Our Market Commentary

You have to reach back to the early years of the Great Depression to find a period comparable to what we experienced in 2008. Fortunately, policymakers have learned from that troubled time in our history and have taken the proper steps to avoid a complete repeat of that period.

We entered 2008 with the housing and financial crisis already well under way. The rapid collapse of Bear Stearns, a storied Wall Street investment house, punctuated the problems in the sector and in effect led to the first government rescue via a JPMorgan Chase takeover (with the backing of the Federal Reserve). The Bear Stearns implosion resulted in a sharp decline in stocks and a shift in investors’ assets toward ultra-safe U.S. Treasury securities.

The economy had to contend with the added burden of accelerating inflation in the first quarter with oil prices climbing above the $100 a barrel mark for the first time ever. Commodities in general were advancing at a rapid clip during the period as demand from emerging markets, most notably China, was far outstripping available supply.

An abortive rally in the first part of the second quarter gave way to double-digit losses for the major averages as the recession in the housing and financial sector worsened, while prices for oil and other important commodities reached record heights. Together, these events prompted fears of ‘70s style stagflation.

The real trouble for the stock market, however, got underway in the third quarter with the government’s decision to allow Lehman Brothers to fail. This led to a sharp rise in counterparty risk in the vast, unregulated derivatives market and set off a domino effect that sparked a wave of failures in the financial sector. At this juncture the financial crisis moved from being a serious liquidity crisis to verging on a total collapse of the financial system—despite record cash injections by the Federal Reserve into the system.

The fourth quarter saw the major stock market averages plumb even lower depths before staging a healthy rebound. During this time the government introduced a massive fiscal stimulus plan to spur the economy, in addition to offering a number of vehicles for repurchasing distressed securities and bailing out ailing financial firms. The Federal Reserve, meanwhile, continued to cut short-term interest rates aggressively, bringing the yield on its key lending rate to zero for the first time ever.

Even after rallying more than 10 percent off of their lows, stocks ended the year with valuations at their lowest levels in decades. And despite the heightened volatility that persisted through December, there was a decided improvement in the underlying tone of the market’s trading beginning in late October, suggesting that stocks have put in an important bottom.

Performance drivers for portfolio for the year were led by financial stocks. That may sound odd given the disastrous declines in so many shares in this space, including many old-line names such as Fannie Mae, AIG and Lehman Brothers losing all of their value. Our approach to the sector has long been to focus on the best-of-breed companies, those that never lost sight of their original focus and, as a result, are taking market share away from their competitors.

We spent much of the second half of 2008 underweight energy shares after taking profits on the group earlier in the year. We’ve since begun to step up our purchases in this area in anticipation of a strong rebound in 2009 and beyond. In fact, we added a number of stocks of companies from diverse groups that are fundamentally executing very well and will benefit from infrastructure spending. We picked up battered fertilizer companies trading at low single-digit earnings multiples despite double-digit growth on tap for the coming years. Other out-of-favor stocks trading at attractive levels also found a place in our portfolio such including housing related and defense stocks.

Some of our stock sales were guided by companies that offered disappointing news, while others were prompted more by a desire to pare back on conservative positions which, while they had served us quite well in recent months, had become too large weightings in the portfolio.

Outlook & Strategy

The closest parallel in history to today is the early 1930s. Back then, stocks were well on their way to recovery after having fallen sharply in the initial decline before costly mistakes were made. It was only after government policy blunders including keeping interest rates too high, shrinking the money supply and raising taxes that the contraction morphed from recession to outright depression. This time around those mistakes are not being repeated. The Obama Administration, meanwhile, is poised to unleash another enormous fiscal stimulus package to further bolster the economy.

The media is abuzz with dire stories about the economy. However, the popular press is typically late to the party. The fall in oil prices, for example, is a tremendous net positive for the economy, but this tonic is largely being overlooked.

While we’ll no doubt have several more months of poor economic news, the worst is likely behind us. Given the unprecedented sums of money being put to work bailing out the financial sector and to get the economy back on firm footing, the surprise events of 2009 are likely to be the strength of the economy and a resurgence of inflation rather than continued deflation as bankers seek a higher return on their assets by lending rather than remaining holed up in government paper paying virtually no interest.

We are fully invested in anticipation of a fairly healthy stock market in the coming months. Although we don’t expect a return to the previous highs, with nearly $9 trillion sitting in cash and money market funds, there is the potential for a powerful rally to unfold. Nevertheless, we’ll continue to invest in a cautious manner, devoting a large percentage of our holdings to high-quality stocks with clearly defined growth prospects that should hold up well even if the economy remains in the doldrums.

Our largest sector weighting relative to the market is in materials, most notably in the above-mentioned fertilizer stocks and gold miners (along with gold itself). Commodity plays are likely to be top performers as global growth starts to pick up again. Precious metals, meanwhile, will get a boost in anticipation of the higher inflation that will result from the massive liquidity injections being used to combat the financial crisis

In short, the first act of this drama was deflation and contraction. The next act will be growth, followed by inflation. The coming year will no doubt have its challenges, but we feel we’re well positioned to meet—and profit from—those trials.

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Disclaimer: The specific securities identified and described herein do not represent all of the securities purchased, sold, or recommended for advisory clients, and that the reader should not assume that investments in the securities identified and discussed were or will be profitable. The mention of securities in this letter should not be deemed as a recommendation to buy or sell the securities. Leeb closely monitors the companies held in client portfolios. If a company’s underlying fundamentals or valuation measures change, Leeb will reevaluate its position and may sell part or all of its holdings.