FOURTH QUARTER 2008 – RETROSPECTIVE AND PROSPECTIVE

AN EXCRUTIATING YEAR!

“Of all the passions, fear weakens judgment most.” — Cardinal De Retz

“People who always try to play the market to its lowest point, always miss it.” — Earl Peattie

2008 has finally ended! As the year came to a close, North American markets came within a fraction of setting a record. Unfortunately, not the kind of record that one would celebrate. During the final days of the year, investors were concerned that the Toronto Stock Exchange would finish with the worst year on record. However, a modest rally in the last few days trading precluded the achievement of this dubious milestone:


1931 2008

S&P/TSX -37.2% -33.0%

S&P 500 -47.1% -37.0%

Dow Jones -52.3% -33.8%

In our last Quarterly Review we stated: “Make no mistake…This is serious”.

Little did we anticipate that the markets would literally jump off a cliff in the fourth quarter. Global government bailouts amounting to trillions of dollars have not proved to be sufficient to quell investor fears. As politicians fall all over themselves to scapegoat business as the culprit for the world’s woes, they are seizing the opportunity to nationalize businesses with massive amounts of your tax dollars. Scant attention has been paid to the role of government policies (e.g. affordable housing, easy credit) and government agencies (e.g. Fannie Mae, Freddie Mac) that fueled and encouraged some of the excesses that have occurred. Surely, some of the markets reaction is reflective of peoples’ concerns that politicians may not be the most qualified to allocate such massive amounts of capital. The long term effects of this immense intervention on the financial integrity of the countries involved is garnering scant attention.

In the UK, $35 billion of public money was injected into Royal Bank of Scotland and a further $30 billion was placed in HBOS and LloydsTSB in exchange for substantial equity stakes. The Americans soon followed by providing $250 billion to shore up the capital bases of nine banks including Bank of America, JPMorgan Chase, Citigroup, Goldman Sachs and Morgan Stanley in exchange for preferred shares. The fallout of allowing Lehman Brothers to fail was worse than anticipated, necessitating a large part of these capital injections. This is a redirection of the $700 billion Troubled Asset Relief Program (TARP). Instead of buying up toxic assets, the new plan is to provide these capital injections. As the price of oil declined, even the United Arab Emirates put $19 billion into their banks.

As business conditions continued to deteriorate, the US regulators had to revisit the previous bailout of AIG, one of the world’s largest insurance companies, and renegotiate the package. Investors woke up to the fact that insurance products are designed on assumptions about investment returns and punished those shares. Canadian insurers were not immune as the shares of Manulife, Sunlife, Great West Life and Industrial Alliance were severely hit. Manulife raised additional capital in order to reassure investors that the company was adequately capitalized as did several major banks. It is unfortunate that management felt this was necessary at such depressed prices as it dilutes the position of current shareholders.

Wachovia, a major provider of financial services in the US announced losses of $24 billion and a merger was arranged with Wells Fargo.

Poor market and credit conditions led to the cancellation of many merger and acquisition transactions around the globe making 2008 one of the worst years ever for investment banking. Google backed out of a partnership with Yahoo, leading ultimately to the resignation of one of Yahoo’s founders. BHP, one of the largest mining companies in the world, dropped its bid for Rio Tinto, another large mining concern. Xstrata, also in the mining business, pulled an offer for another mining company, Lonmin. In the technology arena, Samsung decided not to purchase a memory card producer, SanDisk. Perhaps the biggest shock to Canadian investors was the failure of the takeover transaction of Bell Canada due to a technical insolvency report by the auditing firm, KPMG.

House prices in the US continue to decline as the fallout from sub-prime mortgages is still present. As of October, house prices had fallen 18% from one year ago according to the Case-Schiller Index.

Commodities, which were very much in demand the first half of 2008, recorded their worst year ever as their prices fell on average by over 42% as a result of the perception of economic growth slowing globally. Shipping prices collapsed as a result of the weakening demand for transporting goods and commodities around the world. Oil closed the year at US$44.60 after hitting a high on July 11 over US$147.00! The effect of the second half collapse of commodity prices was devastating to the share prices of corresponding companies. The one exception was gold which closed the year at US$883.40 having opened near US$900.00 at the beginning of the year and hitting a high price of US$1045.00 in March. Several gold company shares managed to post positive returns on the year.

The Canadian dollar had one of the worst years in history (as did the British pound) starting the year near par and finishing at US$0.818. This decline served to offset some of the negative returns on foreign investments in Canadian portfolios. Many pension funds and endowment plans posted losses of 30% or more that will severely hamper their solvency under current accounting rules and, in some cases, their ability to meet current obligations.

Politicians had a field day using the current crisis as an opportunity to grab power and spend lavishly. A rally following the election of Barrick Obama in the US was short lived as euphoria gave way to sober second thoughts about the current economic problems. Canadian politicians wasted little time in an embarrassing display of grandstanding on the issues resulting in a political crisis to demonstrate that they were responding to the crisis.

As the year came to a close, the focus in North America has been on the severe problems in the automotive industry. It would be catastrophic to see the industry collapse, so an effective means must be found to downsize the industry and realign its cost structure to be competitive in what is now a truly global environment.

Unfortunately, just as investor confidence was already deeply shaken, the hi-jinx of Bernard Madoff have come to light. It appears that Madoff masterminded a Ponzi scheme that has lost some US$50 billion. This criminal abuse of clients’ trust will further undermine confidence and focus the attention of regulators.

In all of this calamity, there are some promising trends. We suspect that although the economy may continue to deteriorate through the first part of 2009, the stock market should begin to discount better conditions by year end. Great returns may not be in prospect for the year, but at least returns will be much improved. In the interim, the yields available on equities are extremely attractive relative to negligible yields in the bond market.

The Canadian financial institutions continue to be among the best capitalized and the most able to survive the current crisis in the world. Dividends of the large financial concerns should be safe and the longer term capital returns should be very attractive.

Commodities tend to “over shoot” on the upside and the downside. We suspect that they are currently overly depressed, particularly in the energy sector.

The Canadian economy has entered into this crisis in much better shape than the US. Although the structural changes in industry will be painful, Canada should maintain a better balance sheet. As the US becomes a greater debtor to the world and prints money to meet alleviate the current crisis, the value of the US dollar will inevitably weaken.

All of theses factors point to a better environment for long term Canadian investors. Let us not fall prey to fear.

We wish every one a better year ahead.

FOURTH QUARTER 2008 FIXED INCOME COMMENTARY

The fourth quarter saw a modest improvement in the inter bank lending environment as banks started to increase their lending to one another, a significant improvement from the near gridlock conditions of earlier in the year. Massive bailouts, capital infusions and the clear indication that governments were loath to see a major bank default, tended to instill a degree of confidence in the banking industry.

Nevertheless, this improvement did not translate into increased corporate and consumer lending. Banks intent on repairing their balance sheets continued to avail themselves of both government funding and the open market to raise capital. In turn, they remained tight fisted when providing loans to their customers to the chagrin of governments that had hoped for increased lending activity that would help re-establish the orderly flow of funds in the economy.

The general lack of confidence in corporate borrowers was not only evident by the actions of banks, but by the extraordinary spreads that developed between government and corporate debt. At times the benchmark three month US treasury bill rate was near zero and in some cases moved even into negative territory. Essentially this meant that investors with large cash balances were willing to pay for the privilege of holding government securities which by definition are guaranteed to be paid back on time – the ultimate in deposit insurance.

These are indeed strange times!

Such single minded enthusiasm for government securities is understandable in the context of risk avoidance. However, it bears repeating, the unprecedented levels of government bailouts, funding requirements and the expected eventual weakening of the dollar will likely result in significantly higher interest rates once the economy finds traction. It has been noted, with some justification, that the housing and credit bubbles has now been replaced by a government bond bubble.

Year-end market distortions have further decreased available yields on high quality securities. We have chosen not to fight the tide and have either bought short term government securities or maintained cash positions on which your custodians pay daily interest. While the overall yields are modest, we have opted for safety of capital and are banking on the opportunity of exploiting opportunities created by a return of confidence into the market and some sanity to rates offered on debt securities.

It should be noted that at the time of writing of these comments, subsequent to year-end, there has already been a modest unwinding of the ultra low interest rate regime in government debt.

The total return performance of the bond market for the fourth quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was an increase of 4.5%. The ten year Government of Canada bond yielded 2.7% at quarter-end, a decline of 1.1% over the course of the quarter. The difference between corporate and federal issues continued to increase over the course of the quarter, moving from 2.1% to 3.7%.

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