FIRST QUARTER 2008 – RETROSPECTIVE AND PROSPECTIVE

“The more unpredictable the world becomes, the more we rely on predictions.” — Steve Rivkin

“We have two classes of forecasters: Those who don’t know- and those who don’t know they don’t know.” — John Kenneth Galbraith

Recession or no recession? The pundits are full of opinions as recession fears dominate headlines. But does it matter if we are technically in a recession or not? Given the state of the markets over the last quarter, waiting around for a year or more for the official data to confirm or deny that two consecutive negative quarters of GDP happened around the first half of 2008, will prove to be an unproductive period of anguish while opportunities for farsighted, patient investors will have occurred.

It may not feel like an opportunistic time at the moment. We have seen all of the major world stock indices record negative total returns in the first quarter of 2008! The day to day gyrations in the stock, bond and currency markets have been astounding as market participants reacted in hypersensitive convulsions to economic releases and business developments.

In this quarter, many records of dubious distinction have been set:
• Oil reached levels in excess of $100.00 per barrel.
• Gold crossed the milestone of $1000.00 per ounce.
• US House prices fell by the greatest amount in over 15 years.
• Mortgage delinquencies and foreclosures have hit all time highs.
• US inflation reached its highest plateau in over 15 years.
• Automotive sales are at the lowest levels in over ten years.

But it is the global financial crisis that continues to unfold and envelop the market sentiment. In response to financial crisis, the Federal Reserve has been cutting rates at the fastest pace in 25 years, casting aside inflationary concerns for more immediate imperatives.

Sovereign Wealth Funds from China, Singapore and the Middle East have responded to the needs of major US financial institutions by injecting billions of dollars of capital into Merrill Lynch, Morgan Stanley and Citigroup. Despite protestations of solvency at the beginning of the quarter, Countrywide Financial was forced to accept a bailout and sale to Bank of America which triggered multi-million dollar payouts to Countrywide’s senior management. Societe Generale, France’s second biggest bank, simultaneously announced that it had lost close to $US 3 billion on assets relating to the sub-prime market and another $US 7 billion on illicit trades by a mid-level trader.

UBS, AIG, Swiss Re and many other international financial institutions continued to up the tally of losses stemming from the sub-prime crisis. The Canadian banks followed suit with large loss disclosures for the first fiscal quarter of 2008.

However, the most prominent catastrophe was the failure of Bear Stearns, one of America’s leading investment banks. Bear Stearns, a financial institution that withstood two world wars and the Great Depression, could not withstand the folly of the credit crisis in which it had been a major architect. JP Morgan came to the rescue with an initial offer of $US 2.00 per share for stock that had been selling for $US 170.00 one year ago and as much as $70 a week prior to the collapse! The Federal Reserve cut the interest rate by 0.25% over the weekend the deal was negotiated and by another 0.75% the following Tuesday. Although the offer was subsequently increased to $US 10.00 per share, it does not hide the fact that the Federal Reserve feared that the world came close to calamity.

As worries of the slowdown in the economy reverberated through the financial markets, a correction in the commodity markets was sharp and exacerbated by the leveraged players in the markets (hedge funds).

Despite all of this doom and gloom, there were some bright spots in the markets. Consolidation trends in the mining sector continued as Vale, a large Brazilian mining conglomerate which owns Inco, expressed interest in Xstrata, another large mining firm that purchased Falconbridge. BHP Billiton raised its bid for Rio Tinto which, if accepted, would create the largest mining company in the world. VISA, which was sold off by many banks, including Canadian banks, in preparation for a public issue successfully raised $US 18 billion. This is the largest initial public offering in history. Canadian banks have also had the foresight to shore up their balance sheets by raising capital via equity and preferred share issues. Notably, CIBC was the first “out of the gate”.

Investors are starved for places to put their money in all of this turmoil. At current interest rates, inflation adjusted yields to investors are negative. We continue to recommend high quality preferred shares as a substitute for fixed income where investment policies permit.

It is in these times of uncertainty that we seek to exploit opportunity as many shares become mispriced as other market participants focus on short term concerns at the expense of long term fundamentals. Where companies have the wherewithal to ride out tightening credit markets and produce reasonable return on equity, opportunities will present themselves in the coming months. Large Canadian financial institutions such as CIBC, Sun Life and Bank of Nova Scotia fit this criteria. If there was ever a time to stick with your investment discipline, this is it. Investors tend to make the greatest mistakes when they get whipsawed by chasing current tends.

So, are we in a recession? I don’t know for sure, but I think that it more likely that we are than not. In any case, we at Sprung & Co. are maintaining our discipline and keeping vigilant for opportunities.

FIRST QUARTER 2008 FIXED INCOME COMMENTARY

Instead of abating, the fallout from poor mortgage lending practices in the U.S. continued to spread its tentacles throughout the financial system. This has affected institutions around the globe.

In an attempt to break the credit gridlock, with banks fearful of lending not only to clients, but to each other, central banks have attempted coordinated interventions. Through various mechanisms, they provided liquid funds at low interest rates to squeezed financial market participants. Unfortunately, it is becoming amply clear that it is not so much the availability of funds, but a lack of confidence that is impeding the orderly functioning of credit markets. This lack of confidence is in the intrinsic value and potential default risk of financial instruments and by extension, in the institutions that hold them.

The near death experience of Bear Stearns caused by a lack of public confidence in their ability to meet their obligations, clearly indicated the fragility of the financial system. Without the rapid weekend intervention of the Federal Reserve, it is uncertain as to how well markets would have continued to function on the following Monday.

At the same time, while the Federal Reserve (and the Bank of Canada) proceeded to cut their interest rates, the ugly specter of inflation appeared to raise its head. Central bankers appear to be slowly getting squeezed between the twin, but opposite pressures of a slowing U.S. economy and existing credit problems which argue for lower interest rates, and rising inflationary pressures that would normally mandate higher rates. Inflation in the U.S. is running around 4% and the word “stagflation”, the combination of economic stagnation and inflation, has once again re-entered the lexicon of economic discourse.

A number of our fixed income securities that have done well in 2007 will be maturing this year. Given that shorter term yields have declined, in some cases dramatically, we expect to move mainly towards somewhat longer term Provincial or Government guaranteed issues that will allow us to increase the yield on your investments without increasing default risk.

The total return performance of the bond market for the first quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was 3.0%. Yields on a ten year Government of Canada bond decreased over the quarter to yield 3.45%.

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