Jacob D. Benedict's Perspective on the Current Economic Crisis

Jacob D. Benedict

AMI Investment Management

A Perspective on the Current Economic Crisis | March 2009

Disclaimer
This presentation is not meant for distribution
The majority of graphs that represent data based
upon current stock market levels included in this
presentation were calculated in the first half of
March 2009, when the S&P traded in the
approximate range of 675-780 (a number of them
employ the S&P closing level of 778.12 on March 17,
2009); please see relevant footnotes for further
disclosure


As in every crisis, the main cause was far too large a mass of credits –
that is, of debts – for the amount of cash in which they were redeemable.
Trade and speculation had long been so active, and too often recklessly
expanded, that this disproportion had become dangerous, and a menace
to our safety…a serious reaction, a serious revulsion, was inevitable
unless we moderated our pace and mended our ways…I could foresee
that this vast and growing disproportion between the volume of credits
and cash would finally lead to collapse…

In every panic very much depends upon the prudence and control of the
money lenders…this is tantamount to saying that all depends on the
calmness and wisdom of the banks…if they lose their heads and
indiscriminately refuse to lend, or lend only to the few unquestionably
strong borrowers, the worst forms of panic ensue.

- Explanation of the 1907 Panic by Financier Henry Clews in Fifty Years
in Wall Street, published in 1908


[C]onsider a turkey that is fed every day. Every single feeding will firm
up the bird’s belief that it is the general rule of life to be fed every day by
friendly members of the human race…the Wednesday before
Thanksgiving, something unexpected will happen to the turkey. It will
incur a revision of belief.

- Nassim Taleb in The Black Swan


Organization
[A] The Anatomy of a Financial Crisis
[B] Where Do We Go From Here?
[C] Thoughts on the Stock Market and Portfolio
Management


Themes
[1] While this financial crisis may be more severe, it is not
historically unprecedented
[2] Our nation, both consumers and firms, have been
leveraging themselves for over a decade; it is unclear how
painful the deleveraging process will be, but at some
point it must occur
[3] In order for the economy to work, the financial
systems (i.e. the credit markets) must be restored to
health


[A] Anatomy of a Financial Crisis


A well known tradition in monetary economics…tells the tale of a
business cycle upswing by what Fisher called [1] a displacement (an
exogenous event that provides new profitable opportunities for
investment) leading to an investment boom financed by bank money
(and accommodative monetary policy) and by new credit instruments –
financial innovation. The boom leads to a state of euphoria where
investors have difficulty distinguishing sound from unsound prospects
and where fraud can be rampant. It also can lead to a bubble
characterized by asset prices rising independently of their
fundamentals. [2] The boom inevitably leads to a state of
overindebtedness, when agents have insufficient cash flow to service
their liabilities. In such a situation a crisis can be triggered by errors in
judgment by debtors and creditors in an environment changing from
monetary ease to monetary tightening. [3] The crisis can lead to fire
sales of assets, declining net worths, bankruptcies, bank failures and an
ensuing recession.

- Michael D. Bordo, Rutgers University and NBER


[1] The Boom
Exogenous shock = dot-com crash
Desire for real, income-producing assets (real estate)
Easy money = historically low interest rates
Greenspan and Fed fight the “deflation threat”
Overindebtedness = mortgages to the roof
Securitization markets and derivative products
Unsound prospects and fraud = Ninja loans
Assymetric systems and moral hazard
The evidence = BUBBLE


Stocks, Housing, Int Rates During the Dot-Com Crash
1.60 7.0%

1.40 6.0%

1.20
5.0%

Federal Funds rate
Value of $1.00

1.00
4.0%
0.80
3.0%
0.60

2.0%
0.40
From Mar-00 to Oct-02:
1.0%
S&P 500 fell -49.2%
0.20
CSXR-10 rose +37.1%
0.00 0.0%

S&P 500 CSXR-10 Fed Funds Rate

AMI Investment Management *Source: S&P, Yahoo, Federal Reserve

Real Mortgage Rates (Mtge - TTM Infl)
12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%

AMI Investment Management *Data through March 5, 2009; Source: Federal Reserve

Comparitively High Real Estate Income Yields
12%

10%

8%

6%

4%

2%

0%
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

ICF Dividend Yield 10-yr Treasury Rate

AMI Investment Management *Data through March 2, 2009; Source: Yahoo, Federal Reserve

[2] State of Overindebtedness
Households borrow beyond their means, spurred by
financial innovation and excessive risk-taking
Growth of securitization provides consumers a new
source of funds
Financial institutions employ leverage to magnify
earnings
Derivative products held on the books, difficult for
regulators and investors to gauge risk
Local and federal governments continue to run large
deficits


Asset Backed Securities – Securitizing Mortgages
Tranche A (senior)
Asset #1 Principal = $75 million
Asset #2 Return = 6%
Asset #3 Rating = AAA Big Deal
…
…
… Tranche B (mezzanine)
… Principal = $20 million
… Return = 10%
… Rating = BBB
…
…
Asset #N
Tranche C (equity)
Principal = $5 million
Principal = $100
Return = 30%
million
Rating = NR


45%
Sources of Funding:
40%
1. Banks
2. GSEs
35%
3. Securitization Markets
30%

25%

20%

15%

10%

5%

0%
2000 2001 2002 2003 2004 2005 2006 2007*

Alt-A/Suprime as a % of Total MBS Outstanding Alt-A/Suprime as a % of Total MBS Originated

*2007 represents 1st quarter for amounts outstanding and 1st seven months for amount originated

AMI Investment Management *Source: Federal Reserve, UBS, Gary Gorton

Shadow banks = hedge funds, investment banks, insurance companies
and structured financial conduits (i.e. buyers of securitized products)

AMI Investment Management *Source: Bianco Research, Pimco

Credit Default Swaps
Still, with just over 12% of the mortgage market
comprised of subprime loans, how did it bring down
the entire economy?
Credit Default Swaps (CDS) allowed everyone to get
into the game
Valued at over $40 trillion (notional) at FYE 2007, nearly
equal to the total market cap of all publicly traded
companies in the world as of Aug-08 (note: not all
subprime)
What is a CDS? – a “life insurance” policy for
bondholders
The catch – it doesn’t have to be your life


The Problems with CDS
Don’t behave the same way as life insurance policies
(AIG)
The models are flawed – correlations change in times of
crisis; the “turkey problem” and default rates
Instead of lessening risk, they dramatically increased
systemic risk
Counterparty web difficult, if not impossible, to
entangle…everybody depends on everybody
Introduces leverage on company’s balance sheets
that is extremely hard for investors to detect and
monitor
No system for comprehensive regulation

The Danger of Leverage
Upside Downside
Equity Structure: Unleveraged Leveraged Unleveraged Leveraged
Debt, 6% 0 700 0 700
Equity 1,000 300 1,000 300

Income Statement:
Revenue 100 100 50 50
Expenses 25 25 20 20
EBIT 75 75 30 30

Interest Expense 0 42 0 42
EBT 75 33 30 -12

Taxes (35%) 26 12 11 -4
Net Income 49 21 20 -8

Return on Equity 4.9% 7.2% 2.0% -2.6%

Room for Asset Devaluation -100.0% -30.0% -100.0% -30.0%


Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system.
They have made it almost impossible for investors to understand and analyze our largest commercial banks and
investment banks…

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting
future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that
would come close to describing and measuring the risks in a huge and complex portfolio of derivatives.
Auditors can’t audit these contracts, and regulators can’t regulate them…

Derivatives contracts…often go unsettled for years, or even decades, with counterparties building up huge
claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of
financial statements though these items will not be validated for many years. Additionally, a frightening web of
mutual dependence develops among huge financial institutions. Receivables and payables by the billions
become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as
well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal
disease: It’s not just whom you sleep with, but also whom they are sleeping with.

Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it
assures them government aid if trouble hits. In other words, only companies having problems that can infect
the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome,
I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for
ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence
simply won’t do; it’s mindboggling screw-ups that are required.

- Warren Buffett in the 2008 Berkshire Hathaway Annual Report


The Deterioration in Mortgage Processing and Quality
A focus on quantity, not quality by mortgage brokers and
bankers
No retention of default risk
Down to the department level
Assymetric payoffs for bankers
A reliance on complex models, historical data and credit
approval automation
A supposed “win-win” for the banks, whether the homebuyer
defaults or not, as long as housing prices continue to rise
Fraudulent and predatory lending practices
e.g. – NINJA loans
Option ARMs
A dangerous self-reinforcing cycle

And it is not only
households…it is
firms, states,
municipalities
and the federal
government

AMI Investment Management *Source: Advisor Intelligence

Real Housing Prices and Year Over Year Change
250.00 0.2

0.15

200.00
0.1

0.05
150.00
0

-0.05
100.00
-0.1

-0.15
From Feb-97 to Dec-05:
50.00
Nominal Total Returns: 184.6% -0.2
Nominal Annual Returns: 12.6%
0.00 -0.25

Real CSXR-10 Index Year Over Year Change

AMI Investment Management *Data through December 31, 2008; Source: S&P

[3] The Crisis
Securities tied to mortgage loans had seeped into every corner
of the system
Default rates began to trend much higher then the models
called for (partly as the result of the deterioration in quality
and ARMs adjusting)
Rating agencies begin to downgrade mortgage-backed
securities, causing a fall in prices
As prices fall, firms “mark assets to market” and post losses,
requiring additional capital and collateral
The call for additional capital and collateral further threatens
the financial standing of firms
Fall in real estate prices effects consumer spending, further
pressures default rates


Important Events
3.16.08 – Bear Sterns acquired for $2 a share by JP
Morgan, with backing from the Federal Reserve
7.11.08 – IndyMac seized by the FDIC
9.7.08 – Federal takeover of Fannie Mae and Freddie
Mac
9.15.08 – Lehman Brothers files for bankruptcy
9.17.08 – The Reserve Primary Fund breaks the buck
9.17.08 – The Federal Reserve lends $85 billion to AIG
9.25.08 – Washington Mutual is seized by the FDIC
10.3.08 – President Bush signs into law the Emergency
Economic Stabilization Act
10.6.08 – Stock market has worst week in 75 years

AMI Investment Management *Source: JP Morgan

10-yr Levels on S&P 500
1,800

1,600

1,400

1,200

1,000

800

600

400
Last 10 Years:
Nominal Total Returns: -40.0%
200
Nominal Annual Returns: -5.0%
0

AMI Investment Management *Data through March 17, 2009; Source: Yahoo

Still in the thick of it…
The importance of credit and faith in counterparties
The threat of deflation
Mark-to-market and continuing debt-deflation spiral
The massive de-leveraging cycle


AMI Investment Management *Source: Wikipedia

Spread Between 10-yr Treasuries and Aaa, Baa Corps
7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

-1.00%
Aaa/10-yr Spread Baa/10-yr Spread

AMI Investment Management *Data through March 5, 2009; Source: Federal Reserve

[B] Where Do We Go From Here?


The first major financial crisis of the 21st century involves esoteric
instruments, unaware regulators, and skittish investors. It also follows
a well-trodden path laid down by centuries of financial folly. Is the
“special” problem of sub-prime mortgages this time really different?

Our examination of the longer historical record, which is part
of a larger effort on currency and debt crises, finds stunning
qualitative and quantitative parallels across a number of
standard financial crisis indicators.

- Carmen M. Reinhart, University of Maryland and Kenneth S. Rogoff,
Harvard University


Reinhart/Rogoff Data
Construction of a comprehensive historical database
Includes emerging markets – may react more
severely

Average Decline Average Duration
Entire Data Set
Comps U.S. Comps U.S. US Data as of

Fall in Real Housing Prices 35.5% 31.6% 6.0 years 3.1 years 31-Dec-08
Fall in Real Equity Prices 55.0% 51.2% 3.4 years 1.4 years 17-Mar-09
Increase in Unemployment Rate 7.0% 3.7% 4.8 years 1.9 years 01-Feb-09
Fall in Real GDP per Capita 9.3% 2.1% 1.9 years 0.5 years 31-Dec-08
Increase in Real Value of Govt Debt 86.0% 31.3% 16-Mar-09

AMI Investment Management *Source: Reinhart and Rogoff, Federal Reserve, US Treasury

Other Comparisons…

Great Depression (1929)
Depr U.S. Depr U.S. US Data as of


Japan (1992)
Depr U.S. Depr U.S. US Data as of


AMI Investment Management *Source: Reinhart and Rogoff, Federal Reserve, US Treasury

1.8

1.6

1.4
Std. Unemployment Rate

1.2

1.0

0.8

0.6

0.4

0.2

0.0

# of Months Since Market Bottom

Jun-49 Oct-57 Jun-62 Oct-66 May-70 Oct-74 Aug-82 Oct-90 Oct-02

AMI Investment Management *Source: Federal Reserve

Number of Months Between Market Bottom and
Maximum Unemployment
30

Average = 12.4 months
Median = 10.0 months
25

20

15

10

5

0

AMI Investment Management *Source: Federal Reserve

Markets and Recessions
On average, markets bottom 6 months before the end of the recession;
market almost always begins to advance strongly 3 months before the end of
the recession

AMI Investment Management *Source: John Hussman

The Government’s Blueprint
[1] Stave off financial crisis and massive panic
[2] Restore the health of the credit system
[3] Restore economic growth (consumption)
[4] Prevent future crises


1.20
Great Depression, peak to trough, S&P 500 falls nearly 90%
As of 3.17.09, S&P 500 has fallen just over 50%
1.00
Value of $1.00 in S&P 500

0.80

0.60

0.40

0.20

Would have to fall an additional 69% to match the Depression
0.00

Number of Months Since Market Peak

Great Depression Current Crisis

AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller, Yahoo

Mistakes of the Depression – Federal Reserve
#1: Tightened monetary policy in 1928 despite economic weakness
(meant to purge speculators)
#2: Adherence to the gold standard forced further tightening of
interest rates
Economists later discovered that the length of time a country struggled
with depression was directly related to how long they maintained the gold
standard
#3: Failure of Federal Reserve officials to recognize the importance
of REAL interest rates as they eased policy in 1932
#4: The Federal Reserve’s ongoing neglect of the national banking
system

Also at issue: Smoot-Hawley Tariff Act
Current Federal Reserve Chairman Ben Bernanke is a renowned
scholar of the Great Depression
AMI Investment Management *Source: Milton Friedman, Anna Schwartz, Ben Bernanke

The Tale of Two Crises: Japan and the Nordic Countries
In the early 1990’s, both Japan and the Nordic countries
suffered severe recessions (in the midst of a global recession)
precipitated by an asset bubble in real estate
In Sweden (the crisis also occurred in Norway and Finland),
the crisis began in 1991, but was (relatively) quickly resolved
and did not have a “major impact on economic developments
from 1993 onward”
By 1997, all assets taken over by the state had been sold, and some
claim the country earned a profit
In Japan, the country experienced the well-known “lost
decade” following the crisis
By the late 1990’s, non-performing assets comprised 18% of GDP


Nikkei 225 - Japanese Stock Market
450
Hundreds

Since the Nikkei peaked in Dec-89, the
market has fallen 80%, nearly 8% per year
400

350

300

250

200

150

100

50

0

AMI Investment Management *Data through March 17, 2009; Source: Yahoo

Japanese Price-to-Peak Earnings

US peaked at
approximately
33.0x in 2000


Japanese GDP Growth

AMI Investment Management *Source: US Treasury

Swedish Approach
Comprehensive guarantees of depositors/foreign
counterparties
“Bank Support Authority” – arm’s length organization
designed to monitor process
Strategy for testing banks was developed and explained – if
worst case stress test deemed a bank insolvent, bank was
closed or merged in an orderly manner
Banks were forced to write down bad loans
Split into a “good bank/bad bank”, managed by AMC (RTC)
Strict valuation rules remained in effect
Govt did not take any specific measures to save non-financial
institutions and did not instruct banks on how to use money
Equity and debt holders were forced to share pain

AMI Investment Management *Source: Lars Heikensten

Japanese banks became heavily invested in loans backed by real estate as
collateral, as real estate prices soared. When the turn came and prices
cascaded downward, the collateral became inadequate. But instead of calling
the loans, as most Western banks would do, the bankers refrained. It took
years and many government bailouts before real estate prices stabilized and the
banking system returned to normal lending, with realistic estimates of bad
loans and, hence, capital…

There is no doubt in my mind today, as then, that an RTC-like
strategy invoked during the period of Japanese economic
stagnation, from 1990 to 2005, would have shortened the period of
adjustment and returned Japan to a normally functioning economy
years sooner…

What was the invisible economic force holding Japan back?...The missing force
was not economic; it was cultural. The Japanese had purposely accepted
hugely expensive economic stagnation to avoid a massive loss of face for many
companies and individuals. I cannot imagine U.S. economic policy following
such a track.

- Alan Greenspan in The Age of Turbulence


Japanese Approach
Continued to allow lax acctg standards and tolerant approach
to bank valuation; banks were not forced to recognize losses
Govt support was not conditional on improved risk
management practices; excessive risk-taking continued
Banks sat on bad debt, hoped situation would turn around;
“zombie companies” lingered on
10 years after initial crisis, govt focused on full disclosure and
improved practices – prompted a wave of write-offs
BoJ slow to cut rates (17 months); did not reach 0.5% until
mid-90’s; deflation worries persisted
Resolution and Correction Corporation formed in 1999 to
dispose of bad loans
The govt DID throw a lot of money at the problem


Resolution Formula (US?)
Prevent immediate crisis resulting from panic by
issuing guarantees and protecting the banking
system (yes)
Set-up a transparent process and independent
organization to implement policies (maybe)
Develop a rigorous approach to identify bad banks
(maybe)
Segregate “good bank” from “bad bank”; recapitalize good
bank, transfer bad assets to AMC (not yet)
Remain firm on accounting rules (so far)
Force equity and debt holders to share pain (not
really)

Institutions that cannot survive without continual provision of public funds should
be taken into receivership, their assets should be restructured to better ensure
repayment, their stockholders should be wiped out, bondholders should take a
major haircut, customer assets should (and will) be fully protected, and these
institutions should be re-issued to the markets when the economy stabilizes…

Unless Congress is actually willing to commit that amount of public funds to
defend the bondholders of mismanaged financials so they can avoid any loss, this
crisis simply cannot be addressed through bailouts. Bondholders have
to take losses. Debt has to be restructured (and can be restructured in
ways that largely preserve the present value of the obligations). There is
no other option – but the markets are going to suffer interminably until
our leaders figure that out…

Why should the American public (and eventually our children) foot the bill to
protect the full interests of corporate bondholders? Has everybody gone completely
insane, or is it simply not clear that the sum total of the government's response to-
date has been to squander public funds to defend private bondholders?

- John Hussman in Weekly Market Comment


The Situation

Before the Crisis:
Good Assets 90 Deposits 80
Bad Assets 10 Debt to Bondholders 17
Shareholder's Equity 3
Total Assets 100 Total Liabilities and Equities 100

After the Crisis:
Shareholder's Equity -2


Equity is effectively a
“call option” on company

AMI Investment Management *Source: JP Morgan

Government Proposals

Govt Buys Troubled Assets:
Proceeds From Sale to Govt 5 Debt to Bondholders 17
Shareholder's Equity -2

Govt Provides Capital Junior to Debtholders:
Proceeds from Govt Infusion 5 Govt Pfd Equity 3


Alternative Approaches
Govt Provides Capital Senior to Debtholders:
Bad Assets 5 Govt quot;Super-bondquot; 5
Proceeds from Govt Infusion 5 Debt to Bondholders 15

Good Bank:
Bad Assets 0 Debt to Bondholders* 10
Proceeds from Govt Infusion 5 Govt Equity* 5
Proceeds from Private Infusion 5 New Shareholder's Equity 5

*Govt organization proceeds with monetization of bad assets; proceeds accrue to govt, bondholders


We're setting the stage for when we come out of this of a massive
inflation holocaust.
-Famed Investor Jim Rogers on CNBC

Economic medicine that was previously meted out by the cupful has
recently been dispensed by the barrel. These once-unthinkable
dosages will almost certainly bring on unwelcome aftereffects.
Their precise nature is anyone’s guess, though one likely
consequence is an onslaught of inflation. Moreover, major
industries have become dependent on Federal assistance, and they will
be followed by cities and states bearing mind-boggling requests.
Weaning these entities from the public teat will be a political challenge.
They won’t leave willingly. Whatever the downsides may be, strong and
immediate action by government was essential last year if the financial
system was to avoid a total breakdown.



Government spending and inflation…


What are the risks?
Federal Reserve will struggle to contain inflation (deflation is current threat)
Currently not an issue because of the depressed multiplier
Massive government borrowing shifts bad debt from corporate balance
sheets to public balance sheets, where it can only be serviced through
increased taxes or inflation
Government borrowing may “crowd out” private borrowing, force up long-term
interest rates
Will Japan, China and the rest of the world continue to finance the US
government? (20%/50%)
The risk of inflation and steep government debt may pressure the US dollar
Is it logical to approach our current economic problem, created by the over-
use of debt, by employing more debt?
What does a de-leveraged American economy look like?
What kind of system will we create? More governmental regulation and
intervention; private sector reliance on the state?


First of all, banks and investment banks and insurance companies have
been failing for hundreds of years. Yes, we would've had a terrible two
years. But you're dragging out the pain. We had 10 years of the
worst credit excesses in world history. You don't wipe out
something like that in six months or a year by saying: quot;Oh,
now let's wake up and start over again.quot;

They should be allowed to go bankrupt. Why should American taxpayers
put up billions to save a few car companies? They made the mistakes!
We didn't make the mistakes! I'm sure they'll give them the money, but
I'm telling you, it's a mistake. It's a horrible mistake.

- Famed Investor Jim Rogers in BusinessWeek


AMI Investment Management *Source: Advisor Intelligence

AMI Investment Management *Source: GAO (2008)

AMI Investment Management *Source: GAO (2007)

How do we prevent a repeat?
Guard against assymetric payoffs
Eliminate moral hazard
Attempt to improve transparency so that investors,
counterparties and regulators can evaluate firm risk
Centrally regulate derivative markets
Understand the limitations of models and the
existence of “black swans”
Remove political pressures on consumption
Still, free markets are always susceptible to financial
crisis brought on by debt, exuberance and often
times financial innovation

[C] Thoughts on the Stock Market
and Portfolio Management

Managing a Portfolio in Today’s Environment
Is the US stock market fairly valued? Will it go
lower?
Diversification and Modern Portfolio Theory
What risks must the investor guard against?


The PE Multiple

Price
Earnings

For $X, how many dollars of earnings can I
purchase?
Easy to measure price, but how do we measure
earnings?
TTM, Forward, full cycle, peak…
Perhaps necessary to evaluate other market
valuation measures


S&P 500 TTM PE
50

45

40

35

30

25

20

15

10

5

0

TTM PE Average

AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller

Forward P/E
Duration Price Forward P/E Proj. Earnings
Peak Trough in Years Decline Peak Trough $40 $64
Sep-29 Jun-32 2.8 86% 22.0 10.7 428 685
Mar-37 Apr-42 5.1 60% 28.1 13.4 536 858
May-46 Jun-49 3.1 30% 33.6 10.7 428 685
Aug-56 Oct-57 1.2 22% 26.9 24.5 980 1,568
Dec-61 Jun-62 0.5 28% 38.5 26.3 1,052 1,683
Feb-66 Oct-66 0.7 22% 31.4 25.3 1,012 1,619
Nov-68 May-70 1.5 36% 31.7 21.9 876 1,402
Jan-73 Oct-74 1.7 48% 22.8 11.3 452 723
Nov-80 Aug-82 1.7 27% 10.9 8.5 340 544
Aug-87 Dec-87 0.3 34% 18.0 10.3 412 659
Jul-90 Oct-90 0.3 20% 16.9 14.4 576 922
Mar-00 Oct-02 2.6 49% 26.9 15.9 636 1,018
Average 1.8 39% 25.6 16.1 644 1,030
Median 1.6 32% 26.9 13.9 556 890
Best 0.3 20% 10.9 26.3 1,052 1,683
Worst 5.1 86% 38.5 8.5 340 544

Current Bear Market:
Oct-07 Mar-09 1.4 50% 22.4 10.6

AMI Investment Management *Data through March 17, 2009; Source: Barron’s

Shiller Real P/E Ratio - Real Price/Real Trailing 10-yr Earnings
50.0
Percentile: 36.26%
45.0 Average P/E(10): 16.34
Current P/E(10): 13.57
40.0
If P/E(10) = 7.50 - 10.00…
35.0 S&P 500 = 430 – 575

30.0

25.0

20.0

15.0

10.0

5.0

0.0

P/E(10) Current Average


40th Percentile

50th Percentile

AMI Investment Management *Source: William Hester, March 2009

1881-1999
22.00%
21.00%
20.00%
19.00%
18.00%
17.00%
16.00%
15.00%
14.00%
Next 10-yr Total Return

13.00%
12.00%
y = -0.0049x + 0.168
11.00%
R² = 0.2909
10.00%
9.00% Series1
8.00%
yr

Linear (Series1)
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 45.00
-2.00%
-3.00%
-4.00%
-5.00%
Shiller's Trailing 10-year Real P/E Ratio


1950-1999
21.00%
20.00%
19.00%
18.00%
17.00%
16.00%
15.00%
14.00%
Next 10-yr Total Return

13.00%
12.00%
y = -0.0057x + 0.2045
11.00%
R² = 0.5751
10.00%
9.00%
Series1
8.00%
7.00%
yr

Linear (Series1)
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 45.00
-2.00%
-3.00%
-4.00%
-5.00%
Shiller's Trailing 10-year Real P/E Ratio


EPS Growth Since 1951 - Logarithmic Scale
100.00
EPS growth has consistently
averaged 6% per year

y = 1.9928e0.058x
R² = 0.954
10.00
EPS
Expon. (EPS)

1.00

AMI Investment Management *Source: Robert Shiller

Hussman Model for Predicting 10-yr Equity Total Returns
25.00%
P/E = 7 - 5.41%
P/E = 11 - 8.93%
P/E = 14 - 11.07%
20.00%
P/E = 20 - 14.52%

15.00%

10.00%

5.00%

0.00%

-5.00%

-10.00%
P/E = 7 P/E = 11 P/E = 14 P/E = 20 Actual

AMI Investment Management *Data through March 17, 2009; Source: Robert Shiller, John Hussman

Grantham/GMO 7-yr Asset Class Real Return Forecasts - Feb-09
Assumes Infl = 2.5%
16.0%

2.3%
1.8% 3.7%
14.0%

2.3%
12.7% 12.7%
12.0%

10.8%
1.8% 1.8% 10.7%
10.0%

8.9% 8.9%
2.9%
8.0%

1.5%
6.0%
6.0%
5.7%

4.0%
2.4%

2.0%
1.8% 1.6%
0.9%
0.9%
-0.5%
0.5%
0.0%
0.2%
US Large US Small US High Intl Large Intl Small Emerging US Govt Intl Govt Emerging Inflation ST US Managed
Cap Equities Cap Equities Quality Cap Equities Cap Equities Market Bonds Bonds Market Indexed Treasuries Timber
Equities Bonds Bonds
-2.0%
Real Return With Active Mgmt

AMI Investment Management *Source: GMO

60th Percentile

70th Percentile

AMI Investment Management *Source: William Hester, March 2009

MPT and Diversification
Diversification is meant to reduce portfolio risk
without sacrificing return
Unfortunately, during times of financial crisis, asset
classes become much more correlated

AMI Investment Management *Source: Wikipedia

What Happened to Diversification?

2008
# Asset Class 31-Dec-07 31-Dec-08 Return ETF
1 Long-term US Govt Bonds 93.04 119.35 28% TLT
2 High Grade Corporate Bonds 104.84 101.65 -3% LQD
3 High Yield Corporate Bond 100.72 76.01 -25% HYG
4 Preferred Equity 41.50 29.21 -30% PFF
5 Large-Cap Equity 132.55 87.52 -34% DIA
6 Mid-Cap Equity 84.94 53.33 -37% IJH
7 Small-Cap Equity 75.90 49.24 -35% IWM
8 International Equity 78.50 44.86 -43% EFA
9 Emerging Markets Equity 50.05 24.97 -50% EEM
10 US Real Estate 79.14 44.18 -44% ICF
11 Gold 82.46 86.52 5% GLD
12 Commodities 56.23 35.19 -37% DJP

AMI Investment Management *Source: Yahoo

2008 Nominal Asset Class Returns (Price Only)
40%

30%

20%

10%

0%
1 2 3 4 5 6 7 8 9 10 11 12

-10%

-20%

-30%

-40%

-50%

-60%


Digging Deeper into Corporate Bonds…


Is Diversification a Fraud?
Diversification is an important tool in portfolio
management
However, it is a tool to be carefully applied; while “rules of
thumb” may help some investors, a more careful analysis
may be warranted
MPT optimization must take account of valuation levels
and forecasted volatility, as well the investor’s situation,
risk tolerance, goals and timeframe
Perhaps employ black swan events in analysis
MPT is more robust if truly uncorrelated asset
classes are included
The case for alternative assets


Portfolio Risks
Inflation – investors must guard against the damage
that inflation can wreak on a portfolio
Stock market volatility and uncertainty
The 1990’s are likely not the norm
Depressed valuations look to reward investors with good
returns, but there remains risk to the downside (DCA)
The de-leveraging cycle is necessary, and it is unclear
just how large of an impact this will have on
consumers and firms
Delaying this process does not make it go away


Amid this bad news, however, never forget that our country has faced far
worse travails in the past. In the 20th Century alone, we dealt with two
great wars (one of which we initially appeared to be losing); a dozen or
so panics and recessions; virulent inflation that led to a 21.5% prime rate
in 1980; and the Great Depression of the 1930s, when unemployment
ranged between 15% and 25% for many years. America has had no
shortage of challenges. Without fail, however, we’ve overcome them. In
the face of those obstacles – and many others – the real standard of
living for Americans improved nearly seven-fold during the 1900s, while
the Dow Jones Industrials rose from 66 to 11,497. Compare the record of
this period with the dozens of centuries during which humans secured
only tiny gains, if any, in how they lived. Though the path has not been
smooth, our economic system has worked extraordinarily well over time.
It has unleashed human potential as no other system has, and it will
continue to do so. America’s best days lie ahead.



About AMI Investment Management
AMI Investment Management is an independent registered investment
advisor. Established in 1995, AMI utilizes fundamental research and
analysis in managing equity, fixed income and alternative investment
portfolios for individuals and institutions. Our mission is to protect and
enhance the purchasing power of our clients’ assets.
Contact:
jacob@amiinvestment.com
260.347.1281


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