If you look at your account only quarterly, the third quarter might appear routine. The S&P 500 picked up 2.0%, while small stocks dipped. The Baker Ellis Composite performed relatively well, with a gain of 3.5%.* The quarter was a tumultuous one, however, as the housing finance crisis paralyzed debt markets and the stock market flirted with a 10% correction before the Federal Reserve slashed the fed funds rate by 50 basis points, triggering a major rebound at home and reigniting the frenzy in emerging markets.

While the cut in short-term rates boosted stocks, long-term interest rates rose as bond investors anticipated higher inflation down the road. In conjunction with runaway government spending, the Fed’s action also put further pressure on the dollar, which fell 2.8% against the euro between the Sept. 14 rate cut and Sept. 30. The U.S. dollar index has declined about 4% a year since 2002, leaving the greenback trading near parity with the Canadian loonie for the first time in three decades. Oil surged to over $80 a barrel (demand from India and China plays a role, but the bigger factor is that global commodities are denominated in dollars) and gold hit a 27-year high.

As proponents of free markets, we believe that speculators who made bad investments in real estate and mortgage-backed securities should be forced to suffer the consequences of their actions. The connection between risk and reward is fundamental to the functioning of capitalism. In the current no-sacrifice political and economic climate, however, the powers that be are bound and determined to keep asset prices rising, effectively bailing out Wall Street and leveraged speculators. As former Fed Chairman Alan Greenspan rationalized recently in the U.K. press, “You cannot calibrate liquidity to only rescue the deserving. Helping the greedy and egregious is a price to be paid for overall stability.” In the long run, we believe that the markets would be more stable if the economy were less leveraged and prices fluctuated more freely in response to risk.

On a more pragmatic level, the Fed’s quick action underscores how ill-equipped the American economy is to withstand a downturn. According to the latest statistics from the Federal Reserve, U.S. consumers have $72 trillion of assets, up 43% over the last four years. But borrowing also has soared, saddling consumers with record debt-service costs. Taking into account rising health-care and energy prices, consumers are now spending 41 cents of every dollar of disposable income on fixed expenditures, up from 36 cents in 2000, according to a report by FMR. Consequently, a retreat of asset prices even to levels of a few years ago could cause a major reverse wealth effect.

Investors appear to be betting that the collapse of the structured-finance bubble will not drag the economy into recession. The one weak spot in the market was the Russell 2000, which lost 3.4% in the quarter, snapping an epic small-stock winning streak. This could be a classic late-cycle shift or a simple reduction in risk, but we believe it may also reflect growing disillusionment with the American economy, given that smaller companies often have less global operations. The real action remains overseas as aggressive efforts to reflate make dollar-denominated assets less attractive and encourage the creation of new asset bubbles elsewhere. Since mid-August, emerging markets have soared 26%, triple the gains of the S&P, putting the MSCI Emerging Markets Index back at an all-time high.

While emerging-market stocks have had a big run, we remain long-term bulls on the Asian domestic-demand story. CLSA, an Asia-Pacific brokerage firm, recently conducted a survey of households in Asia. As other studies have shown, average household income in China has doubled in the past 10 years, while India’s has risen 50%. More interesting to us is that the average Asian household reports a savings rate of 30% of earnings and still has minimal debt – the majority of Asian households do not even have mortgages. Growing consumption and increased appetite for risk could sustain the Asian boom for some time. During the quarter we added to our position in relatively conservative plays such as DBS Bank Ltd. (DBSDY), the largest bank in Southeast Asia by assets; and Singapore Telecommunications Ltd. (SGAPY).

In the fixed-income department, we increased our holdings of Treasury bills and reduced our exposure to money-market funds, seeking to avoid murky and ubiquitous credit risks from the structured finance boom.

We see plenty of reasons to maintain a cautious outlook on the U.S. economy. Housing prices are declining in many markets, and inventories are soaring. Bank balance sheets are likely to remain constrained for some time. The market appears to be looking through the current troubles, however, and one of the oldest axioms in investing is, “Don’t fight the Fed!” If growth lags more than briefly, we could see not only further rate cuts at home but also coordinated easing from other central banks in an attempt to shore up U.S. dollar weakness – as occurred in 1992. Under such a scenario, monetary policy could continue to force prices higher, even against a backdrop of generally negative domestic economic news.

Sincerely,

Brian C. Baker, CFA Barnes C. Ellis

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Composite may exclude accounts with legacy positions or restrictions. Performance is size-weighted. Returns vary based on risk tolerance, timing of investment and other factors. Consult your performance report for details. Size-weighted dispersion for the quarter was 1.65%. Further information is available upon request. Performance is net of fees. S&P index includes gross dividends; other index returns do not. Investors cannot own an index, a hypothetical portfolio that does not include fees or expenses. S&P 500 data provided for purposes of comparison and may not be the most relevant benchmark. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.

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