Financial Markets Update

August 21, 2007

In our second quarter commentary, we concluded our discussion of credit market conditions by saying, “Markets, rather than the Federal Reserve, are now in the process of disciplining credit”. Subsequently, the Federal Reserve has taken two measures to restore stability to the markets and may yet employ additional measures in the weeks and months ahead.

At this time, the Federal Reserve is more concerned about the knock on effects of the fallout in the credit markets on the growth of the U.S. economy than about the inflationary setting that has constrained policy this year. Chairman Bernanke should know from his studies of the Great Depression that current financial instability requires actions rather than words with a priority of restoring stability to the markets and reducing downside risk to the economy.

Last week, the Fed as well as foreign central banks injected substantial liquidity to stabilize and hopefully ease increased stress in the global financial system. On Friday morning, the Fed took a second step to support the banks and their ability to allocate credit needs where needed. The discount rate was reduced from 6 1/4 % to 5 3/4% and borrowers were allowed 30 days to repay any emergency credit needs.  This action increased the flexibility of commercial banks to allocate credit to those most in need. 

It is becoming clear to this observer that the Fed will continue to facilitate credit needs in the foreseeable future. Part of the concerns of financial markets is the unknown quantity of credit risk still not reported. Eventually, these risks will be made known.  Until then, it is likely that the Fed is prepared to lower the discount rate further (historically the discount rate has been in line with the Federal Funds rate, which is now at 5 1/2%). Indeed, it is increasingly probable that the Fed Funds rate will be reduced to 5% in September. The point is that the Fed is now committed to protecting the economy and will remain so until stability returns to all financial markets.

At the worst, the stock market, as measured by the S & P 500 index, was down 10% intraday Thursday from its 2007 high in July. A 10% decline, which had not been seen for four years, is generally considered to be a normal market correction. A decline of more than 20% is a bear market. At this time, the fundamentals of the economy outside the housing sector are good and global economic growth remains favorable Assuming the Fed and central banks can contain financial concerns, we do not anticipate either a recession or a bear market. Nonetheless as we observed in our second quarter commentary, economic growth in the U.S. and overseas is likely to be slower than it would have been without the upheaval in the credit markets. Moreover, the upside surprises in corporate profits that have fed rising stock prices in recent years and quarters are likely to be fewer in number. Consequently, investors may have to be more nimble in stock selection.  

On balance, while risk premiums have risen a bit in the stock market, valuations remain reasonable, and the discount rate of future growth should be moderate.  Under this setting, we are inclined to be more of a buyer than a seller.  The problems of the credit and financial markets are being recognized and acted upon.  In view of this, we are constructive about putting funds to work in a diversified portfolio.