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Third Quarter 2008

Clearly the end of the third quarter of 2008 has been turbulent in the global financial sector, and the market has reacted accordingly. The following are several observations concerning the economic environment beyond the government bailout package recently passed by the U.S. Congress:

1) The U.S. bailout plan, while crucial for restoring confidence in U.S. and global financial markets, is no economic panacea.

2) The U.S. economy is clearly heading into a recession; unemployment has risen above 6% and will rise further. The last pillar to fall has been industry; the ISM manufacturing survey fell to 43.5% in September, indicating that industrial output is shrinking.

3) Investors’ focus until recently has been on the bailout plan itself; however, the Federal Reserve has been equally involved with its own bailout plan by pumping hundreds of billions of dollars into the global financial system. The U.S. has finally succumbed to printing money as a last resort. The crucial issue now is to what extent money and credit markets unfreeze after these two bailout plans. The more money and credit markets return to something closer to normal, the less the eventual transmission effect into the real economy (companies and consumers).

Let us assume that the extreme risk aversion seen currently in the financial markets calms. In this case, corporate credit spreads and equities should benefit from a reduction in their cost of capital. However, this potential higher valuation of corporate bonds and equities has to be set against likely further downward earnings revisions for 2009. Clearly, no one expects a quick return to the salad days prior to mid-2007; the effects of the credit crisis will still take some time to work through during which time U.S. and global economic growth will remain very subdued.

Against a background of likely continued volatility, we would still privilege cash rich sectors with good visibility of earnings into 2009 and beyond, solid balance sheets with no short term borrowing concerns, high free cash flow and operating margins with low financial leverage, progressive dividend policies, high return on invested capital, and relatively depressed valuations. Those sectors might include telecom operators, healthcare, consumer staples, software, and food and beverages.

For the first three quarters of 2008, the Dow declined 20.1%, the S&P 500 lost 22.4%, and the Nasdaq was down 41.8%.
Grant Rogers Elizabeth Allen

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