Then we take each of these scenarios and try to create an economic framework that would allow for the outcome to be realized. We feel that this process is extremely important because it ensures that we keep an open mind about different possibilities. If we as advisors become fixated on a specific outcome and don’t analyze and hedge for alternative scenarios we would be not doing the job you paid us to do; preserve the assets you have entrusted to us and grow them at a reasonable rate of return.

Let us go through each of these four outcomes and the economic fundamentals that we believe need to be in place for the corresponding outcome to become a reality. Here are the economic indicators that we believe will play a major role in determining the final outcome:

First and the most dire outcome is where the substantial actions taken by the governments around the world may have only temporarily put a pause on the crisis. This would mean we are still in the middle of a massive bear market and deleveraging will once again resume once the stimulus and fiscal policies wear off. In this scenario the government’s intervention is masking the true economic pain being inflicted on the private sector and at some point the ability for the government to borrow money to alleviate the pain in the private sector will run out. At this point we would have another wave of foreclosures from both residential and commercial mortgages. Banks would fail, unemployment would get over 15% and real GDP would contract to levels not seen since the Great Depression. This outcome is attributed with a probability of 5% as we consider it highly improbably given the willingness from governments to do whatever is necessary to prevent another panic. Currently there are numerous policies in place to support the banking sector to prevent failures, but in the end this is completely in the hands of the Fed, FDIC and Treasury and unfortunately we cannot speak to their future intentions.

The most probable scenario to us is that we are trending towards a ‘new normal’ and it will be a jagged ride to reach equilibrium. By jagged we are of course referring to a highly volatile market. Over the last decade there has been a substantial amount of capital traveling around the world. This capital has led to over investment in capacity. Growth prospects were based on the endless spending from the US consumer and their ability to tap their assets to fuel it. Now that the assets have deflated and the consumer finds themselves overleveraged, this capacity will cause substantial problems on the road to finding a new equilibrium.

Let us use Las Vegas as an example of excess capacity and how several steps must be undergone to arrive at the eventual bottom of the corrective cycle. Vegas over the years borrowed billions of dollars to build more hotel rooms on the strip (excess capacity). Now that demand is down considerably the casinos are in a bit of a bind. They could all keep their prices up and hope that there is enough revenue to cover their expenses and interest payments. It is more plausible though that at some point the weakest player will be unable to cover their operating and debt expenses, leading to bankruptcy. Now the new entity that emerges from bankruptcy will have a lower debt load and be able to cut the cost of hotel rooms while staying profitable. This will now cause the other players to cut their prices or go bankrupt. The chain of events that is required to reach the eventual market clearing price for the hotel rooms could take several years to play out. Initially all hotels probably knew how much they needed to charge to fill all their rooms, but their current capital structure would not allow them to cut it to that level. These business operators will wait until they are forced to make these challenging decisions.

The second best outcome would be for us to have reached the “New Normal” that Bill Gross has referred to in his July Investment Outlook. This new paradigm includes slower growth due to increased savings and debt repayment over the next few years. If we have indeed reached the “new normal” then we can expect most economic indicators to have bottomed, but future growth prospects will be minimal. Even with slow growth this outcome could expect stocks and bonds to be up, while keeping commodities at bay. We attributed this outcome with a 15% probability since the possibility is higher than the two most extreme scenarios but still remains highly improbable.

Then there is the last and best outcome which would require us to pretty much resume the economic growth that we experienced from 2003-2007. Housing prices would stop declining on a national level. Unemployment rate would start to decline from the current rate of 9.5% and this combined with a decreasing savings rate should spur consumer spending. The most important factor would require that access to credit return to the levels before the credit crunch. Of course with growth resuming, stocks and commodities would rally substantially. Bonds spreads would tighten but the Fed would probably have to raise interest rates muting overall bond returns. This outcome is attributed with a probability of 5% since we believe it would require a substantial change in lending standards. This change in lending standards, although possible, is highly improbable.

If you apply this across all industries and the world then the highest probability outcome is that we are still on this road to the new normal. The current rally has been fueled by the speculation that growth is right around the corner and these second derivative improvements may be able to push the stock market higher and possibly even into the end of this year. However we feel that these investors will be disappointed when they realize that profit levels and economic activity will not return to the levels that we enjoyed before the credit crisis. That is why we believe that there is a 75% probability that this is the scenario we are looking at and a majority of our efforts will be put to achieving a reasonable level of return on your capital while trying to avoid the whipsaw activity of the overall market.

In the end we use this tree as part of our process to provide you with an investment strategy that takes advantage of the highest probability outcome, while at the same time being completely cognizant of the alternative possibilities. We then create contingency plans to react as necessary or build hedges into the portfolio to provide additional protection.

We thought it was important to share our thought process with you to make sure that you know we are not fixated on any specific outcome. Part of having this multi-layered approach is to make sure we look at the economy from different points of view. By doing so we make sure we never have our blinders on. We hope this adds clarity to how we are approaching this extremely challenging investment environment. If you have any questions please feel free to call us.

Thank you,

Excelcia Financial Group