Farewell 2008...we'll not miss you at all.  What is it about human nature and the end of a calendar year?  Why do we so quickly dismiss each passing year and accept the coming year with great expectations?  We liberate the past year's misgivings, oversights, and blunders, replacing them instead with promises of diligence and allegiance.  We resolve to look beyond our mistakes and make this the year we lose weight, quit smoking, work more, work less, study harder, read more books, take a vacation, play with the kids, get rid of the clutter, visit Mom & Dad, recycle, go to church...anything that can be done, we vow to do it better...until February at least.
   Unfortunately, the financial and economic malaise of 2008 is not so easily dismissed.  There will undoubtedly be some of the same faults of 2008 carried into 2010 as well.  There is no magical economic eraser that wipes the slate clean for a fresh start.  As it turns out, 2008 was merely a very long hangover from the party of prior years.  We over-imbibed to such excess that the resulting hangover required hospitalization and markets still haven't been able to check out of rehab.  So, we welcome 2009 from the intensive care ward, still ailing from the financial malaise that knocked the world on its back.
   This is no time to mince words.  We have dug a very deep hole, and it will take a long time before we start seeing daylight.  This is no ordinary recession, and the recovery time will be much longer than usual.  Please don't misinterpret us - we are not predicting a Depression, nor do we advocate the abandonment of long-term investments.  We just want to emphasize that the news in the coming months will be dire; it always is in the midst of a recession and will be no different this time as we continue toward the longest economic decline in more than 50 years.  Temper your expectations and disappointment will be less likely.  Don't throw in the towel - we've never had a recession or bear market last forever, and our current circumstances will not last infinitum either.  There is reason for hope on the horizon, which we'll expand on later in this letter.  First, however, let's take a look at why we are so happy to put 2008 behind us.
2008 Performance Review
   Let's start off with some good news.  As bad as 2008 was for most assets, St. Nicholas clients on average fared much better than the typical investor.  Many of our clients have balanced portfolios with significant exposure to high quality bonds, and bond returns did not disappoint.  Our client bond exposure was short-term and high quality - two traits which allowed full participation in positive fixed income returns of 5% to 6%.  Our equity clients fared well also.  While we were late boarding the recession bandwagon, we realized very quickly that equity risk was atypical and did several things throughout the year that benefited relative performance.  We were out of housing and bank stocks even before the year started; we had lowered emerging markets exposure at the beginning of the year; we resisted the urge to chase skyrocketing oil stocks that would eventually come crashing back to earth; and, we had already began cutting back on cyclical stocks.  More importantly, we realized in the third quarter that stocks as a whole carried too much risk and reduced total equity exposure by 20%-30%, saving equity portfolios from further erosion in the fourth quarter and beyond.  We'll remind our clients to examine total portfolio returns rather than equity-only.  The equity-only returns reflect a less diverse portfolio of stocks and do not take into account the return-cushioning effect of significant cash holdings.  This cash cushion helped our clients gain out-performance gaps ranging between 400 and 800 basis points.  When the markets decline by 40% and our managed portfolios decline by 5% to 15% less, we know we have added significant value.
   Still, no one is happy with negative absolute returns, and in the equity markets we saw the worst bear market declines since the 1930s.  US markets in general were down about 40%.  The Dow Jones Industrial Average fared the best, declining only 32%.  The S&P 500 did worse, dropping 37%, and NASDAQ plummeted 41%.  Overseas markets were terrible as well.  Japan was down over 42%, large cap international stocks (MSCI EAFE) were down 43%, and emerging markets fell an eye-popping 53%!  Real Estate prices fell about 20%, with no bottom in sight.  Commodities lost their glow as demand projections fell with the global decline in economic activity, and oil prices fell through the floor, dropping to below $40/bbl from a midsummer peak of $147/bbl.
The Recession
   History will ultimately decide where the fault for the recession lies, but make no mistake - somebody's getting the blame for what will turn out to be the worst recession since WWII.  Fingers will be pointed at Alan Greenspan and the Fed for leaving interest rates too low for too long. Banks will be accused of taking excessive risk through the lowering of credit standards and speculating in what turned out to be company-destroying toxic assets.  Regulatory authorities will be charged with turning a blind eye to hedge funds and derivatives that magnified exposure a hundred-fold.  Real estate speculators and home buyers will be reproached for taking on excessive debt in a greedy attempt to capitalize on a housing bubble set to explode.  And, we can't forget government - George W sat around doing little and his congressional leaders failed to act soon enough.  Still, the reality of it all is that it really doesn't matter why we are here.  What matters is when it will turn around and how bad it has to get before it does.
   If we knew the answers to these questions, we wouldn't be in the business of managing your money...we'd have too much of our own to worry about.  However, since that's not the case, we do have to make an effort to gauge where we are currently in this cycle.  Hindsight being 20/20, the government (specifically the NBER) announced in December 2008 that the recession actually began in December 2007.  Given that the average recession since 1945 has been 10 months, we are obviously experiencing something worse than average.  The reason we are experiencing abnormal declines in economic activity is due to a multiplicity of underlying causes.  This is not a typical recession caused solely by housing, inventory excess, protectionism, or inflation.  Whatever the causes, this recession is exacerbated by a non-mechanical influence.  Consumers have stopped spending not only because they fear for their jobs, but because they have lost confidence in businesses and institutions that form the very foundations of our economy.   They fear losing the financial flexibility that came with growing retirement accounts and increasing home values; they delay big-ticket purchases for fear that the price will be cheaper in the near future; they spend less simply because they are overextended and/or they can't get as much (or in some cases any) credit.
   The end result is that we may see a recession that is longer and more severe than initially expected, one which also lacks the typical self-correcting influences that help the economy recover.  Expect an anemic recovery and get used to hearing the term "double-dip recession".  These self-correcting recovery inducers are generally boosts in private sector demand from housing, the consumer, and/or inventory building.  We've already mentioned the consumer - they lack the confidence and credit to jump back in (as we saw with plummeting retail sales in December).  We've also stated the "no-end-in-sight" scenario for housing.  While a housing recovery will undoubtedly boost the economy, we don't expect it to be the stimulus for our exit from this recession.  Finally, technology has significantly reduced the magnitude of inventory swings, so just as we are unlikely to experience inventory-induced slowdowns, we are unlikely also to expect recovery stimulus from that influence.
   So, guess who's going to lead us out of the recession?  You are... not the consumer-you, but the taxpayer-you.  An examination of the headlines of any newspaper or news website in the world would lead anyone to believe that the only ones spending money in this environment are the governments of the world.  And, not to be outdone, the US government is leading the pack, investing as much as $5 trillion to save this country's financial backbone and the economy as a whole.  We have yet to get a detailed listing of what these funds will be used for, and what allocations will go to saving companies versus fiscal stimulus, but rest assured, help is on the way.  Jobs will be a big part of any fiscal stimulus.  Unemployment is a result of the recession not a cause, and job cuts will continue well beyond the bottom.  Don't be surprised to see the unemployment rate hit double digits before it's all over.  Understanding now how we get out of the recession, how soon will be a function of the speed at which the government initiates fiscal stimulus.  We know from Economics 101 that fiscal stimulus produces rapid results, but the time it takes to legislate that stimulus will go a long way in determining the initial recovery.
Can't the Fed help?
  The Federal Reserve Bank has been doing its darnedest to nip this thing in the bud.  They may have succeeded had they started about nine months earlier.  Contributory actions by the Fed are two-fold at this point.  First, they are in control of interest rates and will look to provide stimulus through monetary policies.  Second, they are charged with rebuilding confidence in the banking system. 
  The Fed has been in a very accommodative monetary position throughout 2008, and has lowered rates to the point where they now hover between zero and 0.25% - basically, free money for banks.  Undoubtedly, the Fed will keep rates at these levels for most of 2009.  Low rates are generally great stimulators of economic activity, and rate levels today are lower that they have been in most of our lifetimes.  However, there has been little economic activity driven by these low rates because banks simply aren't lending.  The economy (and Fed) is caught in a liquidity trap:  banks are afraid to lend and are hoarding cash, and consumers and companies are afraid to borrow.  The rash of bankruptcies, failures, foreclosures, and bailouts makes banks very fearful to lend, and justifiably so.
   Since we're now talking about bailouts, let's discuss the second Fed issue - confidence.  In Bernanke's own words, "fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system...a modern economy cannot grow if its financial system is not operating effectively."  Basically, consumers won't spend if they don't trust the banks, and banks are still hurting badly.  Already, we've seen the "healthy" banks that saved the dying ones come back to the bailout buffet line to get second and third helpings.  There is no way the consumer will be convinced that the banking system is healthy unless or until they are able to stand on their own, and they haven't been able to prove that as yet.  Part of the problem is the ambiguity of the bailout plan - even Congress and the Fed can't figure out what it is supposed to look like.  We certainly wouldn't buy bank stocks today, no matter how cheap.  And, until we have confidence as investors that banks are viable going concerns, we doubt that the average American will feel any level of comfort either.
President Obama and The New Hope
   It's pretty amazing that the new President achieved immediate rock-star status and received the highest approval ratings ever...all before he even took office.  We cross our fingers that the tremendous weight of hope on the new President's shoulders doesn't crush him before he can make a difference.  We understand that the economic situation is dire and the desire for any kind of change was overwhelming.  We understand the cultural and social significance of not only our first African American President, but one also possessing youthful exuberance.  We understand also that Rome wasn't built in a day, and that all of our leaders need our patience and understanding over the short-term while they enact policies designed to stimulate long-term benefits.  We don't yet know the details of President Obama's fiscal stimulus plan other than that it will be close to a trillion dollars and likely involve an amalgamation of projects including education, healthcare, alternative energy, road construction, technology, and utilities.
   The media and perhaps the entire world have set the bar very high for Barack Obama.  However, even he has admitted that we are in extremely tough circumstances and things will likely get worse before they get better.  He has also repeatedly stated that it will be our entrepreneurial spirit and the American people that will lead us back to economic prosperity.  He has indirectly admitted that he is as much a symbolic leader as he is Commander-in-Chief, and that he can not accomplish things single-handedly.  Democrat or Republican, black or white or brown or yellow, young or old...we need to act as a nation and have patience that our elected leaders will lead us back to the path of economic growth. 
Stocks and Bonds
   We've already mentioned that St. Nicholas raised significant cash levels at the end of the third quarter, and we have yet to put any of that money back to work.  Our expectations on January 1, 2009, were for the markets to revisit their lows, and possibly go lower, but finish the year well-above those lows.  We feel like earnings estimates are still too high, and reports in the first quarter will be overwhelmingly disappointing, causing most analysts and CFOs to understate expectations going forward.  If we are correct, we expect to begin putting some of that money back to work at what will feel like the worst possible time.  However, that's the way it should feel - we hold to the oft-cited Warren Buffet axiom: "be fearful when others are greedy and greedy when others are fearful".  We also realize that stock markets begin turning upward far in advance of fundamentals, typically a little more than half way through the recession.  This initial move has historically produced average returns of around 40% one year after the turn, so regardless of the magnitude of the economic recovery, those in earliest will benefit the most.  Our cash positions thus far this year have given us a nearly 50% relative return advantage already, and we'll probably look to compound that advantage by adding positions in the first or second quarter.
   We also can't ignore the valuation argument.  Average PE ratios (even on reduced estimates) are already near levels typically seen at market bottoms.  They could certainly go lower than average in this recession, but we do take consolation in the fact that we might be buying/owning stocks at PE levels not seen more than a few times in the past 50 years.  Price those PEs relative to an inflation rate of nearly zero, and the valuation becomes even more compelling.  Of course, even extreme valuations need to be watched carefully.  Stock market darlings like GM, AIG, and Citigroup all looked like extreme bargains throughout 2008, but ended up with declines of 87%, 97%, and 77% respectively.  We again feel like this will be more of a stock picker's market, and good returns will be a function of being in the right areas.  We intend to focus purchases on higher dividend-yielding stocks (assuming we are comfortable with the safety of those dividends), as well as on some of the more less-cyclical, stable-growth sectors like consumer goods, pharmaceuticals, and utilities.  Also, while we've continued to hold many names that may be early-cycle beneficiaries, we may look for additional opportunities in the technology and oil sectors.  Regardless, this is still the type of market where risk will be above average, so diversification and patience will be critical.
   Moving to bonds, they were one of the few areas where positive returns were generated last year.  US Treasury bonds may be a difficult place to make money given the historically low yields that exist today (zero percent on t-bills and less than 3% on 10-year bonds), but there may still be some value in agencies and corporate bonds.  The credit crisis and finance bankruptcies have caused corporate spreads to widen considerably, but as long as we are comfortable that an entity will survive, some of the yields out there are eye-popping.  Municipal bonds are also in an historically unique position.  Instead of having to look at their normal negative spread to Treasuries (munis typically yield less), we still see muni yields above taxable rates...yep, you can earn more than taxable treasuries, and pay no taxes.  However, that yield advantage is more a function of how low Treasury rates have gone than how high muni rates are, so we still need to be diligent.  Regardless, the bond market is still constrained by the credit crunch, so prices can be all over the place - generally good if you're a buyer, but not so good if you're a seller.  In any event, the economy's going to be weak all year so unless you're buying Treasuries, it should be pretty easy to earn your coupon and perhaps more if you're willing to lower credit quality.  
She Ain't Singing Yet
   The fat lady's not on stage yet, but she's at least warming up backstage.  We're in Act III of what will probably be a five or six act play.  Listen to your President when he says it may get worse before it gets better...the Fed's Bernanke and the Treasury's Paulson have said that as well.  These guys are all smarter than us, so we have a tendency to believe them.  The banking crisis and the resolution of the toxic asset mess is a work-in-progress that likely will not be resolved completely by the end of 2009.  Real estate won't lead us out because we've still got excess inventory and prices will continue to decline.  Realistically, residential price declines are almost always followed by commercial property, so expect that shoe to drop this year as well.  Foreclosures will continue but at a decreasing rate.  Inflation will be non-existent, and get used to hearing the term deflation.  We're hoping deflation won't become a long-term concern due to the massive fiscal stimulus that should help stall the existing deflationary cycle.  Given the huge swing in oil prices last year, we won't even begin to predict where they will go this year.  However, we think prices are probably too low below $30/bbl, but they will obviously increase as forecasts for any measure of global recovery emerge (China is already displaying classic signs of a turn).

   In summary, we're coming out of the worst financial crisis in over 80 years.  The medicine tastes pretty bad, and we're not sure if it is working yet.  We will continue to endure a very deep and lasting recession, and we're all going to run into friends and family that are either directly or indirectly impacted - this will be one we remember.  Still, we're not giving up hope.  In spite of the mismanagement, fraud, deceit, regulatory neglect, and excessive risk that this period possesses, recessions are normal occurrences and they all come with market corrections.  Coming too are the recovery and market rebound.  We may not feel like we've recovered completely by the end of the year but we believe we'll have more pleasant things to talk about by then.