To: All Lido Advisors, Inc. Clients
From: The Lido Advisors Investment Team
RE: Client / Market Update

Quarterly Investment Commentary – October 2008

A fundamental change to the financial system and the economy took hold in September. First, the credit markets went into cardiac arrest during the month, intensifying midmonth, with limited trading going on, and a near run on money market funds. Bond prices on everything but Treasury securities suffered unusually sizable declines—corporate bonds and municipal were particularly poor performers. The stock market began to realize the impact of the deterioration in the already stressed lending markets and moved sharply lower. Days of wild swings followed as a rescue package was proposed, then stunningly defeated by the House, then resurrected as conditions continued to deteriorate. When September finally came to a close, large-cap stocks (as measured by Vanguard’s S&P 500 index fund) were off almost 9% (the entire monthly and quarterly loss occurred on one day, Monday 9/29 after the House of Representatives rejected the original bailout plan) bringing year-to-date losses to almost 20%. Mid-caps saw even bigger losses, with the iShares Russell Midcap down 12.2% in September and also down close to 20% for the first nine months of 2008. Small-caps held up better in September, with the iShares Russell 2000 down 7.9%, and small-cap stocks are also doing better than larger stocks year-to-date, with losses of just over 10%. The performance of small-caps is highly unusual, and though we are not certain, their performance may be partly the result of hedge funds and others dumping larger, more liquid stocks to raise capital, and could also be influenced by the sector weightings of the smaller indexes. International equities dropped by a bit more than domestic equities, hurt further by what we think is likely to be only temporary dollar strength. The bond market was all over the map. The intermediate, high-quality bond index tracked by Vanguard Total Bond Market Index fund lost 1.1%, but this was helped by its weighting to Treasury securities. Other sectors of the bond market were down by much greater amounts (we have added several new indexes to the performance table to show this). Our portfolios performed poorly during the month and quarter, for a number of reasons, and we address these in the Q&A that follows.

9/30/08—Analysis of a Changed World
This commentary is in the form of a Q&A that we are sharing with our clients.  We began writing it on October 1st and completed it over the weekend on October 5th.  The pace of change has been rapid and some of the possibilities we discussed already seem to be playing out. We also apologize for the length. There is a lot to cover and we wanted to make sure to address all the issues that our clients may be wondering about.
We have never been alarmists but what happened the week of September 15 was reason to be alarmed. The failure of Lehman Brothers (the biggest bankruptcy filing in the history of the United States) and the near-collapse of AIG on the heels of the government takeover of Fannie Mae and Freddie Mac were stunning. Merrill Lynch’s sudden decision to sell itself to Bank of America at a price that was unthinkable not long ago reflected its fear that the alternative was to follow Lehman’s fate. Then a major money market fund (Reserve Fund) that owned Lehman debt “broke the buck” starting a run on non-government money market funds. That was followed the next week by the last two major investment banks standing, Goldman Sachs and Morgan Stanley, converting to commercial banks. By the time the FDIC seized Washington Mutual, the nation’s largest savings and loan and the largest bank failure ever (immediately sold to JPMorgan) we were almost desensitized to these unthinkable events. The dominoes falling are the result of a toxic brew of 1) hundreds of billions of dollars of bad loans; 2) financial institutions’ leverage (debt); 3) highly complex securities that, at least to some extent, interlink many players in the financial system and of course greed, fraud and lack of regulation.

The following discussion is in question-and-answer format so you can easily focus on the issues that are of most interest to you.

Is the risk to the economy really that serious?
Warren Buffett was quoted on CNBC saying the following in response to questions about the Paulson plan (this was on September 24, while the plan was still being debated):

“Last week we were at the brink of something that would have made anything that’s happened in financial history look pale. We were very, very close to a system that was totally dysfunctional and would have not only gummed up the financial markets, but gummed up the economy in a way that would take us years and years to repair.”
We, as most investors, have great respect for Buffett. He is not only smart and overflowing with common sense, but he is also a highly ethical person. His opinions are highly credible and in line with several others we respect. Those views are also in line with our view of what was developing beginning the week of September 15 as activity in the credit markets moved alarmingly close to a frozen state (by “frozen” we mean that the willingness to invest in debt securities or lend stops). That state continues as we write this and presents a great risk to both the U.S. and global economy.  This is why we believed the Paulson plan (Troubled Asset Relief Program) was essential to the long term health of the economy and were stunned and frustrated by the Government’s rejection of this plan on Monday.  On Wednesday (10/1) the Senate passed a new and revised “bailout” bill and the house finally passed it as well on Friday (10/3), but the market’s reaction (selloff) tells us it may have been too little too late to restore much needed confidence to the market.

The credit (lending) markets have been dysfunctional for months and we have been writing about this in past letters. However, during the last couple of weeks the risks significantly increased. Regardless of what one may believe about the greed and poor judgment that got us to this point, there is no question that the world needs a financial system that facilitates the workings of the economy. Businesses and banks rely on their ability to borrow so they can invest and grow and create new jobs, so they can bridge seasonal fluctuations in their revenues, and so they can support their day-to-day operations, including making payroll. And Main Street relies on its ability to borrow as well. Demand for a home, a car, or other long-term assets are dependent on borrowing ability. Without that, consumer demand and thus the global economy would be much smaller. A sudden and significant reduction in the availability of credit is happening, and if it continues it will result in significantly reduced demand for goods and services and a simultaneous loss of confidence on the part of businesses that would lead to waves of layoffs and less capital investment. This could create a significant shrinkage in the economy, which would have major negative fallout to businesses and individuals. Moreover, there is a risk that it could develop into a self-reinforcing cycle that would be hard to break.  Ultimately, you, us and Main Street will all suffer which is why we believe it was necessary for the government to pass the “bailout”.

Why did the credit crisis suddenly get worse?
As we have written on several occasions this year, the problems at major financial institutions have been harming the credit (debt) markets, as banks’ weakened financial state left them less able and willing to lend. This situation suddenly and dramatically worsened in mid-September. Despite the Fed pumping hundreds of billions of dollars into the system in the first part of the week, the money markets—where businesses, including banks and financial institutions, conduct their short-term lending and borrowing transactions—appeared on their way to freezing up. The falling dominoes had shaken traders and investors and led to concerns about more dominoes falling. This was exacerbated because of the complex interrelationships between financial institutions. Then news that a major money market fund had “broken the buck” (primarily because of the bankruptcy of Lehman Brothers) triggered what began to look like a run on diversified money market funds in favor of Treasury-only money funds. This all created massive demand for short-term U.S. Treasury securities—the only asset believed to be truly safe. At one point these securities traded at a negative yield—meaning that investors were willing to accept the certainty of a small loss on their investment rather than risk a larger loss somewhere else. The system-wide fear at this point was not merely that some funds might break the buck because they held Lehman or some bankrupt firm’s paper. Instead it was fear of a “run on the bank” that was developing, which would destabilize the money markets, a critical player supporting the normal flow of capital in our economy. This was a far more serious problem.
The immediate impact has been to the market for commercial paper and short-term bank loans, which are essential to business operations. With capital leaving money markets in favor of Treasuries and government-guaranteed securities, there have not been many buyers in the commercial paper market and the rates commercial paper borrowers must pay have spiked up dramatically. This means that some companies and banks that had for decades relied on some short-term borrowing to run their businesses (by allowing them to make higher-returning, longer-term investments with their capital), don’t have that option. If allowed to continue this could be difficult to reverse and would result in financial hardship for many businesses, likely leading to layoffs, a general retrenchment in corporate spending, and in some cases, bankruptcy (once again something our elected political leaders should have known going into the “bailout” vote on Monday). This has the potential to be a severe blow to the economy, possibly leading to a worse-than-normal recession. As we write this, the money markets are still dysfunctional and longer-term credit is also less available. While it is true that a culture of debt resulted in our problems, it is important to understand that while too much debt is bad, some debt is a necessary component of a robust economy.

What is needed to help return the markets to normal?
A capital infusion into the banking system is needed so that financial institutions can take their losses (there are many more loan losses to come) and recapitalize. It is important that it be a system-wide solution, not a string of piecemeal reactions as was the case prior to the recent Treasury proposal. Action is needed both to address the underlying fundamental problem and to help bring confidence back to the market. A continuation of the extreme dysfunction in the credit markets has damaged the economy and will further damage the economy as long as it continues, with potentially long-lasting effects, including more financial institution failures and a deep economic downturn. In our view, governmental action (“bailout” / rescue plan) is the only chance to begin to bring confidence back to the credit markets. Risk would still remain, but that risk would be significantly reduced. It is the credit market not the stock market that is the economic linchpin.

Credit default swaps (CDS) remain a wild card that will not be easily addressed in the short-term. This is an unregulated market where financial institutions and hedge funds sell insurance against credit defaults. The market is huge—estimated at roughly $60 trillion—and because it is unregulated it is hard for anyone to really understand the risks. The government bailouts of Bear Stearns and AIG occurred because they were a major CDS counterparty and their failure would have negatively impacted many financial institutions—potentially putting the entire financial system at risk. The CDS market is headed for regulation but how we get from here to there remains unknown. Our understanding is that the CDS market is shrinking as contracts are unwound. That is good, but it is still a large market that is already contributing to market volatility and risk aversion and it represents an unknown financial system risk.  We also believe there is a tremendous amount of fraud in this unregulated market.  Hedge funds have the ability to buy CDS insurance on a counterparty while simultaneously shorting the stock thus profiting from the price decline of the particular counterparty, then getting paid off if the company goes bankrupt (i.e. Lehman Brothers).

How have recent developments impacted our investment strategy?
The short answer is that we think stock returns will be lower in coming years than what we had previously expected in our likely range of outcomes. Meanwhile, opportunities elsewhere, such as certain segments of the bond market, are priced at levels that suggest they could earn similar or better returns than stocks with lower risk. The reason stocks aren’t likely to earn strong returns in coming years despite their already significant declines, is that the damage to the economy from the credit crunch and its aftermath will hurt corporate earnings. We don’t believe stock investors are fully recognizing the level of damage, meaning that current stock prices don’t take this weakness fully into account. This means two things. First, we could see further losses in stocks in coming months as a new economic reality gets priced in. Second, it means that the possibility that we’ll see good longer-term (five-year) returns is relatively low from current stock market levels. At the same time, significant macro risks and unknowns still remain, and these could further harm stock prices in the short term. So given the unexciting return outlook for stocks, the near-term risks that remain, and the better relative opportunities that exist elsewhere, we will underweight equities when the market stabilizes.  We plan to further increase cash, provided we can do so at market levels we consider acceptable (we aren’t going to sell into a big market downturn). It is also possible that if stocks suffer a sharp drop we would begin to add back to our stock allocation. We are prepared for both possibilities given current extraordinary volatility. We are assessing where we want to allocate the cash we currently hold, and will make this decision very soon.

What is behind this deterioration in the economic environment?
As we wrote in April, we had become concerned that there would be “continued deleveraging on the part of households for several years, resulting in slower credit growth (less borrowing) in the next recovery. If consumers borrow less and spend less, economic growth and corporate earnings growth will be slower than they would otherwise be.” Developments since that time suggest that this scenario is playing out with a vengeance. Our outlook has worsened for several reasons:

• We have gone from five major investment banks at the beginning of 2008 to zero (two converted to commercial banks). Fannie Mae and Freddie Mac are in conservatorship. AIG, the country’s largest insurance company, is also now government controlled. The largest savings & loan (WAMU) failed. Many more bank failures will come (most will be small). The housing market continues to deteriorate. Based on the widely followed S&P/Case-Shiller index, house prices have fallen 20% on average (and far more than that in some markets) from their peak in mid-2006 and the risk of further declines is high though the rate of decline is slowing. So the financial system has been permanently damaged. There is now no question that years of debt growth relative to the size of the economy are in the process of reversing, a process that will last for quite a while. Lending institutions, in aggregate, will be smaller with less ability to lend. And households, with fewer assets, will have reduced ability to borrow. The debt tailwind of previous years will become a headwind to economic growth as the consumer sector shrinks. This outlook is consistent with the experience of other credit busts in Japan, Sweden, and several other countries. Economic growth in those cases was subpar for eight to nine years. The U.S. is different but there are also many similarities.
• 

• There is also a negative “wealth effect” that, because of the magnitude of the decline in home prices coupled with a stock market decline, will almost certainly cause further harm to the economy. Many consumers, with their net worth significantly reduced, will spend less, further contributing to the reduction in consumer spending.
• It is also likely that regulation will increase. Some of the new regulation will be positive and needed but history suggests that governmental reaction to crises tends to be excessive. This will also be a potential impediment to growth.
• The impact of the bailout on our budget deficit makes tax increases ultimately more likely.
• Unlike Japan or even the U.S. in the 1930s, our huge national debt is not self-financed. About half of our Treasury securities are owned by foreigners. As our borrowing needs ramp up, if foreigners (mostly governments) lose their taste for U.S. Treasuries, interest rates will be higher than they otherwise would be—another negative for economic growth and also a negative for the dollar.

In short, our more negative scenario appears to be playing out. Consequently we are giving it more weight.

There is also uncertainty about inflation. In the short run we are not concerned about a big inflation spike. Deleveraging suggests a reduction in demand and lack of wage pressure that should significantly reduce inflation pressures. In fact, deflation could become more of a risk. The only wild card is the dollar. If it declines significantly—e.g., if foreigners lose confidence in the U.S. economy—imported goods will be more expensive. The bigger inflation concern comes into play as we look out into the next cycle. The government stimulus that will be necessary to manage through the downturn does risk some inflationary pressure a few years out.

What does this scenario suggest for corporate earnings and ultimately the stock market?

In this scenario, earnings growth would be subpar over the next several years, and we view the risk of earnings disappointments over the next year as high (Wall Street earnings forecasts still appear to be very high.

Even though, at the time of this writing, the stock market is 25% below its high of last year, it has gone down in spurts as awareness of the severely strained credit markets has grown and the situation has worsened. This is not uncommon in bear markets as optimism from a bull market gradually slides into pessimism. The question is, at what point are stocks pricing in a realistic outlook? Before the significant worsening of the credit crisis, we believed stocks were at least adequately discounting a slowdown, if not a recession. But the fundamental economic deterioration in the last few weeks has been profound. We believe that as investors digest the events of the past few weeks they will realize that the impact of the credit crisis on the economy and corporate earnings will be significant both in the short term and looking out a few years. This digestion process is happening and appears to be accelerating though the market. We believe there is likely to be a downward adjustment to earnings-growth expectations and stock prices and that this will happen in coming weeks and months. Looking out over our five-year decision horizon, overall earnings growth falling below its long-term trend is now part of our baseline scenario, whereas before we considered it among our lower-probability scenarios.

In coming to our conclusion about the likely earnings trend we have considered:

• the qualitative factors mentioned earlier: deleveraging will shrink the consumer sector, an important engine of growth; regulation and taxes are likely to be higher; and later, rising interest rates are a risk
• the historical behavior of earnings in other challenged environments in the U.S. and other countries
• our belief that the challenges facing the U.S. economy are greater than at any time since the 1930s. This supports an expectation that keeping pace with the long-term trend in earnings could be an optimistic outcome.

This all nets out to a drop in our five-year return range into the low to high single digits from current levels (S&P 500 at 1100). To get to the high end of our most likely range (an 8% return) would require earnings in five years to climb back to the long-term trend (which would mean better-than-average earnings growth from this point), and an average multiple of 18x, which is the long-term average P/E. We believe this earnings assumption is possible, but it is at the optimistic end of the range of outcomes we view as reasonable.

It is hard to know how this could play out in the short term. It’s certainly possible that we might see a significant stock market decline over a number of months that sets us up for good returns going forward. It also wouldn’t be surprising to see a temporary rebound over the next few weeks or months based on the government bailout. But, if there is a rebound, we believe investors will still have to fully digest the more subdued longer-term earnings environment.  As previously mentioned in our daily blogs, we will be selling into a short term rally in order to raise cash as we have concerns over the long term health of the economy.

Why didn’t professional investors see this coming, and why do you think they are still not fully getting it?
There were a small handful of investors we know of that warned about the risks that have triggered the current credit crisis and bear market (specifically Steve Romick who runs the FPA Crescent fund). However, a major deleveraging environment is outside of the experience of the vast majority of the current professional investment community. The magnitude of the current credit market stresses and their ripple effects have literally fallen outside the intellectual and decision-making framework of today’s pros. After years of credit growth creating a tailwind for economic growth, there has been a natural resistance to wanting to understand the possibility of its reversal and the resulting fallout. This is partly because this worry has been with us for several economic cycles but we’ve never experienced the blow up, causing investors to be desensitized to the risk. It was hard to know what level of debt was unmanageable for our economy. Investors have also been well programmed over the years to buy when stocks decline and to believe that stocks must be cheap after a 25% decline. We have to include ourselves in the group of investors who didn’t fully comprehend the magnitude of the problems, and were dollar cost averaging into equities throughout the summer when the market would dip.  The events of the last few weeks were a trigger for us to fully absorb the profound nature of what is going on and adjust our thinking. However, we believe many professional investors have not fully made this adjustment nor has the public, though this may be quickly changing. We suspect that process could be complete in coming weeks and months.

What could make you wrong? With all the pessimism, isn’t this a contrarian buying opportunity?
One big wildcard is the impact of the emerging markets and China in particular. They have increasingly become more of a global growth engine in recent years. Many (but not all) are also in a much better position to weather the storm—they are net creditors (not debtors like the U.S.) with large foreign reserves and more fiscal and monetary flexibility. So it is possible that this will provide enough economic support to mitigate, to some extent, the headwinds already discussed. We believe in the emerging-markets’ story long term, but we also believe that it is risky to assume that their growth won’t be temporarily (but materially) impacted by a significant slowdown in the developed world. So our base-case assumption is that they will help, but not enough to offset what will be a powerful deleveraging cycle.

In terms of a contrarian buying opportunity, usually pessimism creates good buying opportunities because psychology comes into play and fear drives prices lower than what the long-term fundamentals suggest is reasonable. But based on our assessment of fundamentals, we don’t think this is the case currently for the reasons we’ve outlined. However, that is a risk, and it is possible markets could go higher from here. If that happens, it could hurt our relative performance, depending on how our equity alternatives perform and when we unwind our equity underweight.  We are currently looking for different 11-18 month principal protected dual direction structure notes which will give us the ability to generate absolute returns if the market is positive or negative as long as it doesn’t go up or down too much (probably something in the 30% range).  The main risk to these investments is will the counterparty be around when the note matures.  It is our belief there will be at least a few survivor’s and they will be J.P. Morgan, Wells Fargo and Bank of America domestically and Deutsche Bank internationally.

Why are bonds performing so poorly?
Although we have had an underweight to bonds, bonds are part of a more traditional asset allocation to protect capital.  There has been an extreme flight to quality with huge demand for U.S. Treasury securities—especially Treasury bills, as they are the only investments that have not lost money during this most recent crisis.  The demand has been so great that investors are willing to accept near 0% returns on short-term Treasury bills. This demand is at the expense of virtually anything else.
Some portions of the credit markets, such as tax-exempt bonds, which are not normally particularly liquid, have been hit with more problems. First, the market has lost major dealers (e.g., Bear Stearns and Lehman) and that has further hurt liquidity and others are too stressed to be a source of liquidity. This has meant higher borrowing costs for tax-exempt bond issuers. So the primary problem is liquidity, and that will eventually pass. However, there may also be some worry about higher borrowing costs along with reduced tax and other revenues in an economic downturn harming the credits and triggering increased defaults. We believe that default losses could be higher than in a typical recession but that the market has more than priced that risk. However, with such poor liquidity it is hard to know how tax-exempt bonds will perform over the short term. Longer term we believe they are now priced somewhat attractively with yields over 4%.
The corporate bond market is also extremely stressed with liquidity drying up in favor of Treasuries. Investment-grade corporate bonds had their worst month ever in September and their worst quarter ever. With the possibility of a worse-than-normal recession, defaults could be higher than in a normal down cycle. So some shift down in pricing makes sense. However, again, the flight to Treasuries has sucked demand out of the corporate bond market and this has led to an imbalance of buyers and sellers, which has driven prices sharply lower (for example an ETF that tracks an intermediate, investment-grade corporate bond index was down 6.8%. We believe this will pass and that corporate bonds will perform well if we look out past this crisis period. The lowest-quality portion of the investment-grade bond universe is yielding close to 8%. Longer-term return potential looks reasonably attractive and could result in capturing the yield or perhaps better, but some short-term risk remains.

Mortgage securities are also suffering. But despite the housing market turmoil, there are residential mortgage-backed securities (RMBS) that are selling at prices that will generate attractive returns, even under very, very negative scenarios (in terms of foreclosures and losses on the foreclosed property).

Are there any asset classes that look attractive on a long-term basis?
On the one hand almost everything has been hit hard and that suggests that there should be some good long-term returns to be had (see the table of index returns above).

Despite poor returns in virtually all asset classes, over the near term nothing is certain. And looking out beyond the near term, the credit crisis is causing real economic damage that is impacting long-term asset values. On top of that, investors are fearful. It’s a bad combination and suggests that high volatility is likely to be with us for a while. And because the freezing up of credit has hurt bonds as well as stocks, some portions of the bond market have not performed as well as they typically do in periods of economic stress. Treasury securities have been the assets that have held up, in addition to gold (flat on the year), which is an asset we don’t normally invest in and has also been extraordinarily volatile.  However, Treasury yields are depressed and prices of these securities will decline (yields will rise) once confidence comes back in the market. Only short-term Treasuries, which offer almost no return, are safe in the short-term (protecting against both credit risk and price risk).

Longer term there are some asset classes that are beginning to intrigue us:

Fixed Income: Driven by the sell-off in everything but Treasury securities, high-quality mortgage-backed security yields and corporate bond yields now suggest returns in the higher single digits over the next few years. These are attractive returns relative to potential stock returns, especially for tax-exempt accounts. Again, short-term returns are less certain. Intermediate tax-exempt bonds offer yields of over 4% for pretax equivalent yields of over 6%. Even with Treasury rates expected to move higher down the road, investors could capture a return close to the yield.

Currency: With the $700 billion bailout package the dollar looks increasingly unattractive. Either way our country’s financing needs are ratcheting higher and government bond yields are lower than in other parts of the world. In the short term we are not at all confident about currency movements—the dollar has actually been quite strong recently, probably because U.S. investors are pulling capital back because of a crisis-driven, home-country bias—but longer term, betting against the dollar is a high-confidence move.

Emerging-Market Equities: Emerging markets are off about 40% from their high, eliminating much of the froth that had built up in that market after five high-return years (we have had no direct exposure to emerging market equities except what our individual international managers have allocated). Longer term we are believers in the emerging-markets story, i.e., that they will, in aggregate, continue to be markets with above-average economic growth and improving macro fundamentals. However, we don’t believe that emerging markets are immune to recessions in the U.S. market. Their economies and corporate earnings are also at risk, but as we look out longer term, not to the same degree as in the developed markets. Emerging markets now look to be near the cheaper end of fair valuation but not yet a “fat pitch” opportunity. We could get there quickly though so we are paying attention.

How long will you stay in the Government Money Market Fund?
This position is transitional. We expect to deploy assets into bond funds or separately managed bond accounts offering higher yields once there is some stabilization of the credit markets.  We are weighing a high-quality mortgage-backed securities fund, foreign currency bond funds (developing and developed), and a couple “unconstrained” bond funds. It is likely that we will deploy into more than one option.
Our move into the Government money market fund rather than a standard money market fund was directly due to the freezing up in the money market. We did not want to take a chance of having our cash tied up if there was/is a system-wide event that harmed money fund liquidity. We were less worried about a loss of capital than a delay in being able to access our capital. Getting a slightly higher yield from a regular money fund for just a few weeks did not justify taking this risk. When the money markets begin to settle down we will move back into a standard and higher yielding money fund for our portfolio’s cash reserves.

Are you going to continue to invest in hedge funds?
In the past week we sold one of our mutual fund hedge fund of funds as the dysfunction in the credit markets, illiquidity and short sale restriction imposed by the government have caused dramatic losses beyond our comfort level in a short period of time.  All three of these issues happening at the same time caused hedge funds as an asset class to have their worst performance month in history in September.  We are also assessing issues with counterparties, reduced access to financing (which may force some funds to unwind leverage) and the chance that redemptions create more selling pressure on securities.  The majority of our remaining hedged allocation is in “opportunistic” managers; however we do have partnership investments in “fund of funds” in which we are continuing to gather information.  The entire financial system has been hit with the “perfect storm” leaving no investment strategy unscathed.  This is disappointing as this asset class has added value over the years and has helped protect capital in other difficult environments.  Unfortunately, the depth and breadth of this crisis has caused securities to trade in ways that are inconsistent with their long-term fundamentals, thus significantly impacting the shorter term results for many of these hedged strategies.  The markets will stabilize over time, but not knowing when and not knowing what else is out there led to our decision to reduce our exposure at this time.  We continue to talk to and gather information from our managers, but we still do have an allocation to these managers at the present time.

How have Lido portfolios performed?
Our portfolios have performed poorly through this environment, seemingly getting hit by a perfect storm. We have always taken pride in our risk management and are extremely disappointed that strategies that worked in the past have also suffered during this storm. During the last very serious bear market (2000-2002), we were able to significantly outperform our benchmarks during the almost three-year market decline.
First, from an asset allocation standpoint, we have been hurt in the most recent quarter as our “opportunistic” managers and hedge funds have suffered because of the unprecedented volatility in the stock, bond and commodity markets.  Though our asset allocation moves have consistently added value throughout this decade until recent months, as the crisis became more acute, our hedge fund allocation underperformed the domestic investment-grade bond exposure we would have otherwise held (it had added value over the past 6 years).  The other was the surprising outperformance of small-cap stocks relative to large-caps. This is highly unusual given the weak economy, their relative valuations, and their lesser liquidity. We believe this relative performance is very likely to reverse unless we experience a sustained stock market advance.
Second, the majority of our active managers have underperformed, in some instances by sizable amounts. In several cases our equity managers were late to grasp the severe ripple effects of the credit crisis. As mentioned earlier, the economic stresses in this environment have never been experienced by anyone currently working in this industry.  In most cases very good analysts/portfolio managers, with very long records of success, simply didn’t catch on to what has been happening. So the unique economic challenge that rocked the stock and bond markets explains part of the poor performance.

There is another question that should be asked, are our managers as good as we think? We continually ask that question and with perhaps more intensity in an environment like this. We have been in close contact with our fund managers and we are evaluating each manager. We do not want to make broad generalizations based on short-term underperformance (for reasons we have written about a number of times already) and we continue to have a high level of confidence in almost all of our managers. However, we also don’t want to be complacent. One thing we are assessing is whether each stock picker is now factoring into their fundamental analysis the more challenged, deleveraging environment we believe we will be facing for awhile.  Because of our belief and the many cross currents in the market, we are seriously considering reducing our eliminating our “style box managers” in favor of principal protected index structures.  In the case of managers who we continue to believe are highly skilled, it is worth contrasting what they perceive as their opportunity going forward with valuation measures for the overall market. While we are not confident that the return potential of the overall market is compelling, despite the already significant decline in equity prices, this is not necessarily the case for our equity managers. This is supported by quantitative measures of market valuations suggest that valuation discrepancies among stocks are unusually wide at present—meaning that there are many more stocks with large valuation deviations from the average stock’s valuation than is historically typical. The potential benefit from this type of environment is supported anecdotally by two examples from other very difficult periods, however we are well aware the period we are currently in is like no other in history (except maybe during the era of the Great Depression):

In 1969, Warren Buffett liquidated a partnership he was running and suggested that his investors invest with the Sequoia Fund’s Bill Ruane. This was a great call by Buffett—Sequoia had a stellar record for the next several decades. However, the timing was bad. In the next four years Sequoia was down 1% while the S&P 500 was up 40%. This period encompassed the brutal 1973-1974 bear market. in the four years that followed this period of significant under-performance, Sequoia was up 250% against 23% for the S&P 500. Around the same time, Buffett’s famous sidekick, Charlie Munger, a great investor in his own right, was running his own investment partnership. From 1972 through 1974, his partnership lost 50% of its value compared to a 21% loss for the S&P.  When looking at returns over the entire life of the partnership (1962-1975) Munger’s partnership returned 14% (annualized) compared to 5% for the S&P 500.

“This Newsletter is intended to be a general discussion regarding various capital markets for 2008. Nothing in the Newsletter constitutes a solicitation nor offers the purchase or sale or recommendation of any security. Nor should anything in this Newsletter be considered as a trend or expectation of future performance of any capital market. Investment Advisors recommendations can be made only based upon each individual’s investment objectives, risk tolerance levels, time horizon, and other personal and financial considerations”.

Securities offered through Investment Security Corporation, Member FINRA, SIPC. Lido Advisors, Inc. and Investment Security Corporation are separate, unaffiliated entities.