The credit crisis continues to take victims. What started as trouble with mortgages has drifted onto Wall Street and virtually disintegrated a number of major financial institutions that have been in its path: Bear Stearns, Fannie Mae, Freddie Mac and now the fourth largest investment bank, Lehman Brothers. Though many have viewed each of these instances as onetime events, it has become obvious that this crisis has not yet run its course.

The implications for the global economy are several fold. Most importantly, foreign and US economies are slowing at best and some are already in recession. In addition, until Wall Street and foreign financial institutions can get on better footing, the global economy is unlikely to recover and once again expand. This crisis also has the potential for US taxpayers to bear the brunt of current or future bailouts which has a longer term negative impact on consumer spending - a key component of economic growth. Moreover the massive capital infusions taken on by companies in the financial industry may significantly reduce their potential to return to reasonable growth rates anytime in the foreseeable future.

We do see light at the end of this credit crisis tunnel, and it is not an oncoming train. We do know that once financial institutions write-down or acknowledge all their greed driven bad investments, the wheels of lending and investing will once again begin to roll and economies will begin their recovery. As you know, we have been monitoring the progress of write-downs carefully and it looks to us that we are probably 75% through the process. Until we can feel confident that this process is complete however, we will continue to focus on managing the risk of your investments through higher than normal bond and cash positions, sector management, and stop loss orders. Keep in mind that typical bear markets (this may be worse than normal) decline by about 30%; this one – so far – has declined by only 20%.

Interestingly, our sector and stop loss management, though not perfect, has prevented you from feeling the full brunt of this financial tsunami. In fact, many of your stocks are up this year and reporting respectable earnings growth – particularly those companies in consumer staples and healthcare. This is a good reminder that even in bad markets some stocks do pretty well, and that liquidating all stocks is usually a mistake.

Though we are concerned about recent developments, we believe that over the next few quarters most of the write-downs will be acknowledged and that financial markets and global economies will once again begin their recovery. We are also confident that stocks will once again provide the best long-term return versus other asset classes such as bonds, real estate and money markets. In fact, we have been very busy making a list of investments to add to your portfolio as the financial markets begin their inevitable rebound. There are several themes we have been considering as we have complied this list which include; a global – not just US – economic recovery with faster growth in some countries such as Brazil, China, and India -a long term rebound in the US dollar -sluggish profit growth in financial shares -above average growth in consumer discretionary, industrial, alternative energy and technology shares and receding inflation. Our research also suggests that though large companies will perform very well, smaller companies will do even better. Though our list is a work in progress, it includes domestic and foreign and big and small high quality companies that should perform exceptionally in this upcoming global recovery.

We look forward to the upcoming environment which will allow your wealth to expand. Until then, we expect a continued bumpy ride. If a more fruitful environment arrives sooner than we expect, we are prepared to alter our current cautious course.

We hope you are doing well and that if you have any questions or thoughts, you feel free to contact us.

Sincerely,

James E. Demmert
Managing Partner