What Is To Be Done

The Markets

“What is to be Done?” Before drafting this letter, we Googled the title, to see who else used it lately. Paul Krugman headed a post on his NYT blog in early March, so while boasting good company, we can’t claim originality. Nor can Paul, of course. Lenin’s 1901 tract so titled set in motion events which define our lives today. What brings to mind Bolshevik theory from the advent of the century past is not the prospect of Revolution, rather the work of Nikolai Kondratieff, Lenin’s chief economic architect, who in 1926 published "Long Waves in Economic Life". Kondratieff's central premise was that capitalist economies displayed long wave cycles of boom and bust ranging between 50-60 years in duration. His study covered the period 1789 to 1926 and was centered on prices and interest rates. Kondratieff's theories documented in the 1920's were validated with the depression less than 10 years later. As the length of these waves roughly coincides with our adult lives, it is instructive to establish where we are, and to position ourselves and our capital accordingly. Watching our world careen forward, we consider some fundamental truths, and how they guide our actions. Above all, the party is over. After living beyond our means, frugality and thrift are the watchwords of the day. This is no elective exercise. In order to spend more than we earn, a lender must be found. As Dave Rosenberg of Merrill Lynch notes: All in, it now looks as though the banks have written off $480 bln and have managed to raise $45 billion in capital, according to the WSJ. That leaves them undercapitalized by roughly $135 bln. Apply average liquidity ratios to that capital shortfall and it implies a $1.9 trillion plunge in lending capacity (an amount worth 20% of total bank credit).

Applying average liquidity ratios to the prospective total $1 to $2 trillion of net capital losses estimated by credible observers like Bill Gross of Pimco, we face a whopper of a credit shortage. While one may contend that a fifth of last year’s borrowers didn’t deserve credit, strip out half our country’s lending capacity, and moving forward becomes a daunting task.

In "Candide," Voltaire defined optimism as a "mania for maintaining that all is well when things are going badly." As professional optimists, charged with keeping our clients focused on a secure future, we face this challenge with acuity. Financial stocks have rallied, sold off, and rallied again, as investors try to handicap the survivors. Keep in mind they trade at a fraction of their bid of 12 months ago. Their capital base is in tatters. A pianist losing a hand has limited prospects. The banks have lost multiple limbs and digits. Commodities have paused in their rallies, having delivered windfalls to investors associated with them. Expect Oil to trade in a broad range, but with the price remaining five times that of a decade ago. Much has been made of the speculative demand for commodities driving up the price. This implies sharp traders, ready to swing to the short side once the last rube is brought in through retail. By all means, they exist. What is underappreciated is the role longer-term financial buyers have played in bidding the prices. Foundations, Endowments, Pension Plans and Sovereign Funds have made allocations to markets formerly the preserve of Growers, Producers, and Industry Users, creating persistently higher demand. Other Sectors have less clear prospects. Investing for a consumer-led recovery is panglossian at best. While sales of footwear, bicycles and scooters are up, not many of us are buying a new Suburban. Arguably the two sectors least impacted by present conditions are Healthcare and Technology. Healthcare is not discretionary, as time and the genome roll on. Technology, while a Capital Good, is essential for a firm’s survival. Rebuild a press, consolidate office space, but keep the servers up to date. Interest, Inflation & Exchange Rates keep us up at night. In the good old days, prudent behavior called for hedging. A laddered bond portfolio, blue chips for income, and all assets firmly denominated in dollars. With the profligate state of the National Debt, our banking system in disarray, and emerging economies overtaking the US in size and dynamism, the hazards of this approach are clear. The Federal Reserve cannot drain liquidity out of a financial system which has slit its wrists. Fed rates will remain muted, as will demand for greenbacks. However, currency leadership will change, with nonEuro instruments gaining popularity.

Copyright 2008, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.

Your Portfolio In a Bear Market, the “enterprising caution” we professed in our last letter seems, in hindsight, rash. Any market exposure has been volatile, and your portfolios were no exception. Energy related positions continued to rally into June, then turned sharply as oil retreated from its highs. Precious metals followed suit, along with other basic materials. Oil Services and Equipment are purchased by the industry on more conservative oil price estimates, upwards of a third below recent market highs, so we are comfortable with this exposure. “Demand Destruction” became the catchphrase on TV for a few days. With a mere four percent of Chinese owning automobiles, a secular case for petroleum and basic materials remains intact. We keep our backs to the TV in our office, and suggest you try it sometime. Healthcare and Technology holdings, added to in the second quarter, held their value relatively well (don’t you hate that phrase?), but more importantly, are beginning to attract more widespread currency as prudent opportunities. Mutual Fund Investors continue to see mixed returns. The “sector neutral” focus of many funds, maintaining weights approximate to their benchmarks, compelled overweighting to losing industries (Banks), as well as frenzied re-allocation to the growing Energy complex. Just in time for the worm to turn. Our focus on funds has been in four areas: Precious Metals, Foreign Stock, US Growth Stocks, and Broad Allocation funds, the last of which replicate our global diversification theme. Precious Metals remain an important part of our portfolios, through ETFs and Sector Mutual Funds. Over the past decade we have counseled clients that we do not really want to see Gold rally, as it implies something very wrong elsewhere in the economy. With a 10 year return of 217.8%, this indicator proved prescient. Foreign Stocks are an imperative, in a world where the US Economy’s relative size diminishes. The hazard, as with all investments, is selection. We adopted a bullish stance on Russia in the first quarter. Apparently, we were alone. The decline in commodity prices and investor demand for risky assets compelled us to trim this exposure at a loss. US Growth stocks have promise in relative terms. In a decade where the total return on the S&P 500 has lagged the Consumer Price Index (+33.2% vs.+34.24%), as the August 98 to December 00 rally of the S&P

(+47%) moves through the snake, there must be a rally somewhere, right? That or we see the 10 year performance of the S&P in 2010 at truly discouraging levels. Broad Allocation Funds permit “one-stop” diversification, a quality we find appropriate for obtaining prudent exposure quickly, as well as conservative solutions for smaller portfolios. We continue to find these portfolios useful, recognizing that while we are unable to influence these fund’s allocations, we are held accountable by our clients for their performance.

Your Pension Income prospects for retirement have not been this vague since Bismarck created the first pensions in 1880s Germany. With the possible exception of 40 years later, when the Saufgau Landesbank printed the 100 Billion Mark note now framed on our desk. Twenty years ago, twice as many American workers had pensions as today. Going forward, this number will be smaller. If you have a pension providing half your expected income needs in retirement, congratulations. Absent that, there is indeed Something to be Done. Let’s review your Pension, Insurance and Annuity policies. The guaranteed portion of our retirement income should command the same attention as our savings and investments. In addition to the fact that few of us fully understand what we own, costs, features, and mortality tables have improved greatly over the past decade. The more certainty we can establish in these uncertain times, the happier we will be. So what became of Kondrateiff? By 1928, “Long Waves” was perceived as a critique of Stalin’s collectivization movement, and Kondrateiff was dismissed from his position in the Soviet planning hierarchy. By 1930 he was in the Gulag, and he was executed in 1938. Please allow your Investment Advisor greater forbearance.

Frank J. Ruffing CFP McLean, Virginia, August 7, 2008 [email protected]

7918 Jones Branch Drive, Suite 800 McLean, VA 22102 Telephone 703-283-5220 www.farragut.us.com

Copyright 2008, Farragut Resources, LLC. The material presented is for informational purposes only and is not intended to recommend a specific investment strategy or the purchase of securities. All opinions are those of the author, and do not reflect the policies of Farragut Resources or Capitol Securities Management, Inc. Investment advisory services and brokerage provided through Capitol Securities Management, Inc, Member FINRA/SIPC.