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Third Quarter 2008

October 1, 2008 • Print This Article

"Short Term Markets are unknowable, Long term they're inevitable"

-Nick Murray

We are witnessing history and it is causing a great deal of uncertainty and it will take time for people to recover emotionally. At the time of writing, the US Senate and Congress have passed the $700 Billion Emergency Economic Stabilization Act. The US and Canadian equity markets, instead of trading higher in a relief rally, saw a broad market selloff to levels below anticipated. It appears likely that smaller investors, with 401K's and self directed RRSPs in mutual funds, seeing their retirement plans uncertain, panicked and sold equities at any price. The redemptions caused mutual funds and hedge funds to liquidate at any cost. As often happens during Bear Markets, emotion takes control of decision making.

The Global banks cut rates across the board 5 basis points in an effort to put some confidence back in the marketplace and attempt to stave off a global recession. Historically moves such as this have rallied the markets and brought back buyers. The response was muted by the general market malaise, but it has shown the markets that the Central banks are poised to do whatever it takes in a unified effort to shore things up and get credit flowing again.

So far all sectors have sold off and it appears that the beginning of the capitulation phase in equity markets has overwhelmed fundamentals. Stocks are beginning to "return to their rightful owners" as some leveraged hedge funds face liquidation.

Second tier companies, especially those with stretched balance sheets, have been hit the hardest. Growth companies have found it increasingly difficult to fund growth and to roll over existing debt. Oilexco, for example, was a darling of the investment community. The shares were trading at $19.00+ as the company grew by the drill bit in the North Sea. Unfortunately, funding challenges have constrained growth and made the company's future uncertain. The share price sold down to $3.94. The assets and reserves appear solid. Either the assets, or the company may well be taken over at a deep discount by a better capitalized major oil and gas company with free cash flow.

Toxic debt much of it stemming from the US sub-prime market, strained many US and European banks' capital ratios and their ability to provide loans. Banks have been hording cash and have been unwilling to lend even to each other. The freeze up in credit is reflected in record LIBOR (London Interbranch Bank Overnight Rate) spreads. The UK has recently pledged assets to shore up their banking system and this has had an impact on the share prices of their banks.

Well capitalized companies with free cash flow will ultimately be the beneficiaries of the current market sell off. Major oil companies, mining companies, financial service companies and industrial companies have an opportunity to purchase assets at a fraction of the values that would have been realized even a month ago. The big will get bigger and the strong will get stronger as it is predicted that there will be consolidation in most market segments. In the U.S. and European financial sector there appears to be emerging an almost Canadian, concentration of large, soon to be highly regulated financial institutions.

There is little doubt that the OCED countries are either in recession or on the verge of recession. Inflation fears are easing as commodity prices fall due to hedge fund liquidations and lower demand. Central banks appear to have room to lower interest rates even further if necessary. However, until some level of confidence returns, it is difficult to see how a further decline in central bank rates will stabilize the markets.

The process and timing of the US sub-prime "bailout" have yet to be determined. Potentially the fund could recapitalize the banking system by $400-$500 billion as frozen mortgage debt will be purchased at fair value (closer to 75 cents on the dollar). Assuming the banks use the recapitalized balance sheets to provide credit, it could result in $4-5 trillion in economic stimulus. Most of the mortgages in the toxic debt instruments are current and are paying interest. Mortgages that default still have the residual value of the underlying property behind them. As mortgages in the debt packages come due, the Fed should be able to recoup most if not all of the funds provided.It is unknown what debt will be taken up and what institutions will be involved but it is hoped, that once the process is made clear, there will be some stability is returning to financial markets and the global credit freeze will begin to thaw.

Moving forward, we anticipate there will be a back to basics approach to investing. Companies with strong balance sheets and stable cash flows that provide high dividend yields should lead the eventual market recovery. Canadian banks, life insurance companies and utilities should perform relatively well.

Strategy

Despite the incredible volatility, it is important to remember that historically Bear Markets decline in the range of 30-35% and that is where we find ourselves. The good news is that once the Bear sees itself through the volatility and a Bull begins the increase is in the range of 180-190%. This is why the historical market trend is up. Sir John Templeton, one of the greatest investors of the 20th century stated, "The four most costly words in the English Language are, this time it's different." Since WWII there have been approximately 13 bear markets, each lasting anywhere from 12-16 months (one every 5 years or so). The last quarter of the century and the beginning of this century brought about some incredible challenges that caused Bear markets. In the 1970's we faced rampant inflation, oil shortages and recession; in the 1980's we faced the challenge of Black Monday; the 1990's brought the Savings and Loan Crisis, the new millennium brought the bursting of the technology bubble and 911. Each cause has been different and seemed to be catastrophic. What Sir John meant was that althought the causes were different, the recovery from all these crisis was inevitable. We all have frayed nerves and the anxiety will likely continue for the short term, but longer term history has shown that we will make it through this. Attached is a chart which shows the volatility we have faced historically.

chart The equity investments in the accounts are primarily common shares of highly capitalized companies, that have the balance sheet strength to weather the current economic storm, benefit from the potential takeover of weaker competitors and should emerge stronger and more dominant when economies recover. Among equities, there is an overexposure in Canadian banks and utilities and relative underexposure to highly volatile commodity plays. The dividends should help insulate the portfolio on the downside and your income will remain relatively stable. We believe that there will be a flight to quality and these companies will help lead the indexes higher when the eventual recovery occurs.

As always, we are here to answer any questions and concerns that you have. Please don't hesitate to call.

Ken, Will & John

Filed under: Quarterly Reports

The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of Mackie Research Capital Corporation ("MRCC"). The information and opinions contained herein have been compiled and derived from sources believed to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. Neither the author nor MRCC accepts liability whatsoever for any loss arising from any use of this report or its contents. Information may be available to MRCC which is not reflected herein. This report is not to be construed as an offer to sell or a solicitation for an offer to buy any securities. Member-Canadian Investor Protection Fund / member-fonds canadien de protection des ├ępargnants.

Mackie Research Capital Corporation (MRCC) makes no representations whatsoever about any other website which you may access through this one. When you access a non-MRCC website please understand that it is independent from MRCC and that MRCC has no control over the content on that website. The content, accuracy, opinions expressed, and other links provided by these resources are not investigated, verified, monitored, or endorsed by MRCC.

 

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