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Financial Market Update September 22, 2011

As you are probably aware, the financial markets experienced a relatively large sell-off today on the heels of yesterdays downside price moves following the Federal Reserves latest monetary policy announcement. Specifically, the S&P 500 stock index has dropped nearly 6% since yesterdays Fed meeting, while more volatile emerging-market stocks have fallen 10% during the past day and a half. While many investors were disappointed that the Fed did not unleash another huge wave of monetary stimulus, I believe the reasons for the sell-off run deeper. Therefore, I continue to maintain a more defensive posture when managing client portfolios. That being said, I would argue that the recent indiscriminate selling has created some asset mispricings that could lead to some interesting longer-term investment opportunities. I will look to add exposure to these areas should investment conditions turn more favorable. Reasons for the Recent Sell-Off 1) Dissatisfaction with the Federal Reserves Monetary Policy While many market strategists were clearly disappointed that the Fed did not announce another round of quantitative easing (where the Fed creates excess banking reserves out of thin air), I think astute investors were far more perplexed by the Feds decision to purchase longer-term Treasuries using proceeds from shorter-term Treasury sales. The goal of this policy is to bring down longer-term interest rates so borrowers can refinance debt at a lower cost. And though this policy sounds great in theory, there are a number of problems with it in todays economy. First and foremost, most Americans are not borrowing. Rather, they are in the process of paring back their debts (as one would expect after a financial crisis). Without a bevy of new borrowers, all lower longer-term interest rates do is punish savers, adversely impact the banks (via lower net interest margins), and increase the present value of future liabilities for pensions, etc. (because the future costs are discounted at a lower interest rate). I believe Fed policy has done more harm than good, as it has increased global economic uncertainty. As Charles Gave from GaveKal Research has argued, there are huge unintended consequences whenever a central bank holds interest rates at abnormally low Lederer PWM cannot guarantee any of the forecasts presented in this document.

levels. When a central bank does so, businesses have less confidence to invest in longerterm projects because they know their cost of capital is being manipulated by the central banks keeping interest rates artificially low. Moreover, whenever the cost of capital is driven below its equilibrium rate, more uncompetitive companies are able to stay in business, impeding the natural economic forces of creative destruction. In addition, when interest rates are held too low by the central bank, governments are incentivized to borrow more money. Capital that would otherwise go toward funding the private sector ends up getting spent by the government, crowding out private sector investment. With investment spending in the United States still well below pre-crisis levels, and with corporations sitting on boatloads of excess cash, I think Charles Gave is correct that the Feds zero interest rate policy has had the opposite effect versus what was intended. 2) Many Investors Took the Fed at Face Value Despite the fact Ben Bernanke and other Fed economists have continued to drastically err in their economic forecasts this year (and in previous years), many investors became more nervous yesterday after the Feds Open Market Committee indicated that it now observed significant downside risks to the economic outlook. I guess high unemployment, a housing market in the doldrums, huge declines in manufacturing since the spring, long-term Treasury rates falling from 4.8% in February to 3.2%, the stock market dropping nearly 20% since late July, and a serious European sovereign debt crisis were not strong enough warning signals before yesterday. Why anyone would give serious credence to the Feds economic outlook is beyond me, but it has no doubt played a role in the recent market declines. 3) China May Be Slowing More Than Expected In my opinion, a hard landing in China is the most serious global economic risk right now. As I have noted during the past few months, many emerging-market economies have been tightening their monetary policies to try to curb rampant inflation. In many Asian economies that peg their exchange rates to the U.S. dollar (China and Hong Kong being two examples), property price inflation has become a huge issue on top of rising food and energy prices. Todays sizable declines in Chinese property stocks have increased fears that China may experience the bursting of a real estate bubble. At the same time, another report released today shows that Chinese manufacturing has slowed substantially. Since China has really been the primary catalyst for global growth during the past several years, a greater-than-expected slowdown there would be catastrophic since the developed economies (United States, Europe, and Japan) are currently extremely fragile.

Lederer PWM cannot guarantee any of the forecasts presented in this document.

4) Problems in Europe Have Not Gone Away European policymakers seem to think that time will heal all economic wounds in the peripheral countries that are experiencing sovereign debt problems (Greece, Portugal, Ireland, Spain, and Italy). Unfortunately, the failure to address structural problems has only made the situation worse. In spite of European efforts to prevent a Greek default during the past 15 months, the markets now consider default all but certain. One thing that isnt certain is what kind of impact a Greek default would have on the global banking system (since many European banks hold Greek debt). Since markets do not like uncertainty, problems in Europe have exacerbated the recent sell-off. 5) The U.S. Political System is Still a Mess Clearly, the failure of U.S. policymakers to meaningfully address structural budget deficits and looming entitlement expenditures has had a terrible impact on business confidence. Given the Congressional Budget Offices recent debt to GDP forecasts, virtually every business owner knows that, if the debt problems are not addressed, either: i) tax rates will go up, or ii) the debt will get monetized, likely creating inflation. As business owners contemplate investing in longer-term projects, the tax/inflationary uncertainty weighs heavily in their decision making. Throw in the Feds zero interest rate policy (see number 1 above) on top of the political uncertainty, and it is little wonder that companies are not deploying their cash hoards into replenishing depleted capital stocks and/or hiring workers. The fact that the House of Representatives just yesterday failed to pass a bill to keep the government running through mid-November (due to objections over funding FEMA, whose costs equate to a rounding error in the federal budget) is incredibly disconcerting. If Congress cannot agree on this minor issue, how will it deal with much more serious issues like reforming entitlements? Investment Strategy I have maintained a more defensive investment posture in client portfolios since early May, when the bond market signaled an impending economic slowdown. While I intend to remain defensive at current valuations, I will strongly consider adding riskier asset exposure should stocks fall another 5-8%. If the S&P 500 were to fall below 1,075, I would want to see a recovery in Chinese stocks, global banking sector shares, and copper prices before adding riskier assets to portfolios. With 30-year U.S. Treasuries now yielding less than 2.8% due to the risk-off trade (where investors have been selling virtually all other asset classes and piling into the highly liquid Treasury market), I think there are some interesting investment opportunities that could arise relatively soon, as fundamentally sound assets have been getting sold indiscriminately of late. The last time the baby got thrown out with the bathwater was in late 2008 and early 2009. Investors that mopped up these mispriced and undervalued assets were rewarded handsomely.

Lederer PWM cannot guarantee any of the forecasts presented in this document.

I think investment-grade bonds, natural resource plays, gold mining companies, and high dividend blue-chip stocks could be areas that prove valuable from current valuation levels. In addition, we are probably nearing the point where beaten-down emergingmarket stocks start to provide long-term value, especially since many of these economies are more structurally sound relative to the over-indebted developed economies.

Lederer PWM cannot guarantee any of the forecasts presented in this document.