The Sage Difference

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TAHP Annual Conference Market and Economic
Outlook By Robert D. Williams, CFA Director of
Research Sage Advisory Services October 23rd,
2008
Sage Advisory Services, Ltd. Co. 5900 Southwest
Parkway Building One, Suite 100 Austin, Texas
78735
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Table of Contents

• Credit crisis and near-term outlook
• Macro outlook
• Strategy

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Damage Assessment
Year-To-Date Capital Markets Total Returns

• Unprecedented Events
• Continued collapse of housing bubble
• Collapse of commodity bubble
• 40 decline in world market cap
• Credit risk re-priced
• Dow worst week in history
• Fannie/Freddie Takeover
• Stand Alone Broker Industry Gone
• Sub-Prime Writedowns pass 500 billion
• Credit Market Freeze
• Money Markets break the buck
• Unprecedented global rescue measures
• Record Volatility
• Record high VIX
• 12/35 days of gt4 price change since Sept. 1

VIX Implied Equity Volatility
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Source Bloomberg
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Housing Boom

• Unprecedented housing bubble
• Easy money
• Low regulation/loose lending standards
• Fueled by securitization
• 90 since 2000 until peak
• Still 55 since 2000
• Built on shaky foundation/leveraged consumer
• 2004-06 subprime loans accounted for 18-20 of
  total mortgage lending
• 2005-2006 40 of home purchased were not for
  primary residence
• Currently 1.3 trillion subprime and 1 trillion
  Alt-A mortgages outstanding
• ARMs rate resets will total 1 trillion over next
  5 years
• 700 billion in mortgage equity withdrawals in
  2006 vs. 93 in 1993
• From 1959 through 1992 the savings rate varied
  between 6 and 12 of disposable income. Since
  that time, however, the rate has steadily
  declined, reaching minus 0.7 in 2007.

Case-Shiller Home Price Index
Subprime Lending
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Source Bloomberg
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Securitization Boom

• Securitization boom
• Financed/fueled the housing boom
• Spread the risk
• Leveraged the risk
• Didnt understand the risk
• Leveraged Financial Sector
• Investment bank leverage 30X
• 50 increase from 2003-2007

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The Painful Unwinding

• Leveraged capital falling liquidity Loop
• Magnified losses
• Illiquid securities
• Difficult capital raising environment
• Updated numbers
• 500 / 1 Trillion est.
• 180-200 of profits
• Credit Crisis/Crunch
• Counter party risk
• Liquidity risk
• CP Market
• Money market funds
• Auction-Rate Preferred

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Confidence Crisis

• Compounding Crisis
• Fears of serial failures
• Ad-Hoc Fed response
• Loss of confidence
• Credit market freeze
• Flight to quality
• Market free-fall
• Stress Indicators
• Fed lending to banks
• Effective Fed Funds
• Banks lending to banks
• Libor-Tbill
• Bank lending to corporations
• Leveraged Loan market
• Revolving lines of credit

3-Month Libor vs. 3-month T-Bill
SP 500
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Source Bloomberg
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Response

• Feds Expanded Toolbox
• Term Auction Facility
• ABS CP liquidity Facility
• CP Funding Facility
• Government Bailouts
• Emergency Economic Stabilization Act (TARP)
• More aggressive and on global scale
• Extend deposit insurance
• Guarantee bank lending
• Inject capital directly with preferred ownership
• Economic Stimulus Act
• Housing and Economic recovery Act

Federal Reserve Bank Assets (billions)
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Source Bloomberg
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Macro/Market Outlook

• Policy makers now realize scope of the problem
• Expect credit market stabilization on more
  comprehensive action
• Risk asset Bounce does not signal sustained
  recovery
• High volatility and uncertainty systematic
  pot-holes remain
• Economic outlook downgraded
• Look for deeper global recession and longer
  recovery period
• 3-4 quarters of negative GDP and major consumer
  retrenchment
• 7 unemployment, further earnings downgrades
• Impact on funding and refinancing on corporate
  sector
• Further global rate reductions
• Implies steeper curves and overall low rates
  near-term
• Credit spreads more range-bound
• Housing recovery 2010, economic recovery late
  2009 and market recovery mid-2009
• Longer-term impacts
• Inexpensive leverage that fueled expansion gone

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Source Bloomberg
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Broad Economy and Housing
LEI Leading Economic Index
Unemployment Rate and Non-Farm Payrolls
Subprime Foreclosures and Delinquencies as of
loans outstanding
Single Family Homes for Sale (inventory), millions
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Source Bloomberg
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Consumer
Retail Sales

• Consumer contraction just beginning
• Fiscal impact faded
• Sources of borrowing limited
• Consumer de-leveraging
• Confidence coming off record lows

Consumer Confidence
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Source Bloomberg
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Inflation
Consumer Price Index
CRB Commodity Index
Wage Inflation
TIPs Breakeven Inflation
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Source Bloomberg
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Lending
-IMF estimates capital losses could swell to
1 trillion 10-15 trillion in lost
lending. -Banks cut back lending in the 2nd
Qtr. of 2008 at a 9 annualized rate, reportedly
the worst contraction in 35 years of data.

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Source Federal Reserve
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Corporate Profits
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Source Bloomberg
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Corporate Profits Earnings Revisions
Weekly Net Earnings Revisions For SP 500
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Source Bloomberg
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Global Impact Top Down Look
OECD Global Leading Economic Indicator

• Developed world led down-turn
• US 21 global economy
• Global commodity spike
• Subprime is a global problem
• 50 of writedowns from foreign institutions

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Source Bloomberg
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Global Impact Bottom Up Look
The Good, the bad and the ugly Deviation of PMI
index from 50
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Source Markit Economics, Bloomberg, UBS
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Valuations
Forward P/E for SP 500 vs. Average
Investment-Grade Credit Spreads
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Source Bloomberg
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Strategy

• Overall/Asset Allocation
• Remain overall defensive
• Equity valuations vs. outlook and risks suggests
  staged re-entry
• Over 6-12 months favor diversified fixed income
  allocations
• Core focus
• Liquidity and diversification
• UW high yield, emerging markets debt
• UW REITS, Commodities
• Hedge Funds
• Take first-half recession positioning
• Index vehicles and strategies
• IPS review and analysis

The Double Dip
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Source Bloomberg, LehmanLive
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Strategy Average Monthly Returns Over Past 4
Recessions

• Short duration
• High quality

• Value/Growth
• Large Cap
• Broad
• US

• Real Assets

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Source Bloomberg, Sage Advisory
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Strategy Fixed Income
US Fixed Rate MBS Spreads and Agency Spreads

• Short/Neutral Duration
• Curve Neutral to steepening
• Negative real rates
• Supply
• High quality bias
• Attractive breakevens
• Less cyclical sectors
• Lower event risk sectors
• Mega banks
• Spread Trade
• Selectively add credit risk
• Avoid High Yield
• Valuations vs. High Grade
• Default cycle just beginning
• 23 billion in refinancing before end of 2009

Ratio of High Yield Spreads to IG Credit Spreads
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Source LehmanLive
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Strategy Equities Go Big and Stay Home
Relative P/E Ratios - Small Cap P/E vs. Large Cap
P/E

• Favor Large Caps
• Recent small cap outperformance
• Valuations vs. Large Caps
• Small caps do poor in first half of recession
• Small caps in difficult credit environment
• 80 of Small cap index is below investment grade
• Large REIT component

Trade-Weighted Dollar Index

• Favor US over International
• US further along the pain curve
• Closing global interest rate differences should
  support dollar
• US net importer of commodities

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Source Bloomberg
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Market Outlook

• Questions?

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Disclosures
Although the statements of fact, analysis and
data in this Report have been obtained from, and
are based upon, sources Sage Advisory Services,
Ltd. Co. believes to be reliable, we do not
guarantee their accuracy, and any such
information and results may be incomplete or
condensed. All results included in this Report
constitute the Sages judgment as of the date of
this Report and are subject to change due to
market conditions. This Report is for
informational purposes and one-on-one
presentation only and is not intended as an offer
or solicitation with respect to the purchase or
sale of any security, strategy or investment
product. Past performance is not a guarantee of
future results.
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