Unfortunately, the world is still ending. GDP here (and nearly everywhere else) continues to drop rapidly. Current government numbers make a period of near-term deflation a real possibility. Deflation, the great bogeyman of the modern central banker is here: wages, commodities, asset prices, imports, exports and corporate earnings are all coming down at the same time. Unemployment is surging and credit is hard to get. “The Great Recession” is in full swing.

Despite impressive federal stimulus and dramatic interest rate spreads, banks are still not lending. As a result, the credit “crunch” is rapidly turning into a full-fledged credit “crisis.” Read on. We have a lot to say on this topic.

How Long Until We Get There?

When will we see the bottom? That’s the question everyone is asking. Obviously, we can only guess. Certainly, in the near term we will watch prices go down. It’s hard to imagine that the prices of energy, housing and food could finish a broad-based decline before the end of summer unless governments step in to jack up prices. It’s hard for us to see domestic unemployment bottoming out at least until late summer. Retail sales, commercial real estate, and food prices have yet to see their ultimate lows.

We expect that 2009 will be a net deflationary year, but that prices will start to go up again by late 2009 or early 2010.

How to Invest in this Horrible Climate

Patient investors can still make money by focusing on quality, valuation and yield. The best investors will find ways to capture all three: Quality means investing in firms that will grow and thrive in the long run. Such firms will find ways to use the current environment to become leaner, meaner, acquire control of valuable assets at firesale prices, rationalize costs and use patience and skill to leave their competitors in the dust. Valuation means investing with a disciplined approach to “buying well.” Value-style investing is back with a vengeance. Simply put, value investors say, “show me the money.” Invest based on dividends, yields, cash flows and earnings. Yield means getting paid current income to own securities. Even long-term growth investors should demand to be “paid to wait” for the markets to rebound. How? By cashing dividend and interest checks until the market--at its own time and on its own pace--rewards yield investors (when spreads eventually come in) by trading effective yield for capital appreciation.

What Happens Next?

When prices are done going down, they will go up again! We can’t be sure whether all this massive federal stimulus will ultimately result in inflation (prices up, growth positive) or stagflation (prices up, growth nil). But we are confident that we will eventually see one of the two.

Yours, Eric Wanger, JD, CFA