The Delta Group

The Delta Group

A FINANCIAL ADVISORY FIRM

Volume 24, No. 1, Jan 2008, Eric Drew Dahl & Patricia J. Williams, Editors

Overview

Geez, finally…!! A full blown real estate recession is with us. Single family home prices are falling across the nation for the first time since the Great Depression. Aided by the evils of adjustable rate mortgage resets, several million foreclosures are expected to occur in 2008. The latest late-night-cable-how-to-sure-thing has gone by the way of the gooney bird.

Recalling the downfall of the glamorous internet stocks of the 90’s with their compounding negative growth rates, the current version of bubble math wizardry was attempted by creating wealth from mortgage debt, subsidized and legitimized by a passive and neglectful Federal Reserve.

Two of the most widely held and plain Jane assets of our time, common stock and single family homes, have been co-opted (stolen) from Mom and Pop American staples, to financial derivatives(concocted schemes) that cannot be understood or valued. This has been Wall Street’s gift for the new Mouse Click Mania Millennia. Volatility and wealth destruction are not new to modern civilization, but heretofore had been limited to tulip bulbs,Florida swamp land, etc.

Wall Street’s derivative creations such as these are self serving butwidely accepted byhedge fund’s quixotic search for risk-free above market yields. The current version of their design utilized the high rate sub-prime mortgage debt to make their leveraged schemes workable, but paid little heed to security (debt coverage/ FICA scores/market prices). The real estate collapse removed the fragile underpinning from their experiment, making the inevitable collapse the economic story of 2007 and beyond.

It took a team approach with top to bottom complicity to create the 8.0 magnitude financial earthquake that weare experiencing. The Fed (top) rate increases in ’05- ’06 to deflate the bubble, has now been forced to cut rates ’07 to save borrowers (bottom) from themselves and to contain the billions in losses ($90B and counting) from investment bankers (middle) and mortgage peddlers.

As was the case in 2000, the Fed should have acted sooner than later in stemming stock market speculation. Today, their “horse out of the barn/better late than never” remedies to deter predatory lending are being put forth to restore confidence in the financial markets. This along with the Administration’s proposals to limitmortgage rate resets will have the annoyingly predictable effect of making matters worse. Surviving mortgage lenders will demand higher credit standards which will prolong the real estate recovery as financing becomesmore restrictive and difficult to obtain.

The stock market’s reasonable valuation in early ’07 has buffered the downside of the real estate induced market tsunami. Diversified portfolios have easily withstood the whipsawing affect of schizophrenic traders, and have left us with respectable returns for the fifth straight year.

The sub-prime catastrophe has affected all credit markets for which an efficiently running economy depends. Lenders, burned by their own stupidity and neglect, are being induced by lower rates from the Fed to expand their risk profile once again. The Fed’s attempt to lubricate credit markets is essential for a non-recessionary 2008.

Several trillion dollars of other derivative schemes are in play in the financial world as various entities hedge bets and speculate with price and currency movements. The potential for ahouse of cards market meltdown worries ole’ wise Wall Streeter’s, and should us as well.

Economic

The constant rattle of Chicken Littlesmay finally have their day in ’08. Negative growth rates, unemployment, higher taxes are their preference, and the credit contraction and real estate slowdown may be their savior. Although many parts of the economy remain strong, its strength will be tested through ’08 as the excesses of the real estate bubble are absorbed.

Recessions are a part of any normal business cycle. Expansion creates excess liquidity as consumers borrow against rising asset values. Eventually, prices far exceed their fundamental value while borrowers over-burden their income with excessive debt payments. Imbalances are created, demand wanes, prices fall, and ultimately the economy contracts as consumers are forced to repay debts and rebuild their balance sheets.

The real estate recession is likely to last through ’08 and into ’09. Lender’s retraction of available credit will restrict buyer demand that would otherwisestabilize the faltering market. The supply side will be overwhelmed by foreclosures. Time is the only cure to restore the market’s demand/supply imbalance. And, like the stock market before it, investors willing to regard this downturn as both a temporary event and an investment opportunity will be rewarded. Like stocks, single family homes will return to their rightful owners at reasonable prices and debt levels.

Investment

Over the past five years, our investment objective has been simple and successful. The expanding global economy put profits in the hands of hard asset providers (materials/energy/industrials) that again provideddouble digit gains in ’07. Blue chip multinationals also continued to make hay with their foreign/emerging market exposure and benefit from the falling dollar. The emerging markets spun gold as more and more investors accepted the global expansion story and related risks attached thereto.

International markets again bested our ownwith the world index rising 16%. Emerging markets did substantially better with gains averaging ~35%. Gold and commodities, darlings since the beginning of the recovery, remained popular with the continued expansion of the emerging markets and growing demand of raw materials.

The Treasury bond market got into the highlight reel with near double digit returns as panicked investors sought the safety of AAA guarantees. The corporate bond market suffered through with minimal returns, singed by the sub primecontagion anduncertainties brought on by obtuse derivative valuations. Returns from tax free muni’s were pitiful, asbond insurers, guarantors of muni bond issues, saw their capital base erode from derivative exposure.

Last year we recommended maintaining the global expansion strategy with exposure to hard assets. Given the real estate effect on local economies, we should again maintain the same focus, albeit with more cash to offset periods of E-ticket type market volatility that will surely annoy.

Conclusion

The stock market will follow the economy, and the economy will track the Fed’s efforts to keep the sub prime infection from spreading. The Fed’s antibiotic efforts will be the market’s focus throughout the year.

Rising commodity prices have boosted inflation, which has returnedwith a cameo role for the first time in years. After three decades in remission, stagflation,defined as below trend economic growth albeit with rising prices, could roil the market in ‘08. All bets are off if core inflation climbs to the 4%-5% range.

May the New Year bring you health, peace and prosperity!!