March 24, 2008

According to chaos theory, a butterfly fluttering its wings in Brazil can eventually instigate a hurricane off the coast of Florida. This concept illustrates how small, seemingly insignificant events can leverage into much more cataclysmic consequences.

While this theory has been used to model events in the physical world, it has also been found to be very apropos to the world of finance. In fact, it has been widely reported that it was distress in a very obscure currency, the Thai Baht, eleven years ago which is credited with leading ultimately to the Asian financial crisis which then played a role in the demise of the hedge fund, Long Term Capital. Along the way, the global financial system was put into jeopardy and only the concerted action of the Federal Reserve and central banks around the world managed to defuse the situation.

Today, we face another dilemma. As the technology/internet bubble deflated seven years ago, the actions of the Fed to revive the economy ultimately contributed to asset inflation in the real estate market. Hot markets invariably attract speculation. Lending standards became very lax and creative financing techniques became very commonplace.

Inevitably, as an overheated residential real estate market started to cool off, cracks in the system began to appear and they manifested first in the subprime mortgage market. While initially it was thought these issues could be contained, the truth is that our financial system, like a biological ecosystem, is very interdependent and what affects one niche can have very serious ramifications for other parts of the system.

In this case, the bundling of mortgage securities into instruments that were sold to investors gave rise to a credit rating system that did not accurately portray the true risk at hand in these securities. As securities were downgraded, institutions that were mandated to hold credit above a certain grade were forced to sell their holdings without any regard to the prices they received.

This sell-at-any-price policy created dislocations in the credit markets which in turn led to other dislocations. It affected instruments one would normally consider peripheral such as municipal bonds through their insurers. Fear of the unknown began to permeate throughout the financial system. For those seeking funding, the question wasn’t what rate this funding would cost them, but whether they could even get funding at all. This is what is commonly referred to as an old fashioned credit crunch.

The time has come for the Federal Reserve and the Central Banks around the world to again step in and diffuse the situation. Some steps have already been put into motion. The Federal Reserve has cut rates more aggressively than it has in decades. It is coordinating with central banks around the world to limit the damage. Creative new techniques are being used to aid liquidity in the credit markets. The executive and legislative bodies have put aside much of their bickering to pass a fiscal stimulus package. Central to all this is the mission of making sure the U.S. consumer doesn’t succumb.

While it is doubtful anyone can say with great confidence when we will see normalcy return to the system, it is in our opinion important to remember that economies around the world are still growing and U.S. corporate balance sheets, outside the financial sector, are in good shape. U.S. equities are trading at multiples that are close to historic averages. Interest rates are historically low and we believe about to get lower. While currently painful, we believe that equities are attractively priced compared to fixed income at this time. We are cautiously adding to large cap equities that do not require large amounts of leverage and derive a large amount of their earnings in non-dollar currencies.

At times like these, we think the most important strategy is to remain focused on long-term goals. We must not let short-term events, even ones as substantial as the credit problems we face today, deter us from achieving your long-term goals.

At Sequoia, we rely on the financial planning process to keep us focused on your long-term goals and use it as a way to continually evaluate the appropriate asset mix for your portfolios. We take into consideration your risk tolerance, your financial needs, and the current market environment to develop, monitor and maintain a portfolio that will be most appropriate to keep you on track toward your long-term goals.

Financial plans serve several important functions for our clients, particularly in times of market volatility.

• We use the plan to illustrate that the returns during any one-year period have a minimal impact on achieving long-term objectives. Our goal is to align your financial resources in accordance with your long-term goals. This allows us to stay invested in difficult short-term declines, and potentially take advantage of short-term weakness.
  
  
• We use the plan to evaluate if you are still on track. Savings goals, spending limits, retirement or business sale decisions are not one-time discussions to be implemented and put on the shelf. The world is changing; your objectives and priorities change. We develop your financial plans in order to keep your financial and personal goals moving in the same direction and at the same pace.