A fundamental change to the financial system and the economy took hold in September. First, the bond/credit markets went into cardiac arrest during the month, intensifying mid-month, with limited trading going on, and a near run on money market funds. Bond prices on everything but Treasury securities suffered unusually sizable declines–corporate bonds and municipals were particularly poor performers. The stock market began to realize the impact of the deterioration in the already stressed credit markets and moved sharply lower. Days of wild swings followed as a rescue package was proposed, then stunningly defeated by the House, then resurrected as conditions continued to deteriorate. Even when finally passed, the markets were not impressed.

For awhile now, a capital infusion into the banking system has been needed so that financial institutions can take their losses (there are many more loan losses to come) and recapitalize. It is important that it be a system-wide solution. Action is needed both to address the underlying fundamental problem and to help bring confidence back to the market. A continuation of the extreme dysfunction in the credit markets will further damage the economy, with potentially long-lasting effects, including more financial institution failures and a deep economic downturn. In our view, coordinated action from governments around the globe is the best chance to begin to bring confidence back to the credit markets. Risks would still remain, but those risks would be significantly reduced. It is the credit market not the stock market that is the cornerstone of our economy.

Usually pessimism creates good buying opportunities because psychology comes into play and fear drives prices lower than what the long-term fundamentals suggest is reasonable. Longer term, there are some asset classes that are beginning to intrigue us. Driven by the sell-off in everything but Treasury securities, high-quality mortgage-backed security yields and corporate bond yields now suggest returns in the 6-10% range over the next few years once the credit markets return to normal. These are attractive returns–especially for tax-exempt accounts. High-yield bonds are looking more interesting, but default rates are likely to be very high for some time so investment there is still premature. But that could change quickly as this market is also getting hit hard.

Our current large position in U.S. Treasury Bills is transitional. Once conditions truly improve, we expect to deploy assets quickly into areas of the market offering higher yields and potential appreciation. We see many opportunities but, as of now, it is too early to move. For now, we are holding more in safe U.S. Treasury money market funds than ever before and a drastically reduced exposure to equities.

We would like to leave you with some thoughts that might be helpful in coping with this very challenging time. It’s important to remember that the more dysfunctional the markets get, the more opportunities we’ll have to add value with tactical moves. We are optimistic that the returns we will capture with our disciplined, valuation-driven approach could be quite good, as they were after the last bear market. Finally, know that our only incentive is to try to do what is in your best interest. Your needs, trust and confidence are most important to us and are the primary driver of what we do.