William Smead
Chief Executive Officer
Chief Investment Officer




Dear Clients and Prospective Clients:

I’m fond of saying that the Math you need to succeed in business is learned by the end of 7th grade. If you can do percentages and simple algebraic equations, you can be a huge success! There are two very important areas of investing and our economy which simple math could tell you are going to change.

The first is in housing. The loans attached to housing are the “Achilles Heel” of this economy. All the securities and balance sheets which are poisoned by mortgages have at their core an unknown. When and at what price will housing bottom in the markets that dominated mortgage origination (California, Florida, Arizona and Nevada)? Those states have also dominated foreclosure statistics and provided the most toxic paper in the most egregious mortgage-backed securities market. If the demand for homes remains relatively constant, then it is the supply of homes on the market which tell you if some kind of equilibrium is being reached.

Here is the simple math. Housing starts were the lowest in 50 years in January at an annualized pace of 466,000 new homes. Don’t just pass that statistic by. MORE HOUSES WERE STARTED IN THE U.S. IN 1960 WHEN WE HAD A TOTAL POPULATION OF 180 MILLION THAN ARE BEING STARTED TODAY WITH A P0PULATION OF 300 MILLION! Home sales are up sharply in the worst performing states. There are about 1.3 million homes absorbed each year in the U.S. The inventory of unsold homes dropped recently to 9-months supply from a high of 11-months last year. The media and internet outlets want you to believe that additional layoffs and foreclosures are the key to housing finding a bottom. However, we believe those negatives are only slowing the positives in rebalancing supply and demand. With more babies being born in the U.S. in 2007 and likely in 2008 than any year since 1957, it is likely that demand is not constant, but rather is growing underneath the surface. The new stimulus bill gives an outright $8000 tax credit to first-time home buyers (anyone who hasn’t owned a home for three years) which does not have to be paid back if you keep the home for three years.

Conclusion: More demand and less supply will lead to equilibrium. Equilibrium in housing prices would clarify the underlying value of mortgages and mortgage-backed securities. Clarification of mortgage and mortgage-backed security values could define financial institution book values. Definition of “real” book values would refocus investors on earnings power. Refocusing on earnings power would restore confidence in the surviving financial institutions and the stock market in general!

The second area for discussion is gold. I read recently that approximately 75% of the demand for gold comes in the form of jewelry. If you read the reports of any jewelry company, you’ll find that the demand for jewelry is down significantly (Tiffany Christmas sales down 21%). The price of gold is up to $970 per ounce this morning and has risen over the last three months. If 75% of your demand drops by 20%, you have a loss in demand of 15% (assuming supply is constant). For prices to rise while that was going on, you needed speculators, who make up something less than 25% of demand, to have demanded everything that jewelry buyers normally demand and buy a great deal more! It is too bad for them that supply is not constant. Thanks to M.C. Hammer and Ed McMahon, people are turning in their gold for cash in record numbers; enough to justify expensive adds at the Super Bowl and all day on television.

Conclusion: Less demand and more supply of gold will lead to much lower prices at the point that speculators run out of bullets in their gun (remember what happened last summer when Oil speculators ran out of “Peak Oil Theory” bullets in the face of falling oil consumption). Those bullets are all “fear’ trade bullets. The “fear” trade goes away when equilibrium is reached in housing, the financial institutions are stabilized and some confidence comes back into our economy. We at Smead Capital Management recommend that long-term investors sell their gold before the “fear” trade disappears and before two plus two goes back to equaling four.

Best Wishes,

William Smead

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