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Panic and Fear - an update, 27 October 2008

How should we respond in these most uncertain times?

It is not helpful to focus on the failure of regulators and the greed of executives of free-wheeling financial institutions that resulted in an untrammeled expansion of debt. (You can count on the system to be over-regulated in the near future).

The key is that we are in the midst of a massive deleveraging process which means risk assets have to be re-priced.

In this process there will be unexpected consequences and damage to the real economy. Corporate profits in general will shrink and those companies which over- borrowed will fail. Though Governments have given and will continue to support those institutions that form the financial superstructure of a modern economy, their shareholders will bear a heavy burden via dilution.

We should not expect a swift recovery and over the coming months we should brace ourselves for the deluge of bad news relating to the economy with accompanying remedial steps proposed by Governments. Companies will generate their own share of misery and hedge funds, private equity, investment banks and the like will lose their following. Chronic earnings downgrades and the impression that we are on an endless treadmill will damage the cult of equity.

Yes, not a pretty picture, but the market is an anticipatory mechanism.

Prices of great companies with low financial risk have been pummelled.

The good companies have been dumped with the bad.

In a typical recession corporate profits tend to decline by say 20 to 25%.

This recession will in all probability be worse, but many of the companies we study are pricing in this sort of deterioration. Moreover, they should be able to maintain and pay good yields even with an unusual drop in profits.

On account of the likely response by Governments which will include reduced interest rates, we might expect the increase in the monetary base to be ultimately inflationary.

In such an environment equities will seem a great deal more attractive than cash.

Kerr Neilson

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