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Have We Hit the Bottom Yet?

By wmadministrator

When talking with individuals and corporations about the future of the capital markets, the most frequent question that I have received since January is, “Do you think we have hit bottom yet?” My answer provides both bad and good news. First the bad news: The bear market is likely to continue for a couple more years because de-leveraging is a long and painful process. Now for the good news: Bear markets can create enormous opportunities.

The painful process of De-leveraging
When you borrow money against your existing assets to buy more assets, this is described as using financial “leverage.” Leverage can be extremely profitable during times of asset price appreciation. But there is a downside to leverage, especially when the prices of assets, such as real estate, start to fall. The amount of downside is usually in direct proportion to the amount of leverage.

Unfortunately, the entire U.S. financial system – everyone, even consumers’ banks and the government-sponsored entities (GSEs) – used enormous amounts of leverage to fuel our insatiable appetite for debt. For example, before the sub-prime debacle began to unwind, the typical investment bank had leverage ratios of 30:1. Even more troubling is the fact that the GSEs – Fannie Mae and Freddie Mac – both have leverage ratios that exceed 60:1.

Therefore, it will probably take several years before the painful process of de-leveraging to sustainable levels has taken place. In the meantime, the U.S. economy is likely to endure a sustained period of recession.

Embracing the bear market
Some economists would argue that it is often “darkest before the dawn.” Indeed, in the past, our country has produced some of its greatest transformation technology and other remarkable innovations during periods of economic recession. Therefore, I advise the following five strategies for embracing the current bear market:

1) Invest in the innovators: The next great economic transformation may be right around the corner. I happen to think the innovations will probably come in the transportation and energy fields. At the end of this century, the idea of a car operating on gasoline as the major means of transportation could seem as foreign as a horse and buggy does to us today. So the next time you feel glum about the current price of gasoline, consider that we may be the living through a landmark period in history where innovations will make gasoline stations a thing of the past.

2) Stay far away from financials: The only question that I receive as frequently as “Do you think we have hit bottom yet?” is “Should I double down on financials?” My answer is an emphatic “No.” It is my opinion that more banks will fail. The expression, “Don’t try to catch a falling knife,” has never rung more true. As tempting as they may look, just remember that a good portion of their business model has failed. Would you invest in a technology company whose product is VCR-related or a biotech company whose major blockbuster drug was just rejected by the FDA because it caused patients to get worse? If not, stay away from financials – as tempting as they may look.

3) Look to invest in countries and companies with little debt: As the United States continues its de-leveraging process, access to new debt may become scarce. We have already seen the tightening of certain lending standards and the requirement of higher equity ratios before banks and other investors will lend to borrowers. This means that those countries and companies with strong balance sheets will be in the best position to deploy research and development dollars and innovate the 21st century’s greatest creations.

4) Consider buying Treasury inflation-protected securities (TIPS): Over the last few decades, the Chinese government has kept its currency, the yuan, artificially low in value versus the dollar. As a result, the price we have paid for many of the goods at Wal-Mart and other U.S. stores has been artificially low. In effect, our prices have been subsidized by the Chinese government. While this has created an enormous current account surplus for the Chinese, it has simultaneously spurred huge trade deficits for the United States. I am hopeful that the yuan will eventually be forced to reflect market rates. This would result in a natural appreciation of the yuan versus the dollar and euro. It would also result in the rise of prices for our goods and services, aka inflation. So, investors may consider buying TIPS. These investments allow the principal of the investment to increase as inflation increases. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.

5) Invest in U.S. companies with exporting power: Unfortunately, a sustained period of inflation combined with a low-valued dollar may be the only way out of this current financial mess. Therefore, it is certainly not a given that the value of the dollar will rebound soon. In fact, I believe both the dollar and the euro will continue to slide versus the rest of the world currencies for the next several years. But the prospect of a weak dollar is not all bad. For example, a low-valued dollar may give U.S. companies pause when thinking about moving their operations abroad. In addition, the low-value dollar may give U.S.-based companies with exporting power a boost in profits.

Volunteering Pays
Good news, Kentuckians! You received some $2.1 billion in free economic contribution in 2007 from your fellow commonwealth residents in the form of volunteer work.

That’s according to a report by the Corporation for National and Community Service that details volunteerism in the nation on its  www.volunteeringinamerica.gov Web pages.

There you’ll find that Lexington ranks 15th nationally among 75 midsize cities and Louisville ranks 15th among 50 major cities. Deriving its numbers from a questionnaire attached to Census Bureau surveys, the Washington-base service found 36.7 percent of Lexingtonians and 30.7 percent of Louisvillians volunteer annually. The national rate is 26.2 percent.

Lexington bested the volunteer rates found in regional peer midsize cities such as No. 30 Dayton (32.1 percent), No. 38 Chattanooga (29.6 percent) and No. 61 Knoxville (24.8 percent). Louisville also came in ahead of the volunteerism rates found in No. 17 Cincinnati, No. 21 Indianapolis and No. 22 Nashville.

On average, Kentucky’s 955,000 volunteers dedicated 106.4 million hours of service per year (between 2005 and 2007). The estimated economic contribution of the volunteer hours served is $2.1 billion annually, according to information posted at VolunteeringInAmerica.gov.

The commonwealth ranked exactly in the middle – 26th – among the 50 states plus the District of Columbia. In Kentucky, more than 32,000 people participate in national service each year through 66 projects and programs that receive Corporation for National and Community Service support. That body will commit more than  $11.5 million to support Kentucky’s Senior Corps, AmeriCorps, and Learn and Serve America programs this year.

The corporation is the nation’s largest grantmaker that supports service and volunteering; it oversees Senior Corps, AmeriCorps, and Learn and Serve America, programs that provide Americans of all ages and backgrounds opportunities to express their patriotism while addressing critical community needs.

Thank you to all the individuals and businesses who give of their time and energy to help make our communities, state and nation a better place.

Oops: Third Time is the Charm
We really were not sampling the product from Buffalo Trace Distillery when this happened, but last month’s correction needs a correction. We hope this time to match Buffalo Trace master distiller Harlen Wheatley with his photo. Wheatley is on the left. That’s warehouse manager Ronnie Eddins in the center and retired master distiller Elmer T. Lee on the right. The occasion was the rolling out of Buffalo Trace’s six millionth barrel in May.

The Most Affordable Homes
Nicholasville homeowners find themselves in a very favorable cohort. According to Money magazine, the Jessamine County seat is the small city with the most affordable homes in the United States.

So what is “affordable”? The CNNMoney.com Web site reports that the median home price is a mere $70,000. Wow.

To qualify for consideration to be on the list, a town had to have at least 100 homes sales inside city limits in 2007. Local Realtors who spoke to the Lexington Herald-Leader for a report about the Money list opined that townhouses had to have been counted to come up with the average, but suggested $70,000 could buy a “nice” two-bed, two-bath townhome.

Bucolic Jessamine, situated in the rolling bluegrass lands in the center of the state, has good schools and a distinctive sense of community. Realtors advised that median prices in the unincorporated areas are at least double the $70,000 figure Money found inside Nicholasville.

Let’s Be Clear
Some clarification is in order for a couple of references in the Venture Capital Glossary on page 32 in the July issue.

Regarding Small Business Innovation Research (SBIR) Awards, the state doesn’t require that “the recipient company agrees to pay it back in jobs.” After a matching funds award, recipients are required for at least 60 months to have no less than 51 percent of their property and payroll in Kentucky and no less than 51 percent of matching fund activities must be in the state. (see http://thinkkentucky.com/DCI/SBIR/SBIRSTTR.aspx)
Also, the subhead for the last glossary term should be Small Business Technology Transfer (STTR) Awards, which are similar to SBIR awards but are federal grants made to small businesses partnering with nonprofit research institutions to develop and commercialize technologies.