From the Desk of Richard Esposito

Investment Report

Happy New Year!

Did you have a splendid Christmas-New Year’s holiday? I’ll start the New Year with a confession: it’s been a long time since I had the slightest desire to go out on New Year’s Eve. I used to think I was a real “stick in the mud” until I started asking people what they were doing on New Year’s Eve. Over-30’s: staying home. (In New York City, the under-30’s go to clubs I’ve never heard of and spend what seem like vast fortunes for food, drinks and party hats to spend the night with complete strangers. To each his own.)

So if no one’s going out, who are all those people in Times Square? Whoever they are, the whole thing appears remarkably, eerily, orderly: everyone squashed into little groups, penned in barriers controlled by hundreds of police, with everything completely cleaned up before the sun rises on New Year’s Day. Within less than 12 hours, it’s as if it never happened.

It got me thinking: how do we know there really were any people there at all? After all, most crowd scenes in movies these days are computer-generated. Could it be…? Nah. Can’t be. At least I’m pretty sure.

Can you blame me for wondering? How hard would it be to do a “virtual” New Year’s Eve in Times Square? It brings up an issue I spent a fair amount of time with when I studied philosophy back in college: what’s real, what’s not. (Admittedly not something I’ve spent a lot of time on while supporting a family of seven in recent years.)

Of all the issues facing us in 2008, figuring out what’s real and what’s not won’t get much press. After all, there’s a lot going on: a Presidential election; continuing war in Iraq and Afghanistan; ongoing threat of terrorism; possible economic recession; the looming threat to our banking system (see our Investment Report); free trade vs. protectionism; open borders vs. immigration reform – the list grows and grows.

For today, let’s give the old philosophical distinction a modern twist: virtual reality vs. “old-school” reality. But it’s not an academic issue. The way we all experience the world is changing. Why should we care? Here’s an example of why.

Have you ever watched kids playing computer games, walking around with head phones, text-messaging at the same time, as they talk into their cell phones? What’s going on? What are they seeing? What are they thinking? What happens to your brain and your senses when you’re hooked up like this?

Sure, it can all be a lot of fun. But what does this do to our brains, to how we think? As for technology keeping us connected, it’s how we’re connected that’s become a problem. I wonder whether real, meaningful communication between people may be dying. When we text-message or we IM we’re just sending or receiving little snippets of ourselves. Our real selves stay “hidden.” Where does this take us let’s say, 10 years from now? What does this do to relationships?

We’re seeing the results of “snippet thinking” in the work-place too. If you’ve attempted to hire someone in his or her 20’s lately, you’ve seen the effects of virtual communication. More and more people can’t speak in coherent sentences. They can’t write a sentence with a subject and a predicate (Huh? Subject? Predicate?). Forget paragraphs that express a complete thought. These folks spit out short, clever comments and respond quickly to the immediate issue at hand in a few clipped words. But anything that requires “thinking” is a mystery for many under-30’s we’ve tried to work with. Not good.

(If you’ve got kids graduating college looking for work, let them know: if you can think, speak, and write, there’s a job out there somewhere.)

Let’s move up to people in their 30’s. I recently asked a highly-compensated, intelligent, professionally skilled and polished colleague for a memo summarizing a proposed project. What I got back shocked me: incomplete sentences, no idea how to group thoughts into paragraphs – and don’t get me started on spelling and grammar. I had to sit and re-write from scratch, taking up more time than if I had written it myself.

This snippet thinking even takes a toll on investing. Certainly, more and better information may lead to better investing decisions. But the “snippet” nature of digital information creates an investing “danger zone.” People grab a snippet of info here and there and then make “buy and sell” decisions. It’s one thing to look up price quotes on Yahoo! Finance – quite another to buy stocks based upon little snippets of information plucked from the Internet. Compound this with pronouncements from experts and “gurus” shoveling yet more snippets of sound and visual “bytes” and you’ll wind up with quite a toxic brew.

(If you read our investment review that follows this letter, you’ll see how this all effects your financial well-being. The YouTube link alone makes the point quite dramatically.)

Well, we won’t settle this issue today. We just know that Virtual Reality will profoundly affect our world over the coming years in ways we can’t even imagine. But that still leaves today. After all, it’s a New Year. What do we do now to get more out of life in 2008? Let’s turn to a really good book recommended recently by a client: “Younger Next Year” by Chris Crowley and Harry Lodge, MD. It’s especially valuable if you’re over 45. (Check out http://www.youngernextyear.com to get a little taste.)

There are lots of books about getting into shape. These guys will help you do that. But they also talk about connecting and caring. Do your aerobics and weight training. Go to the gym. Get out and hike, ski and swim. But you also need more real contact with real people you really care about.

Stick with the Internet, cell phones and all the rest. After all, they help keep us all in touch. But make time to actually be with people you really care about and who care about you.

So there it is. A simple message for the New Year: get real, connect, communicate, care. The more real we can all be, the more connected and caring our personal lives, the less we’ll have to worry about in 2008, no matter what the markets bring. Try it and see.
With best wishes for the New Year,

Rick

P.S. – If you have some time now, check out our investment thoughts for 2008 below. The year has started off rather ominously, with the stock markets of the world shuddering and slipping. We’re not predicting the end of the world. But what happens if people start to feel that it is? (Panic never yields good results – it just scares people into making bad decisions.)

Investment Report

It’s that time of the year when we share our thoughts on the markets and the economy. Let’s start with this:

The first storm hit…now what?

The markets began the New Year with more volatility than we’ve seen in any January in over 50 years. There have been years here in the Northeast when storm after storm hit us in January and February. We don’t know what the future holds for snowstorms this year, but we are battening down the hatches when it comes to financial markets.

The fact is a great adventure began in financial markets in 2007 that will carry over into 2008. The mini-crash of world stock markets in August accompanied by the now well-publicized “sub-prime” crisis sent a warning. What does this all mean to your financial well-being?

Let’s start with a Kudlow and Company video clip from July 2nd of 2007 we found on Youtube. You can check it out at:

http://www.youtube.com/watch?v=jZFmtvXPER8

We don’t mean to single out Kudlow. But what was that “upbeat” expert on the show thinking when he told us that stocks were cheap and we should “buy with both hands”? At that time the Dow was at 13,530. As I write this on January 25, 2008, the Dow is at 12,207. And what’s with saying that the sub-prime debacle will have no adverse effect on the U.S. economy? Never mind the U.S., the Bank of China just indicated it will take a major “write-down” based upon holdings of troublesome investments in U.S. mortgage securities, not all of which are even sub-prime. The problem is spreading here and beyond.

If you’ve gotten into the habit of making investment decisions based upon bits of information you pick up on cable or the Internet, it’s time to regroup and rethink how you’ll be making decisions in the future.

2007: We’re not in the Shire anymore…

So what did we learn from 2007 and what should we be looking for in 2008? For starters, while you may not have noticed it yet, we all left the Shire in 2007. Remember The Lord of the Rings (book and/or movie)? The Shire was the home of the Hobbits. It was a picture-perfect place to live: lovely, calm, orderly and secure, with bountiful food and drink, and friendly neighbors. When Frodo and his companions left the Shire on their long journey through Middle Earth, they began a wild and often dangerous adventure.

From about 2003 until 2007, financial markets felt like the Shire. Volatility was low, money was cheap to borrow, business boomed. Individuals saw their net worth rise alongside corporate profits. Following their 2000 – 2002 collapse, stocks looked like relatively safe investments again. People watched the value of their 401k’s climb along with the sky-rocketing value of their homes. Many people borrowed against the increasing value of their homes and spent that money on all sorts of consumer purchases that further boosted the nation’s and ultimately the world’s economy. It all seemed so perfect – too perfect.

Then, in July and August of 2007, the first signs of trouble appeared. Trouble with some huge hedge funds infected with the “sub-prime” debt crisis signaled a mini-crash of world stock markets. After assurances from government officials and key banking and Wall Street executives that any trouble would be contained, things went from bad to worse. As 2007 wound down, disastrous results forced some of those banking and Wall Street executives to resign – and we’ve already seen more in 2008.

Our conclusion: We’re not in the Shire anymore. Get ready for some wild action in the months ahead. While the meltdown in the sub-prime mortgage market received most of the press, we’re watching other sectors of the markets for signs of trouble.

Let’s start with the BIG ONE

Our biggest worry: the credit markets. Specifically: “credit default swaps” or CDS. The significance of the problem was summed up by Bill Gross, a man who manages more bonds than anyone on earth and understands credit markets about as well or better than anyone. In December, Gross wrote:

“What we are witnessing is essentially the breakdown of our modern day banking system…”

Bill’s not promoting a book – at least not that we know of. And he’s not a scare-monger. People like Gross don’t make statements like this without cause. When Gross speaks, we take notes.

Another of our favorite analysts, John Mauldin, summed up the problem a couple of months ago:

Write this down. Counterparty risk in the credit default swap market will be a huge story in 2008. Losses are going to mount far higher than estimates from just a few months ago. I believe that many financial institutions will be taking large losses every quarter for the next few quarters. At the end of each quarter, investors will hope that this is finally the end. ‘Surely this time they have gotten it all out in the open.’ It won’t be, because banks can’t write down loans until the counterparty risk problem is solved.

Even the Wall Street Journal, perennial cheerleader for the U.S. economy, has joined the chorus. Just a few days ago, on January 18th, we read:

The turmoil on Wall Street is beginning to rock a foundation of the financial system: the ability of institutions to make good on their many trades with one another…. At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn’t like life insurance or homeowners’ insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.

Now, we don’t and won’t predict “The sky is falling” scenarios or “financial meltdowns.” For one thing, you can lose a lot of money counting on or betting on such predictions. But we do attempt to protect ourselves from the possibility of such scenarios – and suggest you do the same. If you’ve never analyzed your investments for exposure to credit market, stock market and other risks, start now. Procrastination is simply not an option. Even some money markets may be at risk.

Why the Stock Market May Not Be The Best Place
to Put Your Money Right Now

Think we’re exaggerating or being too “bearish”? Let’s take a quick peek at stocks. Here’s a chart of the world’s 100 largest corporations. Back on January 11th, it looked like this:

That blue line is called “support.” The chart’s telling us that if and when support is broken, we’ve got a problem. It broke last week.

So where’s the guy who was telling us we should be “buying with both hands”? Let’s face it, Wall Street loves to tout stocks. In fact, they say it’s always a good time to buy stocks. If we were supposed to buy back in July, with the Dow at 13,530, then we should be even more excited about buying stocks now that the Dow has slipped over 1,000 points, right?

If things keep trending down, no. If things start looking better, maybe. The point is, now is not the time to be loading up on stocks. Sit tight, build cash. At some point, and we can’t say exactly when, you’ll have the chance to buy stocks at good prices. But not while they’re heading down. Isn’t that just common sense?

In fact, if you could have avoided this latest downturn (as we were fortunate enough to do) wouldn’t that have made sense? Isn’t it the case with just about everything else we do in life – that is, we avoid bad things when we see them coming? Why do we think of stocks differently than everything else in the universe? Why is it always OK to buy stocks, no matter what’s going on? Doesn’t commons sense tell us that there are times when it’s best to wait, to exercise caution?

Admittedly, there are no perfect “systems” out there to avoid bad markets all the time. And short-term “timing” generally doesn’t work well for most people. But we do think there’s a lot of space between those who are always invested in stocks and those who try to jump in and out of the market all the time. That’s the space we like to be in.

So given the fact that we’re not running around shouting “The sky is falling!” or betting on a “financial meltdown” (scary sounding, isn’t it?), let’s talk a bit about

Getting Past the Gloom and Doom

Are you ready? We’re going to give you a bird’s eye view of the basic strategy we use with every one of our clients. It goes beyond just when to be in or out of the stock market. Here goes.

Most important: Diversify. But by diversify, we don’t mean own lots of stocks. Diversify by having your money in different asset groups – and not even just stocks and bonds. This isn’t a matter of “asset allocation.” It’s a matter of achieving an effective level of “asset balance.”

Here’s a brief list of asset groups: tax-free bonds (but only the highest quality municipals); taxable bonds (Treasuries, government agency, and corporate – again high quality); blue chip stocks (preferably paying reliable, even better rising, dividends); growth investments (not just stocks); real estate (your primary residence, residential and commercial investment properties); collectibles (jewelry, art, gold and other precious metals); tax shelters.

You don’t need to be rich to get this sort of strategy in place. It’s doable on a smaller scale than you might think. The simple point: spread things out. And don’t just focus on financial products.

What about the U.S and International markets? Be careful. It’s time to play defense, instead of offense. Defense might mean selling one or more stock positions. It certainly means being cautious about investing any new cash in stocks for the time being. Besides protecting us from down markets, additional cash helps to smooth volatility. Those are just two ideas.

Hedging your existing stock positions and your overall exposure to the stock market is a third. Here are the basics: Use tight stops on individual positions; Buy calls as a stock substitute; Buy protective puts; Use “inverse funds” to hedge (Be careful with these); Put on bear spreads; “Collar” your positions or even your whole portfolio, if possible.

If you’ve never tried these strategies, get professional assistance. If your advisor or broker either doesn’t know how to execute these protective strategies, or simply says he/she doesn’t believe in them (which usually means they don’t know how to execute them), don’t insist. Just find someone who is willing to help you.

Just as with the weather, the market sends out signals. We can’t always anticipate exactly what’s going to happen. But when the weather man calls for rain, you bring your umbrella, don’t you? Why not exercise the same prudence with your investments?