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Fourth Quarter 2008


Market Review Quarter 4, 2008

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

Third Quarter (% Change in Cdn$)

-23.5

-10.5

-11.3

+3.1

 -31.3

-30.4

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

December 2008

0.85%

0.11%

 2.68%

 2.21%

September 2008

  1.85%

  0.76%

  3.77%

 3.78%

Commodities (in US$)

Oil

Natural Gas

Gold

December 2008

 44.60

5.63

880.70

September 2008

100.45

7.17

  863.05

Portfolio Management Strategy

What Worked

– Treasury Bills

– Bonds

– Gold

What Didn’t

– Industrial Commodities

– Financial Stocks

– Canadian Dollar

Where Were The Adults? – NL

The great bull market of our lifetime began in the summer of 1982. While we like to say nobody rings a bell to indicate the end of a bear market and the beginning of a bull market, in this case there actually was a bell. On the morning of Tuesday August 17, 1982 Henry Kaufman, then Chief Economist at Solomon Brothers, predicted that the bear market of the previous 16 years had ended and that a new bull market was beginning. Inflation had peaked, interest rates were to fall, and stocks were going to rise. And rise they did, finally peaking out in October 2007 in the United States and June 2008 in Canada.The longest bull market in history. Unfortunately, nobody, including Henry Kaufman, rang the bell to signal the end. Many forecasters (including ourselves) thought the markets were overdone on the upside and were due for a fall, but few had any idea of the magnitude of what was ahead.

During that twenty-five year time period, there were excesses aplenty. Greed overtook common sense across the board. Consumers could not buy enough or borrow enough. The US consumer became 70% of US GDP and 20% of global GDP. They kept the economy going through thick and thin. Private equity and hedge funds amassed untold riches through leverage. Especially for those who managed them. Interest rates were low. Credit was cheap and plentiful. Debt levels knew no bounds.

Corporate executives could not be paid enough on the way up and had no accountability on the way down. Housing prices could only go up. Everyone had to own one. Everyone did own one, never mind that they couldn’t afford them. Derivatives and synthetic investment products ruled. Investment bankers couldn’t churn them out fast enough and investors (both sophisticated and not) couldn’t buy them fast enough. ABCP, SIVs, CDSs, CDOs, MBSs. An alphabet soup of structured products. Never mind that nobody knew what they were or what was in them. Squeeze out that extra bit of return. Bubbles kept appearing one after another. The Japanese asset price bubble that affected both real estate and stocks, the 1997 Asian financial crisis, the .com and technology bubble, and most recently the commodity, credit, and housing bubbles as well as Ponzi schemes. All these and more have brought us to where we are today. The question remains: During all this time, where were the adults?

The developed world is clearly in recession while the developing world experiences a severe slowdown. No country is immune. This is not your garden variety recession which, according to economist Steve Roach of Morgan Stanley, is a GDP decline of 1.5% and lasts six quarters and, as much as we wish it would, it will not end with a quick V-shaped recovery. Unfortunately, it will be longer and deeper than any recession most of us can remember. It will not, however, be a depression like in the 1930s, despite what some sensationalist headline writers would like us to believe as far more stimulus is being injected into the system earlier. Additionally while there will be the inevitable lag before the stimulus can take effect, a more generous social safety net exists today versus a non-existent one in the 1930s.

Debt is the problem and debt continues to expand, it seems, exponentially. The US in particular is drowning in debt. According to David Rosenberg, North American economist at Merrill Lynch, the aggregate level of private sector debt relative to GDP is near a historic peak of 172%, which is 50 percentage points above the long-run pre-bubble norm. To put that into absolute terms, the level of outstanding private sector debt in the US remains $6 trillion beyond the bounds of what the economy has traditionally been capable of handling.

This bodes poorly for capitalism for the next few years. We are entering the era of big socialized government. No matter what their country or their political stripe, governments will all be preaching it. Never mind that it was government policies in the US that caused the housing bubble and contributed to the demise of the Big Three auto companies. Government will come to the rescue. Money (yours and mine) is being thrown at the auto companies, banks and insurance companies and asset backed commercial paper holders. Canada has the best balance sheet of any of the world’s major economies. We too will be experiencing a massive deficit over the next few years as good money is thrown after bad for political, not economic reasons. Whatever the amount, it will not be enough to stop the recession. Hopefully (and we expect this to be the case) the various stimulus packages implemented by governments around the world will help prevent the worst from happening.

All is not bleak. The recession will end although probably not until some time in 2010. History shows that it takes two to three years following the bursting of a major asset and credit bubble for weakness to end. That means sometime this year (and it may not be until late in the year) we should finally see some light at the end of the economic tunnel. Equity valuations are becoming more reasonable. Some are becoming downright attractive. We currently carry, in most of our accounts, the highest percentage of cash and equivalents we have ever held. We are eager to put that cash to use. We are constantly looking out for that faint first flicker of light. Patience will be required as no bell will ring.

Independence – FB

My partners have covered the various aspects of the economy, the markets, and what happened last year so I won’t re-plough the same ground but I did want to remind our clients that one of the benefits of having an independent investment counselor is direct access to the person managing your portfolio. As you will read elsewhere here we feel the North American economy will remain under pressure for the immediate future and there could well be more unfriendly bumps as the markets continue their adjustment(s) to that reality. The business media tend to describe every market move and announcement as if it was/is the most important development of the past twelve months. They are wrong the vast majority of the time because they focus on the short term. So if you watch read or listen to too much you are likely to become concerned, worried or scared and that is the time to take advantage of the access we provide and call us as we will have a sensible long term view of the issue. An important part of our service is to do the worrying for you and as bleak as the current outlook is we do see some cause(s) for optimism though patience will likely be required.

I would also like to thank those of you who called and offered support during the past few months. Those calls were most appreciated as were the new business referrals.

Why we sold/trimmed them: – RD
Morgan Stanley MS – NYSE

A short lived investment in this storied investment bank was eliminated during the quarter. Our initial investment thesis had incorporated the fact that the sizeable capital infusion from both the Federal Reserve and from Japan’s Mitsubishi Financial Group would provide much needed stability to the company. The stock was sold despite this good news on its capital flexibility because the ‘market’ continued to savagely sell the stock down despite the capital support. Previously the market had sold both Bear Stearns, Lehman and then Merrill Lynch stock down to levels where a self perpetuating downward cycle ensued. A lack of market confidence put the investment banking business models into crisis and forced 2 fire sales and one bankruptcy (Lehman). As a result of the demonstrated power of the stock sellers in the previously mentioned investment banks we felt it prudent to step aside and wait for saner heads to prevail.

Barclays Bank BCS – NYSE

We initially felt that Barclays Bank was well positioned after its acquisition of parts of Lehman’s bankrupted businesses. However, the stock was sold in the quarter when the company opted for a massively dilutive share issuance rather than a less dilutive and more secure government capital infusion. One can only guess what management was thinking but the fact is that they chose to avoid governmental involvement and forced the shareholders to pay a high price for that decision. Additionally the UK economy deteriorated significantly which does not bode well for its lending business in the near term.

General Electric GE – NYSE

As the economy experienced a sharp deterioration in the quarter GE was faced with deteriorating industry fundamentals on not only its financial services business but on virtually all of its operating businesses. We felt it prudent to trim the position in front of what we expect will be negative earnings revisions. The possibility that S&P would reduce GE’s triple A rating was also a concern. Its ability to continue to shrink its GE Capital portfolio combined with the timing of an economic recovery will dictate when its collection of strong businesses will thrive again.

Canadian National Railways CNR – T

CNR stock was a stellar outperformer during the year ending down just over 5%. We took advantage of its relative strength to trim the position before earnings news begins to reflect the sharp deterioration in the economy that occurred in the 4th quarter. This remains an excellent company; just one that we believe has some downside risk to the stock price.

Neste Oil – Finland

Our position in Neste Oil was sold as 2009 will likely prove to be a year of multiple headwinds. Although this European refiner is competitively advantaged it is facing lower demand for its refined product given the economic slowdown and some lingering operational issues in its diesel operation. We expect 2009 to be a poor earnings year as lower gasoline demand leads to low utilization rates and low refining margins. Given the start up issues in its diesel operations it will be more exposed to gasoline margins than previously thought.

Added:
BCE BCE – T

The almost 2 year saga of the BCE deal ended sadly for existing BCE shareholders. Alas the $42.75/share deal struck to take the firm private proved too rich as the credit markets effectively closed as economic and financial conditions worsened. The legal reason for the deal termination ended up being a failed solvency opinion. The stock immediately traded to attractive valuations and we used the turmoil to initiate our position. In these uncertain economic times we look to invest in companies with stable earnings streams, low levels of debt and stable and preferably rising dividends. Following the collapse of the privatization deal, BCE reinstituted the dividend which had been cancelled in March (now yields 6.6%). A new CEO has been at the helm less than 1 year, has a good track record in the telecommunications business and has already begun to streamline the operations. The company is better positioned, has a better balance sheet and is more operationally efficient (with room for further cost cuts) than in the past.

Important Information For Holders of RRIFs – NL

The government issued a decree late in 2008 concerning the ability of RRIF holders (on a one-time basis) to reinvest up to 25% of their RRIF payments for 2008. Here are the details:

It is proposed ( in the Federal 2008 Economic and Fiscal Statement) that the minimum annual withdrawal from a Registered Retirement Income Fund (RRIF) would be reduced, on a one-time basis, by 25% for 2008 withdrawals. For those taxpayers who have already withdrawn more than the reduced minimum amount, the excess (up to the original minimum amount) would be allowed as a contribution to an RRSP or RRIF, and deducted on the 2008 tax return. The contribution would be required to be made by the later of March 1, 2009, or 30 days after the legislation receives Royal Assent. If an in kind contribution is made to the RRSP or RRIF, do not transfer investments which are in a loss position, as the loss will be disallowed.

Canada Revenue Agency (CRA) announced in a December 11, 2008 news release that the proposed changes can be administered by financial institutions before the law is passed. However, if a taxpayer returns the allowed amount and the proposed reduction is not passed into law, the taxpayer may have to subsequently withdraw the remaining 25%.

Should you wish to reinvest all or some of the 25% in your RRIF, please contact Debbie Masraff at extension 3501 (dmasraff@portfoliomanagement.ca before March 1, 2009.

Changes To Our Telephone System

Please note that we have a new telephone system at Portfolio Management Corporation and as a consequence, we have a single incoming line: 416-363-8797. Please discard any other telephone numbers you may have for our company as they are no longer in service. Our toll-free numbers remain the same:

Canada 1-800-998-9791

US 1-800-998-9791

January 2009


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