U.S. Economy- Only 2 of 54 economists interviewed in January 2008 by the Wall Street Journal predicted a recession in 2008. Today, economist’s opinions on the depth and length of our economic downturn range so greatly, they are still of little predictive value. However, it is clear that this current crisis will alter government, business and consumer behavior into the foreseeable future, just as 9/11 did. Two decades of rapid economic and asset growth, fueled further by easy credit, led to excess consumption and leverage. When the expansion stopped, the system was ill-prepared for the inevitable decline in asset values. We are now desperate to stop the decline and policy makers are trying to inject massive liquidity and bailouts. It is too early to tell whether this strategy will work or whether assets should be left to fall to natural market levels attractive enough to gain the interest of true long term buyers.

While this is the nature of business cycles, the fragility of our banking system, combined with the damage to consumer’s balance sheets, leads us to believe that the effects of this recession will be with us throughout 2009. Furthermore, de-leveraging of consumer balance sheets along with an increased savings rate will slow our economic recovery. We suspect that this will eventually cause a bumpy base building in asset values, followed by a slower than normal recovery.

The two worst economic problems in the past century were the U.S. Great Depression and the Japanese banking crisis of the 90’s. Both were the result of deflation after stock market and real estate bubbles. Luckily, our current economic crisis/deflation is different in three key areas:

1. The magnitude of the crisis is smaller: unemployment, losses as a percentage of GDP, GDP drop, etc…are all predicted to be about 1/3 as big.

2. Policy makers are addressing our problems quickly and providing liquidity/recapitalization to banks and fiscal/monetary stimulus for consumers and businesses. This approach has been successful in resolving all past banking crises going back to the banking panic of 1907.

3. The U.S. does not face the same structural issues that were a result of the gold standard of the 1930’s or the cross-holdings by banks in Japan.* However, even though this recession is unlikely to be as bad as the Great Depression or the Japanese banking crisis, it is already projected to be deeper than most recessions and comparable to the 1973/1974 downturn.

Inflation- Inflation had been slowly rising until last summer with the CPI up more than 4% year over year. Then abruptly, the monthly numbers went from large increases to actual declines (deflation) between August and December. More near term deflation is expected as demand for goods and services have continued to fall. Lowering interest rates alone has not stemmed deflation but President Obama’s large stimulus plan is aimed at stopping these price declines vs. letting prices reach a natural bottom.

Besides saving the banking system, re-inflating the economy is the government’s biggest challenge, both in creating enough liquidity and incentives to turn prices around and then, just as importantly, turning the stimulus off in time to not create another bubble (Mr. Greenspan is blamed for causing the housing bubble by leaving short term interest rates low for too long in the mid 2000’s). Large swings in prices are going to happen depending on this outcome. Gold, for instance, is trying to guess this outcome and at $900 is priced between continued deflation ($700) and too much stimulus ($1,200).

We believe that the policy makers will err on the side of too much stimulus because deflation, like the Great Depression and the last 18 years for Japan, is too painful and is counter-productive. If people anticipate that prices will fall, they delay purchases which exaggerate deflation further. The anticipation of inflation does the opposite. A further benefit of higher inflation is the ability to pay back debts with inflated dollars – as opposed to deflation which erodes equity.

Banking on this future inflation, we are taking advantage of today’s low commodity rates ($40 oil, etc) by making small investments into income producing commodity based funds and gold. When prices stabilize, we will add to these positions in anticipation of 4-6% inflation in 2010 and beyond.

Stock Market- While the stock market’s ultimate bottom may yet to be reached, today’s values already fully discount a long, hard recession. Historically and mathematically, the probabilities of a multi-year (if not decade) bottom being reached in 2009 are over 90% (Goldman Sachs). Even with our expected slow economic recovery, stock prices will start to recover as soon as our downward economic descent lessens. By the time the economy finally bottoms, the stock market will be months into a new bull market. While many comparisons to the Great Depression are being used today, the closest comparison is actually 1973-1974, when we had an oil embargo, large home price declines and a near identical stock market drop. Even though the next eight years brought the highest inflation in U.S. history, the Dow Jones went up 20 times over the next 25 years (500 to 10,000). We believe people with a long investment time horizon and a strong stomach for near term volatility will be handsomely rewarded in the decades ahead by owning stocks this year.

Fixed Income - The 2008 drop in values of corporate and municipal debt was, in most cases, nearly as large as losses in the stock market. Only the highest credits and shortest maturities faired better. However, there is growing evidence that outside of the financial sector, fixed income prices bottomed in mid-December 2008. Rational thinking is slowly returning and we believe prices will rise throughout 2009. The exception is U.S. government bonds, with yields for 10 year bonds hitting 2% in December. They should rise back to 3-4% as America’s government borrowings increase and fears of future inflation grow.

While it may be late into 2009 before the credit markets function efficiently again, today’s valuation on debt represents outstanding bargains. For example, we have recently added a position in many accounts, in a no-load, closed end municipal bond fund, with an A average rated portfolio, that pays over 9% state and federally tax free (California residents).

Real Estate - Commercial real estate transactions are still very difficult to finance. Exceptions are in multi-family buildings where 6% FHA loans are still available. In general, office and retail buildings are suffering from rent and occupancy reductions, while apartments and self storage are holding flat. As commercial real estate lags the economy (as opposed to the stock market which leads), we see further weakness throughout 2009. Fortunately, we do not have an oversupply of buildings like in the 90’s, so the eventual recovery will be faster than usual.

Residential homes have yet to find a bottom despite current availability of 5% interest rate mortgages. The main problem is down payment equity which has significantly diminished for current homeowners and is hard to save for new buyers (the 5-10% down programs are rightfully gone). We believe that home prices will continue to fall in 2009 as unemployment rises and down payments are being saved. Low new housing starts, an end to this recession and compelling values will finally form a base by early 2010. As with many assets, scarcity, location and quality have contributed to keeping the highest priced coastal property value drops to a minimum, with the abundant and cheap housing in Riverside and San Bernardino counties suffering the most.

2009 Forecast & Strategy - As we navigate the world’s first global recession, we are striking a balance between caution and the abundance of good values. Before the economy bottoms, high-grade short and intermediate debt (bonds and trust deeds) should perform best. Commodities may bottom first and quickly advance back to 2006/2007 levels from multi-year lows. When the inevitable stock market recovery begins, we believe it will be led first by small-cap value stocks, then larger value stocks, followed by further gains in corporate and municipal debt. Commercial real estate, having thus far dropped the least, will advance last.

Residential housing should stabilize in 2010, with caution as homeowners view their homes as family shelters, not savings accounts for retirement.

Summary- Thank God for history and perspective. While our current recession has caused serious economic and investment disruption, history shows that we have always recovered from crisis. Every past crisis was different, but the eventual outcomes have all been the same. And so it will be this time as well.

Optivest remains diligent and cautious in light of our economic troubles, yet optimistic that today’s valuations will provide excellent returns in future prosperous years. In the meantime, we are available to answer your questions and concerns, and cognizant of how valuable our clients’ capital preservation goals are during these times of uncertainty.

Sincerely,

Mark Van Mourick
C.E.O.
February 2009

Investment advisory services are offered by Optivest, Inc. under SEC Registration and securities are offered through Gramercy Securities, Inc., member FINRA & SIPC, 3949 Old Post Road, Charlestown, RI, 02813, 800-333-7450.

Optivest Inc. 24901 Dana Point Harbor Drive, Suite 230 | Dana Point, CA 92629 | www.optivestinc.com