San Francisco Financial Planner, San Francisco Financial Advisor

The markets have been shaken by the subprime mortgage meltdown. It may be instructive to recall the market dislocation in the fall of 1987. At that time, decisive action by the U.S. Federal Reserve soothed the markets and bold investors who had purchased beaten down shares profited as markets recovered. Recent efforts by central banks around the world could have similar results in this market downturn. Many of the high-quality businesses we own or are looking to add to portfolios are now available at prices which are significantly below our estimates of their intrinsic value. Further, many of the managers across client portfolios have performed surprisingly well throughout the selloff and should be positioned for solid performance moving forward.

1987 was the culmination of substantial performance in the equity markets, especially international markets. Then suddenly in October the markets began to plummet. On October 19^th, the Dow Jones Industrial Average was down more than 22%! Why? In retrospect, experts agree it was the combination of high valuations, interest rate increases, excessive new issues, a loss of confidence from recent scandals and program trading. There was significant damage to individual and institutional balance sheets and creditworthiness of virtually every market participant was suspect. With credit markets seizing up, causing defaults, the entire financial system was on the verge of collapse. Sound familiar? The Federal Reserve acted as a source of liquidity to support the economic and financial system. Through open market operations, lowering the federal funds rate and other contingency plans with brokers and banks, stability was restored. Amazingly, in spite of the significant stock market losses, the economy continued to grow in both 1987 and 1988.

The hedge fund Long-Term Capital Management started to collapse in the early fall of 1998. This fund, managed by some of the smartest traders on Wall Street aided by a pair of Nobel laureates, had borrowed about $25 for every dollar of its own capital. The market wobbled as LTCM's huge holdings in equities, bonds and other securities were sold. It turned out that many other investors had placed similar trades, also funded with borrowed money. Once again, the Federal Reserve performed its duty, providing liquidity to the financial system and even cutting interest rates. Over the next six months, the market recovered with the Nasdaq soaring by more than 50 percent.

Now, as they did then, central banks are insuring a continuous flow of credit to good borrowers. There are still serious issues in money markets, mortgage-backed securities and other asset-backed securities. The debt and equity markets remain strained but it appears that sound assets are suffering unfairly. This may be the result of forced liquidations, complex derivative trades and the general rush to liquidity among institutions and hedge funds. In any case, there are signs that smart investors are returning to the markets and picking up undervalued securities. One example would be the recent 13F filing from Berkshire Hathaway which disclosed that Warren Buffet was adding to his existing positions in Wells Fargo and US Bancorp. More telling was the revelation that Berkshire Hathaway has added a $425 million position in Bank of America to its portfolio.

There can certainly be additional disclosures over the coming months that upset the markets. Unpleasant surprises are still possible and may result in lower prices into the fall. It is important to note that our firm and its clients presently have almost no exposure to the asset classes that are most affected. Those asset classes include low quality fixed income, mortgage-backed securities and speculative equity sectors such as emerging markets, home builders and mortgage REITS. All that being said, we believe that when we look back at this period in five years from now, it will look like a great time to be accumulating high quality assets.