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Fourth Quarter 2008 Review ASSET MANAGEMENT

An Economic and Market Commentary By Michael Obuchowski, Ph.D.

Managing Director, Chief Investment Officer and Director of Research

Michael Obuchowski, Ph.D. Managing Director, Chief Investment Officer and Director of Research

The 2008 stock market plunge continued during the last quarter of the year, driving prices lower across all equity asset classes. Despite a decreasing rate of stock market decline during the quarter, the cumulative losses for the quarter eclipsed any of the three month periods in recent history. The Russell 1000 Growth and the S&P500 fell below their 2002 post dot-com bubble trough, the Dow Jones Industrial Average fell below 8000 for the first time in five years, while treasury prices rallied in the biggest advance in over 25 years. The Russell 1000 Growth posted four months of consecutive declines, the most since its start in 1979, finally ending the year with a 38.44% decline, despite a 1.81% gain in December. The economy lost 524,000 jobs in the month of December alone, bringing the year to date number of jobs lost to more than 2.6 million. The unemployment rate reached 7.2% by the end of December, increasing from 6.7% in November. Job losses triggered a collapse in consumer confidence which in turn caused retail sales to plunge. Many well known companies fell to the decades’ lows. The price of General Motors, once the world’s largest automaker, tumbled to the level of 1943. Citigroup, until very recently the world’s largest financial services corporation, fell to an eighteen-year low. Goldman Sachs fell below its 1999 IPO price. Circuit City filed for bankruptcy after 55 years in business.

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Expected recovery in corporate earnings proved elusive. Any of the estimates prepared at the end of Q3 proved to be far too optimistic, with demand and earnings falling off the cliff during the quarter, driven primarily by the financial sector and auto manufacturing. In the beginning of 2008, financial companies represented 17.6% of the S&P500 Index. After a nearly 60% slide in share prices and $1 trillion in mortgage related losses globally, the financial sector slipped to 13.3%, behind technology, energy and health care. Reacting to the spreading economic malaise, the governments around the world instituted coordinated rate cuts and a large number of programs designed to prop up the global financial system. In the US we have witnessed an unprecedented growth in such programs during 2008. Those programs began in December of 2007 with the introduction of Federal Reserve’s Term Auction Facility (TAF) and proliferated towards the end of last year. They currently include the Money Market Investor Funding Facility (MMIFF), designed to improve liquidity within the commercial paper market; the Commercial Paper Funding Facility (CPFF) designed to facilitate the placement of traditional commercial paper; the Term Asset-Backed Securities Loan Facility (TALF) designed to increase credit availability and support economic activity; the Troubled Asset Relief Program (TARP), originally designed to buy problem assets from the financial community but then redirected to injecting capital directly into the financial sector that eventually became a pool of assets to be applied as needed (e.g., to help the automakers after Congress failed to act). During the fourth quarter, the Federal Reserve also relied on its standard monetary policy tool, cutting the Fed Funds rate from 2 to 1.5% on October 6th, 1.5% to 1% on October 29th and from 1% to a range of 0.0% to 0.25% on December 16th. In addition, the Fed entered a phase of “quantitative easing”, increasing the size of its balance sheet , announcing a plan to buy $100 billion of Government Sponsored Enterprise (GSE) direct debt and up to $500 billion of GSE mortgage-backed debt. In addition, the Fed has suggested that it will consider buying longerterm US Treasury securities.

As dreary as the economic environment was during the quarter, there were some signs of hope. The decline in equity markets moderated during the quarter, with several indices recording a positive return for December. The country elected a new President and the new administration plans on implementing a fiscal stimulus plan as large as $850 billion. The liquidity programs implemented by the Fed and the US Treasury, together with the drastic cuts in short-term interest rates were signs that policy makers were willing to do whatever it takes to address the economy’s problems. At some point, all these measures will stimulate economic growth. Before economic growth can resume, the credit markets have to start responding to government measures. Until these markets begin to once again function effectively, none of the government efforts will have their desired effect of increasing liquidity and credit availability to consumers and corporations. One of the best measures of credit markets health is the TED Spread. The TED Spread represents the difference between the LIBOR (London Inter Bank Offered Rate) and the Three Month T-Bill rate. The TED Spread is a measure of liquidity and is frequently used as a measure of credit risk. The T-Bills traditionally represent a risk free rate. The LIBOR represents the perception of counterparty risk among financial lenders. Although the TED Spread fluctuates over time, it tends to be much larger during times of financial stress. The size of the TED Spread is measured in basis points and, over time, is typically close to 50 basis points. In times of stress in the financial system banks and other financial institutions don’t want to lend to each other as they are not sure they will be repaid. When that happens, the TED Spread will grow from it usual range. When the markets calm down, the TED Spread should return to its historical range. Looking at the TED Spread chart provides a good idea of where we are in the financial crisis (or at least what the perceptions of financial institutions are of each other). Chart 1 presents weekly US 3 Month T-Bill and LIBOR rates from 1/4/1985 until 12/31/2008. Despite the changes in interest rates over time, the average spread was 0.58, with a median of

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Fourth Quarter 2008 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

Source:

Bloomberg

Chart 1 - Source: Bloomberg US 3 Month T-Bill & LIBOR01/04/85 – 12/31/08 0.45. It is easy to locate on the chart many of the significant financial crises of the past. Before the current crisis, the TED Spread reached its historical peak of 300 (3%) on 10/20/1987, a day after Black Monday – the October 19, 1987 market crash. You can also see the Asian financial crisis of 1997, Russian debt crisis in 1998 and the internet bubble beginning to burst in 2000. We can also see the incredible spike of the current crisis.

After several interventions by central banks around the world, TED Spread dropped below 100 in the second half of October. However, right after the stock market’s peak on October 31st, the spread increased again until the FOMC aggressively lowered the target interest rates on January 10th (by 75bps) and then again on January 30th (by 50bps) and conducted the first auction through the new Term Auction Facility. Everything was moving in the right direction with significant liquidity being injected into the financial systems, moving below 100 in less than three months after the collapse and orchestrated acquisition of Bear Stearns. Everything changed, however, when Lehman Brothers was allowed to file for bankruptcy and Merrill Lynch was hastily acquired by Bank of America. Global equity markets experienced one day declines similar to those after the 9/11 terror attacks in 2001 and the TED Spread quickly spiked to unheard of 463 on October 10, 2008. Since then, with unprecedented, coordinated efforts by central banks and a number of financial rescue programs around the world, the TED Spread had declined to 133 by the end of the year, and below 100 within then first two weeks of 2009. A resolution of the credit crisis, stimulated by the Fed’s interest rate actions and the US government’s economic stimulus package, is a necessary precursor to the economic recovery. We will continue watching it carefully during the next several months.

Source:

Bloomberg

Chart 2 - Source: Bloomberg Daily data since 01/02/07 To take a better look at the last few months, Chart 2 presents daily data since 1/2/2007. Until the spike in September 2008, the recent high was reached on August 20th, 2007, soon after BNP Paribas announced that it could not value assets in three funds containing US subprime mortgage related assets, Coventree was denied credit lines and declared it was seeking liquidity funding, several German Landesbanks (IKB, Sachsen LB and West LB) accepted government organized emergency funding and many quantitative hedge funds started suffering severe losses.

In addition to the steadily declining TED Spread, we have found some additional data suggesting that the US economy might be approaching a turning point in the near future. After the volatile holiday period, January economic numbers will again provide better insight into the trends we are observing. Despite initial jobless claims jumping to 589,000 and continuing claims to 4.6M, the January University of Michigan Survey of Consumer Confidence Index moved higher to 61.9, Existing Home Sales increased to 4.74M, representing a 6.5% increase, and the Conference Board’s US Index of Leading economic indicators increased by 0.3%, after a string of five negative months only interrupted by 0.3% increase in October.

Source:

Bloomberg

Chart 3 - Source: Bloomberg Index for crude goods One of the best but least followed leading economic indicators of US and world growth is Producer Price Index for crude goods – the earliest stage of capital goods production. Core rate of Crude Goods Index excludes the volatile food and energy. Prices for these goods have proven to be very sensitive to economic turning points. Generally, as the economy gears up production, demand for metals, paper boxes and timber increases very early in the process, with accompanying jumps in prices that quickly move down the production pipeline. The opposite occurs generally when economic output turns down. Commodity prices tend to fall months before the economy enters a recession as purchases slow and unsold inventories accumulate. Because core crude goods prices are quick to respond to shifts in economic activity, they can be a valuable indicator for those who want to stay ahead of the business cycle curve. Since July 2008, the Core Crude Goods Index declined in what was seemingly a freefall from 385.9 to 227.30 by November. Interestingly enough, while dropping to 22.40, the slope of the decline was much smaller for December, the latest available period. We will not know whether the rate of decline will reaccelerate or further decline until new data becomes available on February 19th, but any further deceleration in the rate of decline might suggest an upcoming economic turning point. Overall, the numbers suggest that, while the economy is clearly still in a severe recession, the rate of decline might be slowing or at least is no

100 Motor Parkway, 2nd Floor • Hauppauge • New York • 11788 Tel: 631.630.2500 • Toll Free: 888.620.5736 • Fax: 631.622.0168 www.1empiream.com • info@1empiream.com


Fourth Quarter 2008 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

longer accelerating. When will the economy start getting better? Likely not before the excess housing stock built up during the boom is worked off and home prices stop falling. That is likely a necessary condition to break the negative feedback loop from housing to credit markets to the economy. Recent possible slowing in the rate of deterioration in housing activity is encouraging. Of course, the restrictions in the flow of mortgage credit could delay the bottoming of the housing market, creating a Catch-22 situation when the credit markets can’t recover until housing markets bottom, but dysfunctional credit markets make it difficult for housing to reach a bottom.

Eventually, when credit conditions improve, housing markets will have a chance to recover, the excess will be worked off and credit markets will heal. But the effects of the credit crisis will likely last for a long time. The housing and financial sectors will be less leveraged and more regulated than they were before the crisis and will remain so for the foreseeable future.

- Michael Obuchowski, Ph.D. First Empire Asset Management

DISCLOSURES The foregoing letter is qualified by the following notes: 1. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Index is one of the most widely used benchmarks of U.S. equity performance. The Russell Top 200 Growth Index measures the performance of the especially large cap segment of the U.S. equity universe represented by stocks in the largest 200 by market cap that exhibit growth characteristics. It includes Russell Top 200 Index companies with higher price-to-book ratios and higher forecast growth values. The companies also are members of the Russell 1000 Growth Index. The Russell Top 200 Growth Index is constructed to provide a comprehensive and unbiased barometer of this larger cap growth market. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

1000 Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics. The indices referred to herein are unmanaged and therefore do not have any transaction costs, advisory fees or similar expenses to which a client account would be subject. It is not possible to invest in these indices. The indices are for comparison purposes only. It should not be assumed that a composite will invest in any specific securities that comprise the indices. The composites managed by FEAM may not be as diversified as the indices and may experience differing degrees of volatility. Performance for all indices includes the reinvestment of dividends.

Firm Update Jennifer Vernier, Portfolio Administrator, joined our team at the end of September. She will focus on operations and client support. Prior to joining FEAM, Jennifer was a loan coordinator for LPC Services, Inc., managing client contact and loan transactions. Prior to that, she was an executive assistant to the executive team at First Empire Securities, Inc. Jennifer is in the process of completing her BA in business marketing at SUNY Old Westbury. Peter Sobel, Senior Vice President, Investment Consultant joined the FEAM team in November and will focus his efforts on working with institutional clients. Peter has over twenty years of experience in the financial services industry. He spent nearly seven years as Senior Vice President of Fixed Income Strategies with First Empire Securities, Inc. Prior to First Empire Securities, he was associated with Patagon.com, Morgan Stanley and Goldman Sachs Asset Management. Peter earned his BA in American Studies at Tulane University, an MBA at Saint Mary’s College of California and holds Series 7, 24, 52, 53, 63, and 66 licenses from the Financial Industry Regulatory Authority. Peter is actively involved in his local community. At the present time, he is a Board Member of the Heritage Trust and an Advisory Board member of Friends for Life Foundation.

2. This letter is not an offer or solicitation.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 100 Motor Parkway, 2nd Floor • Hauppauge • New York • 11788 Tel: 631.630.2500 • Toll Free: 888.620.5736 • Fax: 631.622.0168 www.1empiream.com • info@1empiream.com

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FEAM Q4 2008 Update