Trying to Shake the Subprime Hangover

On January 22, when we last emailed you with a capital markets update, the Fed cut the federal funds rate by a whopping 75 basis points to 3.5 percent in an attempt to shore-up a rapidly decelerating economy and a faltering equity market.

With S&P 500 down 10.8 percent on the year, the market couldn't seem to shake its subprime hangover. At the time, we cautioned investors to be patient, for if they were interested in reducing their equity exposure, we believed the heightened market volatility would most probably provide an opportunity to lighten at higher levels. Five weeks later, federal funds are now at 3.0 percent, policy makers continue to hammer away to find solutions to the problems in the financial markets, and the S&P has trimmed its loss on the year to 6.6 percent.    

With January payroll employment registering its first monthly decline since 2003 (see graph), the odds of a mild recession continue to increase. Along with the well-documented concerns regarding the health of the consumer, unsustainable risk tolerance in public debt markets, aggressive subprime lending and sharp dislocations in liquidity have all served to bring volatility to the capital markets with a vengeance. Fortunately, this volatility is occurring against a backdrop of global economic growth, healthy corporate balance sheets and a Federal Reserve that has become quite aggressive. In fact, with the federal funds futures now pricing an 88 percent probability of another 50 basis point cut  (to 2.5 percent) at the next meeting on March 18, short rates could easily dip below 2.0 percent before this easing cycle is complete.   

As we have previously stated, our best guess is that the first half of 2008 will remain very challenging for equities (i.e., volatile). However, we believe the economy and the equity market will trough sometime in the second half of the year. To this end, though we wouldn't be adverse to reducing aggregate portfolio risk on market rallies, we would not sell equities below the midpoint of your individual target range.
 
Please do not hesitate to contact me or your portfolio manager with any questions or comments you may have.

Best regards,

George Hosfield, CFA
Chief Investment Officer