The majority of the economic trends are negative. Lower housing values have restricted the supply of credit. Less credit in turn has caused the consumer to reduce spending and slow the economy. Unemployment rates have increased further depressing growth during the first few months of the year. Finally, high energy and food prices are keeping inflation levels higher than we have seen in a generation.

We do not have any unique insights into how deep or long this volatility will persist. Equities will not recover until the banking system becomes cleared of its bad debt and is able to lend freely. Ironically, UBS’s $19 billion write-down was one of the positive catalysts that sparked the market to rebound strongly on April 1^st. The government has also acted very aggressively to address these problems as we will discuss later in our commentary.

Our strategy in client accounts has been to try to preserve capital by avoiding the highly leveraged firms that are bearing the brunt of the market correction. We are also opportunistically buying positions that appear to be good values. On the equity side, we have added companies such as Noble Corporation and Danaher that are trading near historical lows relative to their earnings and cash flow multiples. With the fixed-income portion of portfolios we have reduced our allocation to Treasuries since the panic has pushed up prices to unsustainable levels. The two-year Treasury Note is only yielding 1.8% and the ten-year Note is yielding about 3.5%. These yields are incredibly low since inflation is roughly 4% year over year.

We continue to believe that much of the bad news is already factored into the current depressed prices for common stocks. We do not recommend reducing equity allocations now since stocks are more attractive than bonds and commodities based on their respective long-term potential.

The classic “run on a bank” (as depicted in the movie It’s a Wonderful Life starring Jimmy Stewart) occurs when a bank’s depositors rush to withdraw all of their funds fearing the institution is in financial trouble. Northern Rock in England experienced this recently and the government nationalized the bank to maintain solvency. In the case of Bear Stearns, many of Bear’s multi-billion dollar hedge fund clients that used the firm as a prime broker withdrew their accounts and began conducting business with other brokers. Other banks and brokerages also refused to trade with Bear fearing that Bear would not be able to stand behind the trade.

The combination of lost trading revenues and failure of other firms to buy their short-term securities caused all of Bear’s liquidity to vanish. On March 10^th, Bear Stearns had $18 billion in cash and equivalents. Three days later, on March 13^th, the brokerage only had $2 billion in cash on its balance sheet.

The Federal Reserve was monitoring the situation and did not want Bear Stearns’ imminent failure to cause a financial panic which would have spread to other brokerage firms such as Lehman Brothers. Therefore, the Federal Reserve engineered JP Morgan’s acquisition of Bear Stearns.

JP Morgan agreed to stand behind all of Bear’s existing obligations. In return, the Federal Reserve provided $30 billion in financing by agreeing to swap $30 billion in US Treasuries for $30 billion in low-quality mortgage-backed securities that were held on Bear’s ledgers. JP Morgan is only assuming $1 billion in liabilities on the $30 billion package while the government (and the taxpayers) is assuming the remaining $29 billion in risk.

Treasury Secretary Paulson recommended that a future regulatory framework consist of three agencies with broad powers according to an “objectives-based approach.” These agencies would include a Market Stability Regulator, Prudential Regulator and Business Conduct Regulator.

The Market Stability Regulator would expand the Federal Reserve’s function to insure the smooth functioning of the overall financial system and allow it to oversee all other regulators within the system. The Prudential Regulator would oversee all firms with explicit government guarantees such as Federal Deposit Insured banks to make sure their capital is adequate to cover their liabilities. Finally, the Business Conduct Regulator would include the functions assumed by the Securities and Exchange Commission and the Commodity Futures Trade Commission. This entity would regulate business processes and ensure adequate disclosure within the system.

Paulson’s plan goes further in that it provides for streamlined regulation of state-chartered banks. It also allows for federal regulation of insurance companies which are now regulated by each of the 50 states. Responding to the mortgage crisis, the Federal Reserve also recommends an agency to oversee mortgage origination.

Even though no regulatory framework will prevent future financial problems, this reorganization makes sense from an oversight and efficiency perspective. To handle the current problems, the government and Federal Reserve have basically been stretching their mandates to prevent panic in the markets in ways far beyond their charters. For example, the Federal Reserve has never put $29 billion of its capital at risk to bail out a broker-dealer as it did with Bear Stearns.

Minsky analyzed what causes economic booms and busts. His theory centers around the idea that stability itself produces speculative bubbles as market participants take greater and greater risks since the assumption is that stable conditions will persist. These risks then become insupportable and cause dramatic unwinding.

Minsky describes different types of “units” that contribute to stability or instability. The first unit is a hedge unit that aids stability since it allows market participants to reduce their risk overall. McCulley labels conventional 30-year mortgages as hedge units since they allow home buyers to reduce their risk to house prices fluctuations by paying off interest and principal over extended periods of time.

Hedge Units are then succeeded by “Speculative Units” where investors borrow funds to invest, but the investment cash returns are only sufficient to pay interest on the borrowings, but not principal. An interest-only mortgage loan is an example of a speculative unit since borrowers are only paying interest and not principal. The appearance of speculative units is destabilizing.

The final unit in Minsky’s framework is a “Ponzi Unit.” With Ponzi units, the investor buys an asset, but is unable to pay back principal or interest without the appreciation of the underlying asset. Applied to the mortgage market, a Ponzi Unit would be mortgage loan where payments do not cover interest or principal and then require a balloon payment to settle the accrued interest debt. These types of loans are very destabilizing since the only way the loans can be paid off is if the underlying asset (here the residence) appreciates and somebody buys it at a higher price.

During 2005 through mid-2007, most lending in the housing market was of the destabilizing variety. The decrease in housing prices led to the collapse we have seen in the credit markets.

Wall Street’s compensation structure for firms and individuals has contributed greatly to instability in our financial markets. Wall Street’s banks and brokerages take anything that produces cash flows such as a company or a mortgage and packages it into a security which it sells. The firms that do this get paid on a transactional basis for the sale of that security and the individual brokers and bankers themselves get paid commissions for this sales activity.

When consumers don’t spend, businesses stop selling products, resulting in lay-offs and further slowing consumer spending. A vicious downward cycle can result. This cycle motivated the government’s $168 billion stimulus package put through last month.

A simple mathematical formula, based on the limit of sequences, can be used to explain why consumer spending is so important to our economy, and why the government wants you to spend your rebate checks.

For every $1 I earn, I hypothetically save 20% (or $0.20) and spend 80% (or $0.80). The $0.80 I spend is part of our consumer spending total. But the $0.80 also accounts for earnings for someone else. And let’s assume they also save 20% ($0.16) and spend 80% ($0.64). This $0.64 is also earnings for a third person, who then spends and saves at the same ratio.

Before you know it, we have a sequence of numbers: $0.80, $0.64, $0.51, $0.41… and so on. The aggregate sum of this infinite sequence approaches $4. In fact, any infinite sequence of numbers summed in a similar fashion where the “spend” percent is less than 100% will approach a finite number. The generic formula for finding the sum is: r/(1-r) where r is your ratio (80% in this case).

If we assume that all consumers spend less than 100% of their earnings, which ideally is the case, we can see how consumer spending becomes such a big portion of the economy. Every dollar spent feeds many more dollars into the economy.

This is part of the power behind the $168 billion stimulus package—in the example above the $168 billion could feed $672 billion ($168 billion times 4) into the economy.

We believe our skill set is suited to this middle course. Our analysis of the markets through time and our investment discipline focus on certain financial characteristics. We add value through concentrating our clients’ investment in those companies that sell for a discount to what they are theoretically worth given an expected growth rate. However, we rarely believe that we could run an actual company better than its existing management. We limit our involvement to purchase and sale decisions and voting proxies regarding issues that come before shareholders for a vote.

Quite a few managers often make the leap from our style of investment to a much more activist role. They convince themselves that they have chosen investments so well that they therefore have an ability to run their investments better than the existing managements. Unfortunately, these forays are often unsuccessful because the qualities that lead to superior investment management performance are different from the qualities that lead to operating success in a tangible business.

Edward Lampert’s purchase of a Sears and Kmart is a classic example of the pitfalls that are possible when investment managers get their hands dirty running businesses. Sears and Kmart were and are retailers struggling to compete against Wal-Mart, Costco and Target. However, Sears owned valuable real estate and had a few successful brands such as Craftsman Tools, Kenmore Appliances and Lands’ End clothing. After purchasing Sears, the stock soared to $190 per share in early 2007 from the mid $20s in 2003 as Lampert cut costs and began monetizing assets through real estate sales. The acquisition would have been brilliant if he had stopped there and completely restructured the companies and liquidated all of their assets.

Instead, Lampert continued to operate Sears and Kmart and results faltered. Poor locations and previous cost cutting have hurt sales as same store sales declined 4-5% when they reported 3^rd Quarter earnings in November. Net Income plunged to $0.01 per share during that quarter from $1.27 per share during the 3^rd Quarter of 2006. The company also warned last month that its 4^th Quarter earnings for the period ending February 2^nd will be about $3.00 per share which is significantly lower than the $4.40 predicted by analysts.

Running a successful retail business takes an astounding amount of execution to offer compelling merchandise, price the wares competitively, invest the right amount in store upgrades and finally motivate employees. These skills do not normally match the temperament or training of the vast majority of investment managers even if they are brilliant portfolio managers such as Edward Lampert.

In the financial and popular press, the US economy is frequently described as one “battered by a housing crisis.” A Google News search returned over 28,000 hits for the term “housing crisis.” The price for residential real estate across the country is decreasing and the inventory for unsold homes is increasing (currently at over 10 months), but there is no generalized crisis. Median housing prices have declined by about 3.3% from last year’s peak levels to $210,000 for all types of housing according to figures released by the National Association of Realtors. The year-over-year declines experienced this year represent the first decreases in almost 20 years!

Housing prices reached speculative levels which caused over-investment and the markets are now dealing with the aftermath. Wall Street investment banks and giant money-center banks such as Citi earned tremendous fees securitizing mortgages and then selling those debts in very complicated bond instruments. These same institutions are now stuck with these bonds which they are unable to value. So far the banks have taken between $80-100 billion in write-offs with every additional charge dragging the stock markets down further.

The Federal Reserve and the government have also been relatively ineffectual in addressing these problems. The Federal Reserve reduced its target rate from 5.25% to 4.25% over the past four months. However, lending rates as indicated by LIBOR have only decreased to 4.6% from 5.1% during the same period. The Federal Reserve’s policy to increase liquidity into the system is being counteracted by the banks’ fear that their counterparties might not be able to repay their debts. Therefore, the banks themselves continue to charge each other higher interest rates which reduces lending and retards economic activity.

One reason for these problems in the credit markets stems from the failure of the bankers’ models to work as expected. For example, every individual borrower has a credit score based on his or her historical ability to pay-off his debts. Given the primacy of home loans, it was widely assumed that individuals with good credit scores would pay their mortgages come good times or misfortune. However, these models did not take into consideration the fact that many homes purchased during the late stages of the bubble were bought for investment purposes and/or with almost no capital down. Borrowers who are often up-to-date on their credit card payments are walking away from their mortgages since they never put any money down. Since these borrowers had negative equity in their homes, their decisions to abandon these properties are economically rational.

Tighter credit has lead to slower economic activity. The Institute for Supply Management’s manufacturing index dropped to 47.7 in December which is the weakest number in 4.5 years and indicates a contracting manufacturing base. December’s unemployment rate also increased to 5% from 4.7% last month.

Even though these economic numbers are concerning, we still believe that creeping inflation is the greater threat to equity values. The most recent government numbers indicate that prices for consumer goods are 4.3% higher than they were last year. While the core figure excluding food and energy is only 2.3%, we believe the higher number is more accurate and that commodity prices are not poised to fall anytime soon. Energy prices increased 21% over last year and food prices appreciated by 4.8%. Similarly, inflation in the Euro Zone increased at a rate of 3.1% during November according to EuroStat. Finally, inflation in China is increasing at an even faster rate. During November prices surged at an annual rate of 6.9% and food prices increased at rate of over 18%. Energy prices increased a modest 5.5% since China subsidizes fuel costs to its population and industry.

Given our inflation concerns, we will continue to tilt the portfolios under our management to preserve capital in a rising price environment. Inflation is corrosive and undermines almost all asset classes except for cash and certain commodities which retain their value.

We believe that most of the bad news is priced in to stocks and stocks are still more attractive long term than fixed-income securities. Housing prices will stabilize at some point and real estate will become less of a drag on the overall economy. The credit markets will also normalize after the banks take appropriate write-downs. Even the simple passage of time gradually lessens problems in the bond markets since more and more loans are maturing daily and being replaced with simpler more transparent bonds. Volatility will most likely persist unabated until the markets receive positive signals regarding economic growth or receding inflation.

The cell phone business model is currently based on proprietary standards that are closed and limit innovation and consumer choice. The infrastructure/chip companies such as Qualcomm and Texas Instruments develop systems to transmit wireless voice and data and then sell chips to the handset makers. These handset makers, such as Motorola and Samsung, then design and manufacture phones which take advantage of the features embedded within the chips on which the phones are based. However, the carriers (with AT&T and Verizon dominating the US market) subsidize the handset cost and restrict the features available to the end-users. The carriers want all services to run through their networks. For example, such items as ring tones remain stubbornly expensive since the carriers require individuals to download those tones through their services.

Apple began to circumvent this process through its iPhone which was launched earlier last year. AT&T exclusively provides cellular services to the iPhone; however, services such as Apple’s music service, iTunes, are delivered directly to the consumer without AT&T’s interference.

Apple envisions a similar role for the iPhone as the Mac personal computer. Apple designs intuitive software and aesthetically pleasing hardware. The software is typically bundled into the hardware and Apple sells the hardware at a premium price. Apple’s environment is proprietary and closed; Apple writes the software itself and designs the hardware and does not license either to the broader technology community.

More than twenty years ago, Apple competed for the desktop market against Microsoft and the numerous PC manufacturers. Initially, the Macintosh held its own after establishing a stronghold in the educational market since its computers were easier to use. However, Microsoft PCs equaled Macs on the software side and PC makers such as Dell and Hewlett Packard were able to sell far more powerful PCs for an equivalent price point. Apple never licensed its software to various manufacturers or software developers and its market share was driven into the single digits.

On the way home there is often a passenger who does not know the drill. And often does not have a ticket. The price of a ticket depends on where it’s purchased; a ticket from Katonah to New York is $8.75 at the station and $14.75 on board. Upon hearing about the 60% mark-up the passenger often questions the mark-up and sometimes gives excuses for not having a ticket. The conductor ignores the complaints and issues the ticket.

When the Metro-North first jacked up the on-board fairs I also questioned the rates, feeling the punishment didn’t fit the crime. After riding the train for many years I understand the mark-up is not punishment, but paying for the additional labor required to process the ticket.

Tickets purchased at the station are done at an ATM like machine and once on the train it takes less the 10 seconds for the conductor to take the ticket and complete the transaction. When you buy on-board, the transaction includes the conductor receiving cash, creating the ticket, giving the passenger a receipt, and making change. The process takes a couple of minutes, and even more when the passenger complains.

The time difference is important because the conductor has to check hundreds of tickets over several cars before the train stops and passengers can get off without paying. When it takes less time to check the tickets, one conductor can check more tickets and ultimately fewer conductors are needed on each train. This can save the Metro-North significant salary as train conductor salaries can exceed $100,000. Thirty three trains run from New York to Katonah each day so knock out a dozen conductors and the savings reach into the millions. Metro-North has further streamlined the process as conductors only sell one-way instead of round-trip tickets, which can take significant time to process as rates vary depending on the time of day.

Allen comes across as a likeable guy who just wants the best for his teams and the cities in which they play while trying to learn from his mistakes. For me, the most interesting part of the article referred to his mistakes as an investor. It turns out Allen, while extremely wealthy, should be much wealthier.

According to Forbes, Allen is worth about $18 billion, making him the 5^th wealthiest American. Allen originally held a 28% stake in MSFT before gradually selling shares in order to invest in other ventures. Today MSFT is worth more than $310 billion, meaning a 28% share would be worth about $85 billion. In theory, if Allen had done nothing with his shares he would be worth about $67 billion more.

Some of Allen’s money went to charity and some was spent on extravagant items like Jimi Hendrix memorabilia and a giant yacht with two helicopters, a pool and a submarine; this explains some of his reduced wealth. However, the majority of the loss is from ventures on which I’m almost positive Allen was trying to make money.

He’s had a few winning investments. He indirectly owns more than 10% in Plains All American Pipeline LP, a $6 billion oil and gas pipeline company that has performed exceptionally well. But he’s had some big losers, such as Charter Communications of which he owns 7%, which IPO’d at $24 and now trades around $1.25. The first company he founded after leaving MSFT, Asymetrix, went nowhere.

My point is not to bash Allen—his wealth is beyond imagination and he co-founded one of the most important companies of the information age. My point is investing in winning technologies is very difficult, and doing it once no matter how successful, does not make you infallible, especially when you extend beyond what originally made you successful.

We take this into consideration in our investments. Just because a company has come up with one product does not mean it can recreate the magic. K-Swiss Inc., makers of the shoes, is a good example. The company can’t seem to expand beyond its original shoe. We are also weary of management teams which invest beyond their expertise. Google comes to mind, with their recent investment in solar power. Some wish they would just stick to what made them so successful in the first place—organizing the world’s information.