April 2008

MARKET UPDATE

The first quarter of 2008 left many investors feeling like they were on a roller coaster ride, with ups and downs dramatic enough to take your breath away. First, there were asset write-downs totaling billions of dollars at the world’s leading banks, along with talk of a credit crisis, the likes of which have not been seen since the Great Depression. In addition, mortgage defaults and the Bear Stearns debacle led the markets on a volatile path not experienced in years.

After this year’s shaky start, there are some signs that perhaps the worst may be behind us. Since March 31^st, the Dow Jones Industrial Average has returned over 3.5%, by far the best month year to date. The S&P 500 and NASDAQ composite have responded favorably as well, both returning over 4%. Perhaps more importantly, the market instability that characterized the first three months of the year has lessened. The credit freeze has begun to thaw a bit, as the cost of corporate debt has declined relative to Treasuries. We believe the Fed’s policy moves are instilling confidence in large lenders and the Fed will do its part to keep the financial system afloat. Corporations have begun to release first quarter results, and except for financial firms, the results have been better than expected. Investors seem to have accepted a mild recession and high energy prices as the present reality, eliminating two of the larger concerns of the past few months. Our conclusion is that as long as there are not massive shocks to the system, the markets could be relatively calm for the foreseeable future.

Looking ahead, our outlook for equities is more encouraging than it has been in several months. The importance of the Federal Reserve and the U.S. government’s commitment to ensure proper functioning of financial markets cannot be overstated. Stronger-than-expected earnings results provide investors with another data point indicating that the sky is not falling and that perhaps market conditions are not as bad as feared. Supporting both of these positives are forward P/E multiples (price divided by future earnings) that are still near their 20-year lows. These factors together make us more sanguine regarding equities for the rest of 2008 and into 2009.

IMPACT OF INVESTOR PSYCHOLOGY

One could argue that investor fear and greed contributed to the increased volatility and poor market performance during the first quarter. Behavioral finance deals with the effects of human psychology upon investors’ actions and the direction of the broader markets. Behavioral finance covers a long list of curious investor behaviors. For example, there is a tendency for investors to hold on to losing positions in hopes that these stocks will make it back to break-even while selling “winners” too early in order to lock in gains. One of the most important aspects of behavioral finance addresses the dangers of the “herd mentality.”

Herd mentality arises when most members in a group begin to think alike and accept the status quo as fact. In the late 1990’s, the herd believed that the heady growth being experienced by technology companies could last indefinitely and that the internet revolution would substantively change the shape of American business in the years ahead. As such, more and more investors began to believe that astronomical valuations were warranted due to such high growth expectations.

The study of behavioral finance has shown that the majority is rarely right. In fact, the point at which everyone has jumped on the bandwagon is precisely the point where the consensus opinion is no longer valid. The 1990’s tech bubble is a good example. In late 1999, three books titled Dow 36,000 (by James Glassman and Kevin Hassett), Dow 40,000 (David Elias) and Dow 100,000 (Charles Kadlec) were published. These three books, with such bullish titles, came to summarize the overriding feeling at the time – the stock market would continue to run up, up and away. The demand for such books was clearly a reflection of the market euphoria of the time. Of course, such sentiment actually marked the top in the market, highlighting the dangers of the herd mentality.

There is no shortage of great quotations summarizing the peril of accepting popular opinion. From George S. Patton who stated, “If everyone is thinking alike, then somebody isn’t thinking,” to legendary investor Benjamin Graham who reminded investors, “Be fearful when others are greedy, and be greedy when others are fearful,” the potential danger of everyone adopting the same opinion has been documented for centuries. Hindsight, however, makes it easy to adopt a contrary point-of-view. Upon reviewing recent history, it is clear that valuation multiples and growth assumptions for tech stocks in the late 1990’s were unsustainable. The challenge to all investors is to avoid the pitfalls of blindly accepting the consensus opinion.

There are however some indicators that can give investors hints as to the strength of consensus opinion regarding financial markets: non-financial magazines (Time, Newsweek, etc.) that plaster their covers with financial topics, the number of times a financial topic is mentioned in the popular press, or the prevalence of a specific issue at the water cooler or cocktail party. However, our analysis shows there is no hard and fast rule to determine when it is in an investor’s best interest to adopt a contrarian point-of-view.

In this situation, it is best to adopt the philosophy that a good offense is the best defense. At RiverPoint, we keep a skeptical eye on Wall Street strategists and the financial press. It is necessary to independently question popular opinion and to weigh the legitimacy of the general consensus. We always challenge ourselves to dig deeper in an attempt to stay ahead of the crowd to provide the best possible investment advice for our clients.

Market Summary	4/29/08	YTD Price Change
Dow Jones Industrial Average	12,832	-3.3%
Nasdaq Composite	2,426	-8.5%
Standard & Poor’s 500 Index	1,391	-5.3%

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.