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Shaken by continued credit problems in the mortgage markets and the
forced sale of Bear Stearns, equity markets dropped in the first quarter of
2008, causing concern for economists, investors, corporate managers, and
consumers alike. The S&P 500 Index of large stocks was down 9.44%,
extending its losing streak to five consecutive months, the longest since
1990. A flight-to-quality resulted in strong returns for government bonds
while “junk” bonds produced negative returns.
Credit & Liquidity
A market liquidity problem has been created from the lax underwriting
standards in subprime mortgages, primarily in California, Florida, and
Arizona. This liquidity problem has been further exacerbated with the
obscuration of values through the securitization of these loans into
collateralized debt obligations (CDOs) that own small slices of thousands of
different loans, whereby buyers and sellers are unable to assess the value of
these mortgage backed securities.
Bear Stearns became a casualty of this market illiquidity as CDO assets
lacked ready markets and short-term funding evaporated. Bear Stearns'
Chief Executive Officer, Alan Schwartz, concisely described the event as a
“run on the bank.” Lack of liquidity has now spread from the mortgage
backed securities market to the commercial and investment banking
markets where major firms are scrambling to arrange capital infusions. This
is making credit more expensive to corporations and consumers alike and
is dampening national economic growth. The effects of the credit crunch on
employment can be seen in the chart below (See chart: Jobs).
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Source: Labor Department
Data is assumed to be reliable |
Regulatory Response
The Federal Reserve historically reacts to credit and economic stress by
lowering their target Fed Funds interest rate for the banking
industry. The current crisis is no exception as the Fed has taken decisive
action, as illustrated in the chart, Fed Funds.
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Source: Bloomberg
Data is assumed to be reliable. |
But this added liquidity to bank balance sheets is not having the same
salutary impact on the economy as it has in the past. The reason for this is
that, over time, financing for consumers and companies alike has moved
from commercial-bank balance sheets to the investment banks and the
capital markets where the Federal Reserve has not had a regulatory
presence. In fact, when the U.S. Treasury lent $30 billion to J.P. Morgan for
the acquisition of Bear Stearns and made its “Discount Window” available to
investment banks, this marked the regulators' first act in recognition of the
fact that the financing of consumer and corporate America has moved
beyond the reach of our current “bank centric” regulatory regime. We view
the extended regulatory reach of the Federal Reserve beyond commercial
banks into investment banks as inevitable and correct, but largely still ahead
of us. Until then, by engineering the sale of Bear Stearns, the Fed has
become the lender of last resort to the investment banking industry to avoid
future “runs on the bank,” as happened with Bear Stearns. We believe this
stance will go a long way in calming markets.
The Economy, The U.S. Dollar, & Inflation
Heightened credit risk, a slowing economy, and lower interest rates have
combined to drive the U.S. dollar to all-time lows. “Stagflation,” a term
originated in the 1970s as inflation soared in a period of job losses, has
re-emerged. The most evident example is the failure of three airlines, Aloha
Airlines, ATA Airlines of Indianapolis, and Skybus, due to the
combined pressures of declining passenger counts and mounting
jet-fuel costs (think of fuel prices as the inverse of U.S.-dollar strength).
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Source: Bloomberg
Data is assumed to be reliable. |
The Stock and Bond Markets
These credit and economic conditions present investors with an
environment of heightened risk. However, due to investor flight out of stocks
and bonds, the markets are offering investors greater returns for taking on
that risk compared to risk-free Treasury securities. In this environment, we
urge investors to not flee the bond or stock markets. Currently, investors
receive historic incremental yield from municipal bonds over Treasurys and
from the earnings yield of stocks over Treasurys, as illustrated in the charts,
Municipal Yields as Percent of Treasurys and S&P 500 Earnings
Yield/10-Year Treasury Bond Yield.
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Source: Bloomberg
Past performance is no guarantee of future results. |
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Source: Factset Research Systems
Past performance is no guarantee of future results. |
We also believe the current environment of credit and economic stress
should favor securities with quality business, profitability, and balance-sheet
characteristics. Kayne Anderson Rudnick's “Quality at a Reasonable Price”
investment philosophy is well suited for this environment.
Portfolio Asset Allocation
Please review your asset allocation with your Kayne Anderson Rudnick
adviser and consult other financial advisers on which you rely. We
recommend that you continue to have a conservative asset allocation that
maintains a balance between stocks, bonds, and alternative investments that
fits your unique income requirements, risk tolerance, and time horizon.
For those of you with interest in a more detailed analysis of the current
credit dislocations, we invite you to ask your Kayne Anderson Rudnick
adviser for a copy of our white paper titled Credit Crunch.
Firm Promotions
Kayne Anderson Rudnick has a long history of grooming and promoting
talent from within. Following in that tradition, I am proud to announce the
promotion of two of our research analysts, Todd Beiley and Julie Kutasov to
portfolio managers and senior research analysts. In addition to Sandi
Gleason and myself, Mr. Beiley will work as a co-portfolio manager on the
Small Cap Sustainable Growth Portfolio, and Ms. Kutasov will work as a co-manager
on the Small Cap Quality Value Portfolio. Further, Craig Stone and
Jon Christensen will be taking on additional portfolio management duties
outside of their responsibilities on the Mid Cap Core Portfolio. Mr. Stone will
join Ms. Gleason and myself as a portfolio manager on the Small-Mid Cap
Core Portfolio and Mr. Christensen will join us as a portfolio manager on the
Small Cap Core Portfolio. We also hired two new research analysts which
allows our senior equity analysts to take on these additional responsibilities.
The individuals being promoted or assuming additional responsibilities have
been with the firm for a number of years and have contributed meaningfully
to the portfolios' performance. They are all ready for additional
responsibilities and the firm is happy to provide them the opportunity.
We thank you for your continued confidence and we invite you to contact us
with any questions or comments.
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