Dear Mr. and Mrs. Sam and Amy Kratchman

New Ideas Inc.

306 N. 32nd Street

Philadelphia, PA

Prepared By

Gillian E. Kelly

Dear Mr. and Mrs. Sam and Amy Kratchman,

As we discussed in your initial consultation you have recently inherited $750,000 from a wealthy grandparent. New Ideas Inc. has put together a mock portfolio, detailing all potential assets to be included in the portfolio, as well as a forecast of the economy, markets, etc. and why New Ideas, Inc. will provide a higher risk adjusted rate of return than other managers. Here is a list of your objectives to the best of my understanding:

· You would like to buy a new house, valued at $900,000 outside of Philadelphia

· You would like to buy a vacation house in a beach town or travel more on an annual basis

· You would like to retire at an age between 60 and 67 without having to pay any debts

· You would like to budget to pay for your children’s (ages 5 and 8) college education in full to a four-year institution

· Your risk aversion does not exceed 11% for the nominal rate of return on the portfolio

Given these objectives and other stipulations your have voiced during our first meetings, I have set up a portfolio that has an estimated return of 9.413% on an annual basis. There are 3 main tactics used in portfolio strategy: Security Selection, Market Timing and Asset Allocation. New Ideas Inc. uses all three of these tactics with our clients however asset allocation is the main driver behind secure, sustainable return of a portfolio. Asset Allocation allows the investor to hedge their securities among various classes of investment vehicles. Diversification is the main element in this theory because having a mixture of assets is more likely to meet your investment goals.

The following chart shows and example of the asset allocation I have chosen for you and the benchmarks I have used to forecast performance:

You already have a substantial amount of your wealth in Apple Stock (large cap equity) however; I would like to diversify your stock portion of your portfolio by adding equal amount of mid-cap stocks, which, as a sector, has returned higher in the last 20 years than other domestic equity classes[1]. I have also added some small cap equity because there is a great potential of growth among smaller companies.

I used Domestic Fixed Income, Real Estate and Cash in your portfolio to add to its diversification. These types of instruments historically award a less-volatile return and are less correlated and thus easy to hedge. For example cash and short term fixed income are affected greatest by monetary policy unlike long term rates (like treasury notes or corporate bonds) where inflation is the biggest driver of yields.

I have also added a great deal of weight into international markets. Emerging markets have above average returns for the past 15 years but with a higher risk of volatility. Within the past 10 years the returns have stabilized but are still seeing steady growth.

I’ve added commodities into your portfolio on the theory that return will rise in upcoming years through the push for alternative energies. This allocation needs to be monitored on a stringent basis because I believe presently a modest investment in oil will be beneficial on the assumption of many economists that our dependency is not near an end. But in the near future I believe the drive toward ethanol and other energy sources will increase the return for corn, soybeans, nuclear energy and others. In which case, the type of commodity in your portfolio will change.

Financial Market Analysis

From the beginning of the third quarter, 2006, through the first quarter of 2007 the spread between the 10 year U.S. Treasury and the 3-month T-bill was negative (spread at the end of the first quarter in 2007 stood at a negative 29 basis points)[2], indicating an inverted yield curve and predictive of a slowing economy or looming recession. Federal Reserve Chairman Ben Bernanke argued that it resulted from global liquidity that had led to unusually heavy purchasing of longer-term notes by pension funds, oil producing and developing nations with high purchasing power against the dollar[3]. This high demand of UST increases prices and drives yields to an artificial low (prices and yields move inversely). During this time period the Federal Reserve was lowering short term rates as part of an expansionary policy, so aggressively, in fact, that inflation was the main concern through the first half of 2007.

For the banking sector, the inverted yield curve reduces the margin between earnings from investments (long term rates charged to borrowers) and expenses (short term rates; i.e. interest payments to depositors). This will usually validates banks to invest in riskier securities in attempt to balance out the loss by (possibly) achieving a higher return. This often pulls the yield curve out of inversion because if demand for liquid securities increases so will prices; yields will decrease in the short term. I believe this is one component that pulled the yield curve back to regular in 2Q of 2007 without a change in monetary policy by the Fed, which kept short term rates at 5.25%.

The end of the second quarter the yield 10-year treasuries pushed to 5.116% and short term rates remained over 50 basis points lower. This was caused because there was such large fear of inflation that investors were adding in the predicted raise of interest rates by the Fed and heavily sold long term securities before prices decreased. However some economists believe this was not that case and the selling of securities should have been viewed as the first sign of the sub-prime mortgage crisis; managers needed to hedge their portfolios, by selling notes and bonds, to compensate for the deteriorating value of the assets in soured mortgage-backed securities2.

Investors began to reassess their risk aversion and yields between high- and low-quality fixed-income securities widened significantly as 2007 dragged on. The 3-month t-bill lowered almost 70 bps in the third quarter because demand was so high for these safe securities. The Federal Reserve lowered the discount rate by 50 bps in August and September and lowered the Fed Funds rate to 4.75% to aid in the credit crunch’s first signs of an illiquid Commercial Paper market, and causing concern for inflationary pressures.

As expected, in the fourth quarter for 2007 treasury yields declined, helping fixed income investors that bet on the slowing economy, but minimizing returns of investors holding corporate debt instruments because concerns over liquidity. Concerns over bond insurers guaranteeing the credit worthiness added to the credit crunch. Even investors in high yielding bonds (junk bonds) only saw flat returns during the 4th quarter.

Liquidity anxiety and aggressive Fed interest rate cuts started 2008 with the steepest yield curve since 2004. The rate cuts helped long term risk-free US bonds to gain because there was a drastic flight to quality, making UST extremely tradable. Tax free bonds declined because faith in local governments was jeopardized due to rising foreclosures and declining property values. The spread between high yield, high risk bonds and US treasuries widened.

In the second quarter, The Fed kept trying to stimulate the economy by lowering Fed Funds to 2.00% however futures predicted a raise in by the end of the year[4]. The two- and five-year treasuries rose most signficantly with 104 and 89-bps changes, respectively. This steapened the yield curve in the short term slightly. Bond prices, moving inversely with yields, fell and caused returns for the quarter to reach negative. However this was a short-lived wave of optimism in the economy and the beginning of a very tumultuous summer for investors.

According to Bloomberg, third quarter yields on speculative grade bonds rose to distressed levels for the first time since 2002. By the end of the quarter, investors were demanding close to 1,000 basis points to chose corporate high yield bonds over treasuries. For investment grade corporate debt, investors were demanding exceeding 4.5 percentage points by the end of September[5].

After the third quarter, on the 29th of October the Fed lowered interest rate to 1.00%, tying its lowest level in half a century. Although less than two weeks later, domestic fixed income has saw a rise in all yields and a slight steepening of the yield cureve. The US t-bill yield rose 0.15%, indicating a slight shift into riskier assets. The 2-year note rose 1.22%, while the 10-year and 30-year bonds rose 3.72% and 4.22%, respectively. This can be viewed as an increased confidence in the stock market or an artificial bump as inflation-sensitive investors wait for fed funds rate cut befeore the end of the year. Contrary to the yield curve’s perception of an improving economy, the inter-bank lending has tightened through November thus pushing banks to further restrict lending practices to consumers.

Economic Analysis

The Federal Open Market Committee began in 2001 what turned into almost three years of a monetary stimulus plan. After a long time of keeping the federal funds rate at a very low level, by mid-2004, the Committee began to raise the federal funds rate and continued to do so, on a quarter-point basis, for 17 consecutive quarters[6]. In late 2006, the Committee voted to not raise the rate another quarter point and paused the rate at 5 ¼%. Tightening of monetary policy is a tactic used by The Fed to slow the economy of the United States to a more sustainable growth rate. The main concern with rapid growth is inflation. The slow approach of The Fed to pause the interest rate and not lower it is so they can then monitor the inflation level and avoid a severe downturn caused by too much volatility.

The first quarter exemplified an inverted yield curve as mentioned earlier. By March, investors saw a slow start to the year- GDP growth was 1.1% but the cost of capital was still high at 5.25%[7]. Historically, when the cost of borrowing is higher than the GDP growth it is indicative of turbulent times in markets that depend on leveraged assets (real estate i.e. mortgages) for two main reasons. First, the market value of such assets is tied to the strength of the economy: GDP growth. Second, because GDP is a measure of the return on capital; if the cost of capital is higher than the return, investors’ cash flows suffer and begin to liquate those markets, inevitably below book value.

US stocks returned 6.1% in the second quarter of 2007, up from 1.4% in first quarter. (MSCI US Investable Market 2500 Index). Economic growth was up to 4.8% prompting inflationary pressures and long term investors to anticipate a rate increase by the Fed. Main concern by mid-year was not a possible recession but the risk of global economic overheating. Month of volatility started in the fixed income markets as bond yields rose to almost 5.5%, the highest in five years[8] amid pressures that China and other nations would cut back purchases of US treasuries due to the sliding value of the dollar. By the end of the second quarter and the start of the third, investors began to predict the crises in the housing market due to a high rate of defaulted loans. This also brought concern to the equity markets and Wall Street’s exposure to mortgage backed securities.

In the third quarter; US equity market returned a 1.6% gain but the bond market returned 2.8%, up from the negative returns of last quarter. This flight to quality came on the heels of the subprime and MBS market crisis. Also in the third quarter, what many economists see as the first sign of crisis is Bear Stearns banned hedge fund withdraws from two sub-prime backed funds.

By the end of 2007, what started in the third quarter accelerated in the fourth; flight to quality increased, UST yields continued to fall and the Fed continued to lower the Fed Funds rate at each meeting ending the third quarter at 4.00%.[9] Global overheating was no longer an issue and the world economy started to see the implications of the subprime mortgage crisis across all markets. The Bureau of Economic Analysis (BEA) singled out four industries in 2007 that they predicted would cause the largest percent of economic slowdown in the United States. According to preliminary industry accounts statistics those industries include: finance and insurance, real estate, construction, and mining. In 2008, the BEA found economic analysis to confirm their predictions. These groups accounted for nearly a quarter of real GDP in 2007, however they accounted for nearly 80 percent of the economic slowdown. Information-communications-technology industries continued their double-digit growth for the fourth consecutive year, increasing 13.2 percent in 2007. These industries accounted for 3.9 percent of the economy but for 22.3 percent of real economic growth[10].

First Quarter 2008

If it wasn’t obvious before January, the Fed’s emergency meeting to cut rates amid the Bank of China’s announcement to have over $8 billion in sub-prime write-offs, followed by another cut one week later definitely drove the economy into emergency mode. Over the course of the first quarter the combination of Federal Funds rate decreasing from 4.25% to 2.25% and the uncertainty of the future strength of the economy causing investors to move into quality instruments, contributed to driving US treasury yields lower. The Fed also lowered the discount rate from 4.75% to 2.5% and opened the discount window to all investment banks after Bear Stearns informed the Fed of their solvency issues. The Fed helped save Bearn Stearns from filing for bankruptcy when JP Morgan was able to buy the company to prevent illiquid/essentially “frozen” markets. This was the government’s first wave of its “bailout”.

The Lehman Bond Aggregate Index boasted 2.2% return as prices rose to match the falling yields and investors fled to quality. Unfortunately the US stock market is not faring so well and suffered near double-digit losses in the first quarter posting a -9.4% loss to the MSCI US Investable Market 2500 Index. It isn’t surprising seeing that stock markets worldwide tried to weather a credit crisis, slowing economic growth, rising commodity prices, the declining dollar and disappointing earnings.[11]