Third Quarter 2008 Commentary

The Economy
As the third quarter began, it looked like ‘more of the same’ – gradually slowing growth, rising costs for businesses and individuals, and the complex but apparently manageable unwinding of the nation’s multi-year debt binge and resulting housing-related boom/bust.  This view proved to be largely accurate through June and into July as energy and commodity prices peaked and key measures indicated meaningful economic slowing.
But, by mid-July, it was becoming evident that the nation’s and world’s financial system ills were much more serious than initially perceived.  Fannie and Freddie, the government-sponsored entities created to expand home ownership, were declared essentially bankrupt and the government’s implicit guarantee of their paper was made explicit.  Merrill Lynch was folded into Bank of America, Lehman Brothers entered liquidation, and AIG was effectively nationalized.

In spite of all these truly unprecedented actions, by late-September, it became apparent that the mortgage-related problems were still spreading, not only in the U. S., but also in other developed market economies.  The quarter ended with the U. S. government desperately working to find a solution that would be effective, affordable, and palatable to the American public.  As this goes to press, the issue remains unresolved.

The Markets
Investment markets in the third quarter illustrated once again that even when things look quite grim and securities prices appear to be very depressed, they can suddenly . . . get even worse.  This in particularly occurs in economies struggling to correct several years of excesses.  And, it is especially true when the government is at the same time struggling to counter previous naive and largely politically motivated actions with a new generation of questionable judgments.

In this environment of growing investor concerns, the securities markets behaved as expected – stocks sold off, low-quality bonds plummeted, and burgeoning demand for the safest investments drove their yields to near zero.  The other traditional ‘safe harbor’ investments, however, did not behave as expected.  Precious metals, as well as most other commodities (including energy) saw price declines.  And real estate, of course, suffered greatly with the continued tight credit and excess supply.

For the quarter, after maintaining a modest trading range for the first couple of months, U. S. stocks declined through September, suffered extreme volatility late in the month, and ended the quarter down from -4.4% for the Dow to some 9% for the S&P 500 and NASDAQ from their June 30 levels.  International stock markets fared much worse with, for example, the German and UK markets off about 12% (all numbers in local currency), Japan down 18%, China 23%, and the Eastern European markets off 35% to 40%.

Ten-year Treasury yields declined from nearly 4% at June 30 to 3.8% at September 30 while 90-day Treasury bill yields declined from a modest 1.8% to a Japan-like 0.5%.  Foreign bond markets were generally even more volatile at higher rate levels.  Precious metals failed to uphold their reputation.  Gold’s decline was only about 1.5% between June 30 and September 30, but that was after peaking at $980 in mid-July and plunging to $750 by mid September, a peak-to-trough decline of nearly 25%.  In the currency markets, the U. S. dollar ended the quarter approximately even with the Yen, but gained significantly (12.5%) versus the Euro and approximately 6% on a trade-weighted basis.

The CoreStates Strategy
We, like virtually all other investors, are disappointed and somewhat surprised that the mortgage-related markets have continued to erode.  We are also troubled with the lack of price support provided by our usually non-correlated asset classes, which failed to provide the gains we expect at times like these when traditional asset classes are declining.

But, we also know from many years of experience that, when markets are suffering severe stress, troubled investors are forced to raise cash from whatever they can sell at a reasonable price.  These are usually the higher quality asset classes, and the selling depresses even their prices.  Only after some degree of liquidity returns to the markets do these asset classes become the effective diversifiers we know them to be long-term.
We maintain our faith in the ability of the U. S. and world economies to provide attractive long-term returns to prudent, well-diversified investors.  We also maintain our hard-earned humility, which prevents us from betting too heavily on either our fears or our inspirations, especially with our clients’ hard-earned wealth.

So, although we and our carefully selected specialty managers continuously try to prudently adapt our specific day-to-day management tactics to the current market environment, the foundational CoreStates investment strategy remains unchanged – allocate with the goal of moderating risk, not to seek maximum returns, focus on quality investments, and maintain a long-term perspective.  This kind of intellectual and emotional grounding is always valuable, and can be invaluable in times like the present.