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October 10, 2008

Dear Client and Friends,

Third Quarter 2008 Financial Asset Performance

The Lehman Brothers Aggregate Bond Index was down 0.5%. The S&P 500 U.S. Stock Index, a representative index of large companies, was down 8.4%. The Russell 2000, a representative index of small companies, was down 1.1%. Foreign equities, as represented by the MSCI EAFE Index, were down 20.6%.

We have included a Morningstar table of performance figures for many of the mutual funds in your portfolio plus some comparative market indices noted by the prefix “Idx.”

The Financial Crisis

We are in the midst of a perfect storm that threatens global financial stability. For an explanation of the causes, we refer you to our September 24, 2008 letter. The more this crisis unravels, the more we find out how dangerous a combination of mathematical modeling, greed, lack of effective internal and external oversight, the absence of common sense, and a lack of respect for the well being of others can shake the very foundation of our financial system.

We are extremely upset by the events unfolding and respect the view of many Americans who did not want to pass the bailout plan, now known as the Emergency Economic Stabilization Act of 2008. However, taking some action was necessary and only time will tell if the plan will be enough to return stability to the markets.

At the core of the crisis is falling housing prices and securities tied directly or indirectly to mortgages. The only effective cure for an asset bubble is for asset prices to revert back to reasonable levels. The longer you artificially hold up inflated asset prices, the longer it takes for markets to fully recover.

The Economy

What started out as a financial crisis in the credit markets has now spread to the broader based economy. As a result, we will clearly be in a recession, the length and depth of which will determine its severity. Consumer spending comprises 70% of the U. S. economy and consumers have been doing far too much spending and far too little saving for far too long. If and when the American public ever comes to the realization that their habits must change, lower consumption will lead to lower profits for domestic companies catering solely to the U.S. consumer.

The economic engines of emerging markets and countries such as China, Russia, India and Brazil, still have the wind at their backs, growing a consumer base with extensive purchasing power. The companies that can compete and provide those countries with goods and services should prosper.

The Stock Market

Benjamin Graham, the fabled value investor and mentor to Warren Buffet, once said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” In other words, in the short run prices for marketable securities reflect human behavior and reactions to current events. In the long run, however, market prices will reflect fundamental values.

Stocks provide some protection against the loss of purchasing power (inflation) by providing returns ultimately linked to a growing economy. We believe that any setback in global economic growth will be temporary as the world’s consumers fuel significant growth.

The Bond (Credit) Market

There are times when the bond market serves to cushion stock market declines. Unfortunately this is not one of those times. This is a financial crisis with roots in the credit (bond) markets. As a result, the prices of some good fixed income investments are being dragged down along with those of questionable value, such as sub-prime mortgages. Money that is flowing into U.S. Treasuries from other fixed income investments will reverse course when the crisis abates, resulting in price recoveries in many segments of the bond market.

Confidence must be restored to the commercial paper money markets, which provides short term loans to businesses, as well as within the interbank lending system, before any of the financial markets return to normal. We believe that world leaders and banking officials will eventually restore the necessary order and confidence.


While the financial crisis has spread to overseas markets, we still believe in an overall theme that rewards a global approach to investment diversification.

We also still believe, as we have stated many times, that future returns from stock and bonds will be below average for several years. This increases the importance of diversification and the need to search out investment opportunities in some non-traditional areas. This approach will certainly result in times where portfolios decline. However, we are convinced that this approach is superior to limiting investments to the most conservative choices.

Our job during these difficult times is to remind clients of the importance of a disciplined approach to investing. This is not a time for an emotional reaction to market turbulence. Cooler heads often prevail. The managers that run the mutual funds we own and recommend will be making purchases at attractive prices. Someone once said: “You make your money in bear markets; you just don’t know it at the time.”

Dalbar, Inc., a financial-services market research firm, periodically reviews the performance of mutual fund shareholders. Their most recent survey was completed in 2004 and covered the previous twenty years. They examined the flows into and out of mutual funds.

Those investors who tried to time the market, with frequent sales and purchases in an attempt to maximize their returns, lost 3.3% per year on average over that 20 year span. During the same period, the S&P 500 Index of large company U.S. stocks returned an average of 12.98%. The average mutual fund investor, buying when they saw stocks rising and selling when they feared losing, averaged a return of 3.51%. Clearly, the lesson here is not to abandon a well thought out investment plan when faced with panic selling.

What actions are we taking now?

We are keeping abreast of financial, economic, and market news to deepen our understanding of this crisis.

We are tapping into conference calls with money managers we respect the most for their thoughts and strategies.

We are exploring investment opportunities to supplement the opportunistic buying we know is taking place within the funds we own and recommend.

We are recommending the reversal of Roth IRA conversions made in 2007 when market prices were higher. This will result in amending tax returns and receiving refunds of taxes paid on those conversions. By law, you have until October 15, 2008 to re-characterize those 2007 conversions. You have until a later date to actually file for the refund.

We will be reviewing portfolios for selective tax loss selling prior to year and banking those losses to offset future gains.

We continue to work daily to earn your trust and confidence.



Best regards,

Vincent A. Schiavi, CFP®, CPA/PFS


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