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An Open Letter to Clients – January 2008 As I write this letter on January 25th, after four years of relative calm, markets throughout the world have experienced the most wild and volatile start to the year in decades! The Big Issue According to the media the big issue is whether or not the US is heading for a recession. The US is the largest economy in the world and the pundits seem to think that if the US slows, every country will be affected adversely. Personally, I think the real issue is far more significant and “systemic”. The world is awash in debt, particularly in the United States. In my last letter I wrote about the burgeoning US debt. For readers new and not so new, I’ll repeat the figure. They have $55,000,000,000,000 (that’s Trillions) of unfunded liabilities. What is a recession? Technically, its two consecutive quarters (3 months in a quarter) where the nation’s gross domestic product (that’s the total dollar value of all of the goods and services produced) declines. So imagine for every $100 of production last quarter, they produce $99 this quarter and $98 the following quarter-that’s a recession. If the economy “shrinks”, generally speaking, companies don’t make as much money and therefore they aren’t worth as much in the investors’ eyes. Hence, the down draft in the markets. Prime Time News and Sub Prime Loans So how did we get here? Why are a lot of these big financial institutions around the world taking such big write downs? Why is this stuff all over the news? Good questions. Some of the biggest institutions have taken some severe hits: Citigroup, Bear Stearns, Merrill Lynch, Credit Suisse, BNP Paribas, CIBC, etc, etc. have all been exposed to this sludge. I can’t say for sure how it all started or who is to blame. But here is my interpretation of some of the key events. Maybe you’ve heard of Alan Greenspan, the former Chairman of the Federal Reserve Board in the United States (their job, in part, is to help manage the economy). One of the ways they can influence the economy is by increasing or decreasing short term interest rates. In theory, if rates fall, business activity is stimulated. Conversely, if rates rise, a slowing of activity should occur. In my humble opinion, recessions and slow downs are necessary for the overall health of the economy. It’s sort of a jungle thing. The strong survive while the weak die off, not unlike the cycle of life. Nothing lasts forever. So it seems to me that businesses which are well-operated can survive slow downs and ultimately benefit from down turns as their weak competitors don’t. Does this make sense to you? It does to me. Poorly run businesses, and for that matter, societies, should not be rewarded for being inept. That’s capitalism. That’s business and that’s life! Again, it’s just my opinion, but it seems that almost every time there was a hint of a slowdown, Alan Greenspan lowered interest rates. This enabled weak companies to stick around longer than they should and it also led to extreme speculation. Don’t believe me? Try this one on for size. Imagine lending $500,000 to someone who is purchasing a house for $500,000 (in other words, no money down). On top of that, this person has already been bankrupt, owes chunks on credit cards and can’t even provide proof that they earn enough to pay their monthly mortgage. To add more insanity to the equation, this person gets a “preferred” short term enhancement in the form of a ridiculously low rate, say, 3%, and only pays the interest! Isn’t this nuts? You bet it is! Now what would possess any one in their right mind to loan money on such terms? Well, imagine you could borrow money at a very low rate and lend it out at even a slightly higher rate. What a deal! It’s like shooting fish in a barrel as you could borrow an inordinate amount of money and by “re-lending” it to someone who has a lower credit rating than you, your profits could be huge! Besides that, there’s “insurance” on that loan. If the person taking out the mortgage can’t pay, you’re covered. No worries. At least, no worries as long as interest rates stay low, people make their payments and there are lots of other willing lenders who will take similar risks. Well a funny thing happened on the way to “easy money”. Interest rates started to go up. When interest rates go up property values can decline. And then, POP! There goes the housing market! Remember the loan made to someone who shouldn’t be borrowing money? That interest rate spiked upon renewal (typically a few years after the original purchase had been made). In some cases, such types of mortgages had their interest rates double, even triple. You guessed it. They can’t carry that mortgage now with higher rates? The keys get returned to the lender and the downward trend in home prices is off and running. The lender takes the property back and lists it for sale, after all, they’re not in the property management business. So who holds all of these mortgages that are turning sour? Based on the write downs we’ve been seeing in the news, its big financial institutions, pension funds, hedge funds and a whole host of investors throughout the world. Helicopter Ben To The Rescue I think it was 2002 when Ben Bernanke, the gentleman who replaced Mr. Greenspan as Chairman of the Federal Reserve Board, gave his (in)famous “Helicopter Speech”. He basically said that the US has a wonderful tool, an electronic printing press. They could print as much money as they found necessary and drop the dollars from helicopters to put out any fires. Mr. Bernanke has studied the Great Depression of the 1930’s and has concluded, in part, that the Federal Reserve Board of the day didn’t act swiftly enough to help the economy. The problem with printing money out of thin air is that it reduces the value of the other dollar bills that are already out there in circulation. It’s simple. The more money you print the less it’s worth. You’ll need more of it to buy that cup of coffee, that loaf of bread or a pound of bacon. I’m still convinced that we’re in an inflation cycle, a period of “printing money out of thin air”. By the way, it isn’t just our neighbors to the south who are doing it. We are too as are the Europeans, the Russians and every nation I can think of. Simplistically, if we print relatively less money than the Americans, our currency increases in value. Real assets like precious metals (which can’t be printed out of thin air), food and energy do wonderfully in “inflationary” times. It’s still the same tune, just a different day; food, energy, precious metals, water and necessities of life continue to be my preferred areas of concentration. Yes, these areas can be volatile but so is life. Are We There Yet? Every parent who has gone on a road trip with their children must have heard the above question before. As it relates to the global equity markets, no one really knows the answer. I suspect that due to the fact that there are still large dollar values of American Adjustable Rate Mortgages yet to “rollover” and reset, potentially at higher rates, we may not have “bottomed out” yet. I can tell you that I see some compelling valuations for some great companies. I’d generally be a buyer as opposed to a seller at this juncture. I doubt that Warren Buffett is bailing out of his companies and in fact, he’s been doing some “deals”. People seemingly love a big sale except when it’s in “financial” assets! Doesn’t every smart investor try to “buy low”? Seasonal Issues This year’s deadline for tax deductible RRSP contributions is February 29th. To determine your maximum contribution room, please refer to your 2006 “Notice of Assessment”. It’s that statement Revenue Canada sends you after you file your tax return and is light blue in colour. (Yes, I know-technically Revenue Canada is “CCRA” but I still call them by their old name). The last few years have been a mess when it comes to tardy receipt of T3 slips during tax season. This year we’re told that the slips have to be out in a timely fashion. Our expectation is that the last mailing for T3s should be on April 2nd. Before your return is actually filed, so as to circumvent the nuisance and potential cost of adjustments, either have your tax preparer cross reference last years’ return or wait till the last week of April before filing. New Clients I do my long term business planning at the end of each year and I’ve been fairly accurate in my forecasting. As always, I am happy to assist relatives of my clients. Besides being of service to that specific segment of those whom I serve, I forecast that I will be able to assist six to eight “new” families this year depending upon the complexity of their respective situations. Housekeeping One of the best aspects of my career is that I am able to attend so many interesting events. Though I’ve plotted out the full year already, here are some dates that are confirmed: RBC Dominion Securities Directors Council Orlando Florida Feb 25th through 29th Masters Golf Tournament Augusta Georgia April 11th through 14th Berkshire Hathaway Shareholders Meeting Omaha Nebraska May 1st through 4th New York Hard Asset Conference New York City May 11th through 17th There are other meetings with mutual fund managers and investment professionals but these are the highlights over the next few quarters. Closing Remarks I appreciate the time you have taken to read this letter. I think it is important for me to share my views with you. If you’d like to share this letter with someone, simply direct them to the following website where it will be posted along with others. The link is: http://dir.rbcinvestments.com/john.davies Though the markets have been quite volatile I am very confident in our approach. We appear to be in an inflationary cycle not unlike the 1970s. As such, I’d expect investments that give you a natural hedge against inflation should out perform those that don’t. History might not replicate itself but it sure does leave clues. Should you like a meeting, simply give us a call at your convenience. I will be seeing people on select Saturdays and evenings. I can be reached at 519- 252-3517 or at [email protected] . Erin’s contacts are 252-3671 and [email protected] . On behalf of Erin Hooper and the rest of the crew at Dominion Securities, I wish you a very happy day and good health. Sincerely, John Davies, CFP Investment Advisor