QUARTERLY LETTER

Year-End 2008 — Investment Strategy Review

“I can calculate the motions of heavenly bodies, but not the madness of people.”
                                          — Sir Isaac Newton – 1721

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”
                                          — Alan Greenspan – 2004

“I think it is important to point out that house prices are being supported in very large part by very strong fundamentals.”
                                          — Ben Bernanke – 2005

“This is far and away the strongest global economy I’ve seen in my business lifetime.”
                                          — Hank Paulson – 2007

“It is in booms that the seeds of busts are created, and the heroes of one era can be the villains of the next.”
                                          — Floyd Norris – 2008


2008 will be remembered as one of the most destructive years in financial history. Fortunes and reputations have been ruined and the economic recession has gathered momentum. Sir Isaac Newton was wiped out in the South Sea Bubble three centuries ago and his comments ring true today. As noted by Floyd Norris, veteran columnist with The New York Times, the punishment delivered by the current bust was fueled by the exuberance of the previous boom. Few could have imagined how terrible 2008 would become. Here at Mercer Capital, we had managed to avoid the damage of past bear markets, but 2008’s attack came from a different animal. This beast was more vicious than any we have ever seen and our value-oriented approach offered little protection. Yes, our performance compares well relative to the indices, but losing less brings zero satisfaction. While portfolios benefitted from cash cushions and the takeovers of Anheuser-Busch and Wrigley, our patience with longtime holdings such as American Express and General Electric was a mistake. We should have cut back exposure, especially when it became clear that the economy was in deep trouble.

Mercer Capital erred in other ways in 2008. We believed Ben Bernanke and Hank Paulson when they claimed that the credit crisis was containable, but this was not so. We also felt that the Fed’s easing of interest rates would stabilize the equity market — again, not so. Every contrary sentiment indicator that we monitor also backfired. Pessimism, that in the past has signaled bottoms, only produced more selling. Historically, when negative financial news hits the front pages, it quickly becomes discounted — once again, not so in 2008. As mentioned earlier, we have been battling a different kind of animal.

From its high on October 9, 2007 to its recent low on November 20, 2008, the S&P 500 fell 51.9% becoming the third worst bear market since the 1929-1932 debacle. (See table on page 2) Stocks were weak right out of the gate in 2008, but the fourth quarter was brutal. The S&P 500 plunged 38.5 % for the year with 22.4% of the decline coming in the final three months. As bad as it was here, many international exchanges fell more. The boom’s darlings —- Brazil, India, China and Russia lost 41%, 52%, 65% and 72% respectively.

10 Worst S&P 500 Bear Markets Since 1929
StartEndStartEnd% ChangeMonths
09/03/2906/01/3231.924.40-86.2%33
03/06/3703/31/3818.688.50-54.5%13
10/09/0711/20/081565.15752.44-51.9%13
03/24/0010/09/021527.46776.76-49.1%31
01/11/7310/03/74120.2462.28-48.2%21
11/09/3804/28/4213.797.47-45.8%42
11/29/6805/26/70108.3769.29-36.1%18
07/18/3303/14/3512.208.06-33.9%20
08/25/8712/04/87336.77223.92-33.5%3
05/29/4606/13/4919.2513.55-29.6%37

The combination of the financial crisis and recession triggered the liquidation of just about everything. By year-end, asset classes such as corporate bonds, municipal bonds, converts, REITs, private equity, oil, metals, and agricultural commodities had been crushed. 2008’s turning point was Paulson and Bernanke’s decision in mid-September to allow Lehman Brothers to fail. This was a colossal blunder from which the markets never recovered. The ensuing loss of trust between counterparties caused the credit area to cease functioning and also led to a run on hedge funds. Most significantly, Lehman’s death, along with the initial failure to pass the TARP rescue package, killed both business and consumer confidence, sending the economy into a tailspin. Fraud is another byproduct of bear markets and the Madoff scandal has to be 2008’s lowlight – too bad Bernie is not spending New Year’s Eve on Riker’s Island. Rather than rehash all of the year’s gory details, we have compiled a collection of headlines from the past twelve months on page 4. As you can see, the bad news was relentless.

Enough of the gloom – what’s our strategy for 2009? When the current bear market began climbing the top 10 list, we scrambled to the history books hoping that stocks were not headed down the path of 1929-1932. Today’s decline is different from others in the post-World War II era for several reasons – one being that deflation, not inflation, is the menace and the other being the overleveraged financial system. The unwinding of this leverage has shoved the present selloff below where a normal one might bottom. It also accounts for the dumping of non-Treasury fixed-income securities despite absurdly high yields. Deflation encourages the hoarding of cash and we see evidence of this today with investors parking dollars in T-bills offering zero rate of return. Thankfully, the Fed is taking powerful steps to avoid a replay of the 1930s. Stabilizing the banking system must be a priority, because the 1929-1932 bear cycle was exacerbated by a series of bank failures. The Dow actually rallied 48% from a post-crash low in November, 1929 until April, 1930 when the collapse of the Bank of the United States, a large commercial bank headquartered in New York, turned a short-term panic into a mega-bear market. This is why the Lehman decision is so perplexing and the TARP so critical. President-elect Obama faces a tough task ahead, but FDR was greeted with a bull market and so could the new administration.

How will investors know if the stock market bottomed on November 20? At the 1932 low there were key signals which we summarize as follows:

  • The stock market stopped declining in reaction to bad news and it is doing the same in late 2008. Stocks will bottom well before the economy and earnings, so it is a mistake to wait for the headlines to improve.
  • Light volume declines became common. There was no high volume capitulation. Everyone on CNBC keeps looking for a huge selling climax, but a lasting bottom should arrive quietly. Recent selloffs toward the November 20 low have been on lighter volume. This is bullish…
  • Corporate bonds rebounded along with the stock market in 1932 and they are acting better now. Back in the early 1930s, institutions dumped corporate bonds and fled to Treasuries just like today. A stock rally in 2009 would be suspect if not accompanied by corporates.
  • Stability returned to the commodity markets. A firm copper price has often been a reliable indicator. Copper strengthened late in the year and should be watched closely.
  • It goes without saying that valuation benchmarks were also at historic lows in 1932. Today, while not as cheap, valuation is as attractive as it has been in many years.

The bear market may or may not be over, but the crucial point for investors is that bargains are abundant. There are rare occasions when cash buys a tremendous amount of value and now is one of them. History shows that sentiment changes suddenly and if you are not already invested you will miss out on a large portion of the returns. The world’s greatest investors have been defined by their action in bear markets, not bull markets. Sir John Templeton said that “the time of maximum pessimism is the best time to buy”. If late 2008 is not “the time of maximum pessimism”, when is? Templeton also once commented that, “people are always asking me where the outlook is good, but that’s the wrong question. The right question is: where is the outlook most miserable?” Investors don’t have to search hard for the answer today.

Thanks as always for your confidence and support. We hope you have a happy, healthy, and prosperous 2009.

12/31/08           Henry D. Mercer III

Index2008 ReturnKey Int. Rates12/31/0712/31/08
S&P 500-38.5% (worst since 1937)Fed-funds4.25%0 - .25%
DJIA-33.8% (worst since 1931)3 mo. T-bill3.24%.11%
Nasdaq-40.5% 10 yr. T-note4.03%2.25%
Russell 2000-34.8%

* Please contact Mercer Capital Advisers, Inc. if there are any changes in your financial situation or your investment objectives or if you wish to add to or modify any restriction to the management of your account. Our current disclosure statement as set forth on Part II of our form ADV is available for your review upon request.

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2008 — The Headlines Tell a Grim Story

January
“Oil Hits $100, Jolting Markets”
“Jobless Rate Spooks Markets”
“This Time, Rate Cuts May Not Be a Panacea”
“World Markets Plunge on Fears of U.S. Slowdown”
“French Bank Says Rogue Trader Lost $7 Billion”

February
“Mortgage Crisis Spreads Past Subprime Loans”
“America’s Economy Risks the Mother of Meltdowns”
“Decline in Home Prices Accelerates”
“Dollars Dive Deepens As Oil Soars”


March
“Hedge Funds Squeezed As Lenders Get Tougher”
“Is Fannie Mae Toast?”
“HO NO”
“BAD NEWS BEAR”
“Slump Moves From Wall St. to Main St.”
“Stocks Tarnished By Lost Decade”


April
“Leveraged Planet”
“Bernanke Says the Word, ‘Recession’ May Be Near”
“GE’s Results Pull Plug on Wall Street”
“Wall Street Winners Get Billion Dollar Paydays”
“Pain of Foreclosures Spreads to the Affluent”


May
“Analyst Warns of $200 Crude Oil”
“Fed’s Balance Sheet Worries Volcker”
“Charity Gala Feels Chill of Wall St.”


June
“Big Loss at Lehman Intensifies Crisis Jitters”
“Concerns on Economy Are Shifting to Inflation”
“2 Face Fraud Charges in Bear Stearns Debacle”
“Battered By Oil, Dow Touches Bear Territory”


July
“The Bear’s Back”
“Analyst Says More Banks Will Fail”
“SEC Moves to Curb Short-Selling”
August
“More Arrows Seen Pointing to a Recession”
“In China, Signs of Softening”
“Greenspan Sees Bottom in Housing”
“Dr. Doom”

September

“Hedge Funds Get Rattled As Investors Seek Exit”
“U.S. Seizes Mortgage Giants”
“Lehman Faces Mounting Pressures”
“Dow Crashes 504 Points”
“SHOCK MARKET”
“THE BAIL FAILS”
“Your Cash — How Safe is Safe?”
“Credit Enters a Lockdown”
“Wall Street, R.I.P.”
“Dow Tanks After Nix of Re$cue”


October
“No Bull: Guru Sez Get Out of Stocks Now!”
“STOCKS SOAR! (in Baghdad)
“Sell-Off Persists As GM Tumbles”
“High-Flying Hedge Fund Falls back to Earth”
“The Age of Prosperity is Over”
“Are Stocks Really Best For the Long Run?”


November
“OBAMA”
“Hedge Fund Selling Puts New Stress on Market”
“It’s Like 1929, Says Merrill Chief”
“Bankruptcies By Consumers Climb Sharply”
“ONLY 7,997 LEFT!”
“CITI OF FOOLS”


December
“Recession Began Last December”
“Recession Trickles to India”
“Job Losses Are Worst Since ‘74”
“Investors Buying U.S. Debt With Zero Yield”
“Wall St. Boss’ Shock Confession — $50B Lie”
“WIPED OUT”
“Fed Cuts Key Rate Almost to Zero”
“Stock Investors Lose Faith”
“Toyota Sees First Loss in 70 Years”
“Big Madoff Investor Found Dead”

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