3rd Quarter Review
     In hindsight, it's probably fortunate that equity markets were only down 13% through mid-year.  The downward spirals of the third quarter (and continuing into October) are the market's way of discounting the unknown.  Now that the unknown is better out of the closet, the markets are reflecting some tough economic times ahead.  Every major market index is down significantly in 2008.    In the US, NASDAQ owns the worst YTD return, down 21.5%.  The SP500 isn't far behind with a YTD return of -19.3%, and the Dow Jones Industrial Average leads US indexes, down only 16.6%.  Overseas, it's the same story, only worse.  Japan's Nikkei is down over 26% YTD, large cap internationals (MSCI EAFE) are down 29%, and emerging markets (MSCI EM) are down a whopping 35%!  Bonds were also no place to hide as bond indexes were down for the quarter, leaving most bond proxies flat YTD.  Commodities also suffered significantly in the quarter as prospects for slowing global growth reduced demand forecasts.  Oil price declines in the quarter brought at least some good news for consumers.  Oil is now off nearly 50% from its high this year, and pump prices are finally starting to follow.

 The Fed and the Financial Bailout
     This is clearly the most critical time in our lifetimes for the Fed.  They are faced with unprecedented problems and subsequent actions that have not been considerations since banking reform of the 1930s.  The issue that we can all take solace with is the change in rhetoric that has occurred in the past few weeks.  We had a Federal Reserve Board (and Treasury Secretary) that were crying panic just a few weeks ago, and that tone has changed significantly.  They have gone from addressing a calamitous financial crisis to a now much more relaxed tone.  The Fed, the Treasury Secretary, and the current administration have now moved from a "we have to do something now" attitude to a "we've got a plan in place and it will just take time to work" outlook.  In spite of the market's reactions, our leaders are much more reserved and feel that we have plans in place to restore stability in the financial sector.  Nothing will happen overnight, but there are measures in place to restore order - it will simply take time to have an impact.
   The Fed has taken extreme measures - the passing of the bailout plan, flooding the markets with liquidity, and the continued reduction in interest rates.  None of these individually will solve our problems immediately, but all of the combined lay the foundation for increased stability of our banking system.  We have complete confidence that our credit markets will be restored, and we simply have to be patient for the result.  We also have complete confidence that the Fed and the current administration have removed much of the panic related to our banking system.  There will undoubtedly continue to be smaller bank failures, but be assured that the major players - the most important financial institutions in the world - will survive and eventually be the conduits of recovery for the US economy.  We are certainly shocked by the magnitude of the disappearance of so many of our major institutions, but we are confident that the players that remain will have the financial strength to survive.  Whether you believe in government intervention or not, it is critically important that the strength of the remaining institutions has been reinforced by the actions of the Fed and the US government.  Banking liquidity is the lifeblood of our economy and without it the economy would fail completely.  We fully expect that the Fed will continue to be accommodative for months to come, and now the real dilemma will be convincing banks overall to begin lending to quality companies that need funds on a daily basis.

So what to do with stocks?
     We had previously fought the notion that a recession was forthcoming, but at the same time accepted that it was certainly a possibility.  We are now firmly in the recession camp.  Regardless of the stock market losses thus far, it is readily apparent that the economy cannot ignore the liquidity issues that have amplified over the past few months.  Companies can simply not survive without credit liquidity, and now that that liquidity looks to eventually be restored, we are content that normal day-to-day operations can be funded.  However, we also accept the fact that this liquidity issue will ultimately have an impact on future growth, and ultimately earnings.  Even if liquidity were restored immediately, you'd be hard-pressed to find any CFO that would recommend taking on debt to expand operations.  In light of these circumstances, we don't feel that growth in earnings (the end-driver in stock price appreciation) will be enough to lift stock prices in the coming months.  Stock prices are already discounting a severe recession, and the length and magnitude of that recession will ultimately dictate returns going forward.
   We don't feel that individual consumers will come to the rescue as they have in previous years given the huge swing in sentiment caused by the sensationalist media and the grasp of the reality of what may be forthcoming.  Consumers, like CFOs will curb discretionary spending, which also has a negative impact on earnings.  A change in our political leaders only adds more uncertainty to the equation.  Given all of these circumstances, we feel it prudent to lower the overall risk of our clients' stock portfolios.  Addressing these concerns, we have already taken action.  We have liquidated several positions that we felt held the most risk and volatility.  All of these companies still hold tremendous long term merit, and we would eventually like to buy them back.  However, the market will continue to be faced with tremendous volatility and we feel it is in our clients' best interests to reduce equity exposure.  In consideration of the impact of cash, we remind clients to examine total portfolio returns rather than simply equity-only.
   Going forward, we continue to be concerned with economic growth.  We would still look to reduce the cyclical risk of our stock positions by eliminating stocks with cyclical earnings and replacing them with companies that lend greater stability in any economy.  This means reducing exposure to sectors like manufacturing, technology, and retail, and shifting to more defensive sectors like energy, utilities, consumer staples, and pharmaceuticals.  We anticipate making opportunistic changes rather than wholesale shifts, but much of our actions will be dictated by price opportunities.  None of this is to say that we are abandoning our long-term outlook for equities.  Indeed, we feel that the markets have already priced in a severe recession, and that many companies we currently own (as well as ones we may buy) are at extreme valuation levels and hold tremendous upside from current levels.  The question that remains is whether it will take 12 months to realize this value or three to four years.  Regardless, we don't think it's time to abandon long-term equity approaches - just expect us to err on the side of caution and try to hold less cyclical stocks during the coming recession that may last for many months.

Oil and Gas
     If there is any reason for optimism, it is that we have seen oil prices come down tremendously from their highs.  We had forecasted that price levels were far too high and would decrease substantially, but we were a bit off on the level of the decline.  Regardless, lower energy prices are a boon for consumers.  Pump prices are now falling below the $3 per gallon level and will likely decline further.  This rapid price decline has primarily been a function of lower global growth forecasts, but we surmise that a portion of it was due to the removal of speculative excess.  What matters most is that consumers will now have to spend less of their discretionary income for gasoline and heating oil, freeing up more for discretionary spending.  While this extra cash will probably not be enough to elevate earnings elsewhere, this is needed relief for consumers' pocketbooks heading into recession.  We don't really have a sense of where oil prices will level, but we speculate that they will not precipitously fall.  Given this circumstance, we also anticipate that there will be better investment opportunities ahead in an energy sector with solid growth prospects and attractively safe dividends.  We have not had significant exposure to the energy sector in the past year, but now feel that market declines have made many of the major oil companies much more attractive investment considerations.

A Word on Housing
     Let there be no doubt - the instigation of this crisis was the collapse of the housing market.  We accept that easy borrowing as a result of low rates and creative financing was a big part of the problem, but would argue strongly that the real problem was the emergence of a derivatives market based on the underlying loans.  Without this speculative influence, we surmise that the housing correction would have created a normal economic headwind.  However, the derivative instruments were allowed to grow unregulated and sent us into a financial spiral unprecedented in our history. Still, the US economy is inexplicably tied to housing and we don't feel we can experience upward momentum until real estate prices bottom.  There is good news in that housing starts have fallen to the lowest levels since 1991.  However, new construction is only about 15% of the market, and we still don't see any bottom in existing home inventories.  While we have lower borrowing rates ahead, we also have extremely tight lending standards by banks.  It will still take more time to reach equilibrium, and we continue to watch housing numbers for further indications that a bottom is near.  Until we reach that bottom, it is a reasonable expectation that the economy will continue to flounder.

What about Bonds?
     This typical safe haven is also in flux.  A big part of the reason is the liquidity crisis.   Regardless of credit quality, all bonds seem to be priced for worst case scenarios.  We still feel that investment grade bonds are safe, particularly those in the financial sector that now have indirect backing from the US government.  Our strategy is to keep the investment grade bonds that we own.  We feel that bond returns and prices reflect extremely dire circumstances, and unless there is a massive default due to lack of liquidity, that investment grade borrowers are completely capable of meeting their obligations.  We take great comfort in the fact that the Fed has acted to address the liquidity issue with regard to our corporate and municipal bond holdings.

The Election
  We've been pretty quiet regarding the upcoming election, and for good reason.  Our contention is that the economy is too big and too resilient to be impacted in any major way by the rotational leaders of our country.  An examination of economic performance over the past 50 years leads us to believe that neither Republicans nor Democrats have any consistent record of success or failure.  That being said, we certainly have to wonder whether party actions will impact the economy in the short term.  It is still a huge unknown whether the actions of Obama or McCain will help or hinder our current economic circumstance, but needless to say, either will be inheriting quite a mess.  At the risk of calling the cards incorrectly, we wish President Obama great success.