September 2007

Turbulence Elicits Prudent Response

Several times in the last year, we have written about our concerns with the risk level of the stock market. Some of these risks include the risk inherent in the high degree of leverage found in hedge funds, the risk of using esoteric investment products, or the risk stemming from the sub-prime mortgage market. It appears that these risks have combined to cause investors concern about the direction of the market. It is for these reasons that we are rebalancing our clients’ portfolios by shifting 5% from equities to bonds and cash.

In fact, over the past year, we have developed strategies to mitigate these risks in a few different ways. Earlier in the year, we took profits in the form of equity gains and reallocated the proceeds into bonds and cash. We also have avoided investing in companies heavily exposed to the sub-prime mortgage market. And we have continued to advise clients against the use of hedge funds. This has turned out to be prudent advice given the number of high-profile hedge fund losses in 2007.

For most of the year, the sub-prime mortgage meltdown had been relegated to a relatively small segment of the overall mortgage market. However, recent volatility in the stock market reflects concerns that fallout from the sub-prime sector is becoming more widespread. Because it will take time for this situation to play out, we believe it is prudent to reduce our clients’ current equity allocation for the second time this year.

Yet, as we have reiterated throughout 2007, underlying fundamentals of both the economy and the stock market appear to be in good shape. The global economy is expanding, corporate profit growth is still positive, and market valuations continue to be reasonable on a historical basis. In a recent issue of Barron’s, Ned Davis Research pointed out that over the last 35 years, the S&P 500 Index has returned an average of 11% per annum when the index’s price/earnings (P/E) ratio drops below 18. (Currently, the S&P 500’s P/E ratio stands at 16.6.)

The uncertainty surrounding how far and how broadly the effects of the sub-prime crisis will spread is the major concern we have right now. It is also the main catalyst behind our decision to reduce equity exposure. While we have alerted our clients to our concerns about sub-prime mortgages in the past, the long reach of this crisis has surprised many investors. Not only has the crunch driven many mortgage lending firms into bankruptcy in 2007, but now tangential effects are taking a real toll on other participants in the marketplace. Several highly leveraged hedge funds have suffered massive losses as their sub-prime related holdings have deteriorated in value. This price collapse has led to margin calls by the hedge funds’ lenders, which causes “distress selling” and drives the security prices even lower, resulting in even greater losses at the funds (A website, www.hf-implode.com, tracking such failures has even sprung up.) Falling security prices have increased the risk premium demanded by lenders and buyers of corporate debt, making it more difficult for companies, private equity firms and leveraged buy-out funds to raise capital to complete their deals. This lack of new deals has, in turn, caused fixed income trading to slow to a crawl, making it difficult for yet other firms to sell securities needed to repay short-term obligations.

No one is certain when this cycle will stop or who will end up bearing the brunt of the fallout. One thing is certain, however, our constant advice against the use of hedge funds by our clients has proven to be sage advice. Not only are hedge fund fees exorbitant, but the amount of leverage employed also puts them in danger of realizing spectacular losses as well as potentially realizing spectacular gains. For example, earlier in the year two hedge funds managed by Bear Stearns ran into significant problems due to the heavy leverage they utilized. As of March 31, 2007, the two funds combined held over $1.5 billion in capital that was leveraged to more than $20 billion in assets (over thirteen times their capital). The intent of such leverage was to magnify small gains into much larger ones. In this case, though, the large debt burden had the opposite effect, magnifying reasonable losses and generating calamitous results. It should be pointed out that similar degrees of leverage are probably being used by a large number of hedge funds. The relatively lax regulatory environment surrounding hedge funds makes it difficult, if not impossible, to tell which hedge funds are dangerously levered. Our investment strategy and research team is continually monitoring this hedge fund imbroglio to determine if any other changes to client portfolios should be made.

The recent actions of central bankers around the world have eased the short-term liquidity concerns in the credit markets. The Federal Reserve Bank of the United States, along with the European Central Bank and others, have injected billions of dollars into the financial system in order to induce the flow of capital into the credit markets. Also, the Federal Reserve’s recent move to cut the discount rate (the rate the Fed charges banks to borrow money) by half a percent sent a strong signal to the markets that it will take swift action when necessary. We also believe that the odds of a federal funds rate cut (the rate at which banks loan fed funds to other private institutions) on or possibly before its September 18^th meeting have increased, especially if the sub-prime market continues to deteriorate and credit markets remain stagnant. To keep things in perspective, despite the recent pullback in the equity market, this has been one of the longest running bull markets in history without a 10% correction. At this point, we would consider the recent pullback in the equity market as natural. Even accounting for the pullback, the S&P 500 Index is still positive on a year-to-date basis and over the last four years has generated an average annual gain of approximately 12%.

Going forward, we will continue to monitor the situation closely. As the uncertainty in the marketplace plays itself out, there will almost certainly be chances to purchase shares of high-quality companies at attractive prices. In this way, times like these can provide an opportunity to add some fresh and exciting prospects to our clients’ investment portfolios.

Market Summary	08/31/07	YTD Price Change
Dow Jones Industrial Average	13,357	7.2%
Nasdaq Composite	2,596	7.5%
Standard & Poor’s 500 Index	1,473	3.9%

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