US Equity Income & Capital Appreciation Strategies
Game Changer

The S&P 500 plunged 8.5% over the three months end-ing September 30 - compared to losses of 9.4% and 2.7% in the first and second quarters - a dismal 19.4% retreat for the year’s first three quarters. Financial industry turmoil and a slowing economy marked the quarter. We are witnessing one of the largest government interventions in the economy since the 1930s. History is being written in the financial world, as Treasury Secretary Paulson, Federal Reserve Chairman Bernanke, SEC Chairman Cox, Democrats and Republicans alike change the rules of the game.

U.S. banking system unravels
We witnessed the following extraordinary events during the quarter’s last two weeks:

• The Securities and Exchange Commission banned short selling (selling borrowed stock today, in the hope of buying it back at a lower price later, i.e., placing a bet the price of the stock will drop) on more than 799 financial institution stocks through October 8, which may be extended for another 30 days.
  
  
• The Treasury loaned the American International Group (AIG) $85 billion receiving 79.9% ownership, causing the Dow Jones Industrials Average to drop AIG from its index, replacing it with Kraft Corporation.
  
  
• Lehman Brothers, one of our nation’s most respected global investment banks founded in 1850, filed for bankruptcy.
  
  
• The Treasury said it would “insure” up to $50 billion in struggling money market funds held at financial companies that are not FDIC-insured. In the rescue package the new FDIC limits have been raised to $250,000.
  
  
• The Fed announced it would make “unlimited funds” available to banks to finance purchases of asset-backed commercial paper from money market funds.
  
  
• The fourth largest bank in the country, Washington Mutual, was seized by the FDIC and promptly sold to JPMorgan Chase.
  
  
• Regulators spared Wachovia from being the second biggest banking failure in one week, with Citigroup and Wells Fargo competing for its banking operations.
  
  
• A $700 billion bailout plan has been signed into law whereby the Treasury would be allowed to buy illiquid bad loan assets that are weighing down the balance sheets of financial institutions that own them. This is known as “troubled asset relief program” (TARP).

Setting this chain of events in motion was Lehman’s failure and the need for the government to play the role of bankruptcy custodian for AIG, Fannie Mae and Freddie Mac. No one seemed to be prepared for a money market fund to break the $1.00 valuation for the first time since 1994, and for the second time ever. The events of September 17 were shocking. Investors pulled a net $89.2 billion out of money market funds, or 2.6% of total assets. Over the next week, the outflow totaled $145 billion. Putnam Investments’ announcement that it would liquidate a money market fund under intense redemption pressure led to panicked cash hoarding and, in turn, a liquidity crisis in the financial system. To give an example of the market chaos in the flight to quality and liquidity, T-bills traded briefly with a negative yield and Libor rates surged. No one was too big to fail and no lenders were willing to take on counter-party risks. The market basically froze. Corporations need buyers of their commercial paper to fund day-to-day operations; with no buyers, the market imploded. To keep the economy from total breakdown, the government took the opportunity to aggressively counter the illiquidity and inject confidence in the system - adding liquidity to the commercial paper, mortgage and asset-back markets through its actions.

The upshot of these events is the demise of the banking system as it has evolved over the past 20 years. While this period saw greater regulation of banks, it also encouraged the expansion of financial intermediates like broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds, and non-bank mortgage lenders. Like banks, these institutions borrow short-term and invest in longer maturing assets. Unlike banks, in their search for greater returns during a time of compressing yields, they borrowed from skittish institutional markets for shorter terms while investing in illiquid assets. This will no longer be the case. We expect the new emerging financial entities to be bigger, more liquid, and subject to greater government scrutiny.

We believe these steps are necessary to reduce panic, fear, and the perception of financial collapse. But they are also likely to accelerate economic slowdown, pushing the US toward deep recession. The Fed and Treasury are merely cushioning the deflationary forces in the financial system. Although government intervention will create substantially more debt (inflationary), this should be offset by credit contraction in the private sector which will come from deleveraging balance sheets, asset liquidation, debt repayment, and increased savings. We anticipate that inflationary pressure will be more than offset by deflationary forces allowing interest rates to come down. This will benefit the refinancing of the housing industry and counteract recessionary forces.

Portfolio Management
We continue to approach the stock market with extreme caution. Oakwood’s value style of investing is an appropriate way to find opportunities and manage risk in this market. We are beginning to see attractive new values. We believe the key to success will come from investing in solid value companies that will earn good relative returns throughout the continuing market turbulence. We continue to carry above-average cash positions in search of opportunities that will emerge as the economy slowly improves. We continue to favor consumer staples, telecommunications, healthcare, and the utility sectors. We also look to add positions on weakness to the energy and technology sectors.

Our wealth management approach asserts that if clients use discipline in defining investment goals up front, and then adhere to those goals with minor readjustments along the way, they will then be positioned to reap the benefits from a market recovery. The following chart demonstrates that recovery tends to come in the first months after the bottom.