with insolvency is that no amount of liquidity or credit can solve this condition. It would be the equivalent of throwing good money after bad. As it is, there is a shortage of both liquidity and credit at present.

The last time that a liquidity and credit crisis happened was 1998, the culmination of the Asian "sovereign debt" crisis which began in Thailand, July 1997.

Some analysts, comparing the current situation with 1998, have been quick to conclude that, yes, this crisis too shall pass. We would agree -- with the qualification that a "credit crisis" rebound stands likely to be yet a ways off ... perhaps a long time off. Time will tell.

We see notable differences between the two periods.

Firstly, the "catalyst" for the current liquidity crisis is found in America ... specifically in sub-prime real estate loans of households in the largest economy in the world. These are not Third World debts. Despite the many assurances by regulators and authorities that it would be "contained," it has proven to be quite contagious. Why? Financial markets today are highly correlated. In other words, it is the same high-powered money, the same type of players, with the same sources of leverage that are operative in many assets, not the least of which in mortgage repackaging, leverage and speculation. They will tend to act as herds.

All, if not most of these financial players, are dependent upon credit and also often upon sophisticated financial strategies that, in turn, depend upon unproven financial models and risk equations. This produces an environment similar to a turn-of-the-century gold rush town in a dry spell. There eventually arrive conditions where not much more than a single spark is required for all the ramshackle wooden buildings to burn down together. That is the danger that the central banks wish to forestall at present. They have been dousing the emerging conflagrations with liquidity very early.

Given that the epicenter of the crisis is in North America, it is important to note that this has occurred in an environment of a decelerating economy. In 1998, US economic growth was strong. Not today. In fact, the US household sector (yet to be further dragged by housing woes) is now in a deleveraging mode. The US economy is heading towards a recession, barring some miraculous intervention.

Next to consider is that the majority of the credit creation today takes place outside of the banking sector ... namely the non-bank financial institutions. This was quite the opposite just 20 years ago. This is significant for two reasons. Firstly, only banks have access to true liquidity through the central banking system. Therefore, when credit crisis do erupt, central banks have less means to reflate collapsed "liquidity channels." That is what is unfolding now. Secondly, the greatest credit and leverage boom in history has occurred over the past six years. In other words, on top of the instabilities that already existed, there is also a lot more debt to contend with.

A emblem that aligns with this last statement, is that interest rates have in fact not risen as much to date as in past liquidity crisis. Interest rate spreads which reflect different risk levels have only widened about half as much as in 1998. It indicates the higher leverage and vulnerability that exists today.

What is the appropriate course for investors to take at this time?

This is entirely dependent on the conclusion to our brief analysis here. If the crisis is soon over, we would be prudent to invest our currently-high cash balances, which have been built up in anticipation of just such an opportunity.

However, should the crisis worsen, then giving up high cash levels (which, incidentally, are earning very competitive interest income) would be much too early.

Here is what we expect: We can be sure that authorities and central banks will do everything possible to avert a further meltdown. That means quite a few more months of volatile securities and currency markets. At the very minimum, we should expect to see short and sharp recoveries, followed by further declines.

All indications to this point suggest that the financial contagion is still spreading. We are monitoring a long list of key "bell weathers" that provide either a direct or indirect window on these ongoing dynamics. Among these: yen strength vs. the US dollar (and also other currencies) the relative performance of the financial equities sector, various yield spreads and a host of others.

We also anticipate that the US dollar may rally substantially versus the major currencies, and also the Canadian dollar. (The CAD has already fallen almost 5% against the USD from its July peak.) Actually, we think this has a high probability. This view is quite a shift for us. We have been unsupportive on the US dollar since 2001. While we do not yet suggest that the US dollar is out of its long-term troubles, for an interim period at least -- perhaps a year or two or longer -- it is liable to rise sharply. Why? It is related to liquidity concerns. But, also much more than that. We will delve into these reasons more deeply in our upcoming HITCH Report.

This trend in turn will have downward implications for commodity prices. Industrial metals markets -- and, yes, even crude oil prices -- should continue to moderate in price.

All of these factors taken together favor a continuing cautious stance for the time being, and a focus upon safety -- high quality bonds and income. We are also emphasizing investments that show promise of being inversely correlated to crisis conditions. This includes a continuing position in gold shares and bullion as well as an exposure to such currencies as the yen.

We do anticipate opportunity ... eventually. For now, we expect a continuation of volatile, confusing and dangerous conditions.

A long-term perspective is necessary through this volatile period. While portfolios may experience declines over shorter-term periods, we still anticipate reasonable positive returns over the next few years. Moreover, we are hopeful that our established longterm, low-risk, outperformance record will be enhanced throughout this time.

During this time we endeavor to redouble our diagnostic efforts, remaining focused upon an objective of capital preservation.

(The following selection of charts lay out some current dynamics as well as a broad background to our discussion.)

The Catalyst Was Here: High-risk &
Adjustable Rate US Mortgages

Still much more hardship to come for over-extended US homeowners.

"House Poor" US Households Became Very
Illiquid and Indebted

Spending exceeded income, investment and savings. Now, contributes to slowing economy.

Financial Sector Stocks Among Worst Hit

Sharp break-down and underperformance an indicator of "credit crisis."

The Credit Pendulum Swings Back:
Risk Aversions and a Paucity of Loans

From feast to famine ... and a new appreciation for loan quality risk.

Comparative Tremors to 1998 LTCM Crisis
Greater leverage, higher vulnerability

Spread rose 200 b.p. in 1998 LTCM crisis. Recently, only 77 b.p.

Indicators of Higher Vulnerability to
Credit Crisis Today

Unprecedented risk & complacency met with boom in exotic credit vehicles.

LBO Support to Equity Markets Now
Disappearing as Loans Get Pulled In

Many investors have been loathe to sell stocks due to high takeover levels.

Condition of Extremely High Global Capital
Mobility Now Adds to Volatility

Credit crisis, surprisingly, quickly has spread to Europe.

The Carry-trade: No Longer a One-Way Bet
CAD could now be vulnerable

Aussie dollar (another commodity currency) has already begun to correct.

Economic Issues to Assess Looking Forward

Current liquidity crisis hits at a time of various economic risks.

Yen an Important Bellwether: Now Turning Up?

Yen is a finance currency. As such, a rising yen raises cost of financing.

Crucial Trend to Watch: USD

Several reasons why USD could now begin an extended upturn.