As we enter into a second week of extreme equity market volatility and the fourth consecutive week of market declines I wanted to write to you to put forward my views on the situation.

First, in terms of the recent downgrade of the US credit rating by the S&P, I believe that markets have vastly over reacted. In my view none of the credit rating agencies have much credibility, though it is worth notingthat two out of the three major rating services have not lowered the rating of the US. These, after all, are the folks that kept banks’ credit ratings positive in 2008 as they drove straight off the cliff. Furthermore,if the past is any guide to the future, and it may not be, over the past 25 years the bulk of the countries which have been down graded have actually seen substantial increases in their stock prices over the next 12 months. Perhaps the most interesting aspect of the U.S. downgrade, and other European ones which may follow, is the symbolic recognition that the balance of global power is continuing to shift East, away from the traditional Western powers, and that the corporate sector today is in considerably better shape than the public sector, particularly in terms of creditworthiness.

Speaking of which, in my view there is an almost schizophrenic aspect to the current crisis. From a global macro perspective the world looks a scary place. Japan has just been through an enormous natural disaster (and attendant fall out), while Europe continues to struggle with both its credit problems and the over riding issue of whether the political will exists to fashion together a coherent economic unit –and face the loss of individual country sovereignty that would entail. Meanwhile the US, like much of the rest of the developed world, is caught between the cruel dilemmaof trying to shake off its history of excessive borrowing and the need to stimulate a lethargic economic recovery. Only emerging markets look to be in reasonably good shape, but, even there, the efforts by some countries, especially China, to reign in inflation are not without peril.

Compounding the problem is the lack of leadership in Washington. Indeed, as even the S&P said in its decision to downgrade the US, ” governance and policy making are becoming less stable, less effective and less predictable”. In short, political risk is rising in America and in my view, the market’s recent behavior is as much a crisis of confidence in our abilityto govern, as it is a response to the economic realities. Or, to paraphrase a friend who I had drinks with last week, and also happens to be theCEO of one of the Federal Reserve Banks, “policy making in Washington today is like a religious war, both sides feel that they have the direct line to God and neither are prepared to compromise in any meaningful way”–hardly a framework for constructive decision making. Furthermore, thoughI have a lot of sympathy for the long term need to have a balanced budget, with the economy already faltering the last thing we need in the immediate future is more austerity and cut b acks from the public sector–a perception I believe the market shares.

If one turns to focus on the micro side of things, the current picture isvery different. Corporate profitability in the US is running at an all time high as a percentage of GDP, and companies have a record amount of cash on their balance sheets. In the second quarter of this year 75% of allcompanies beat earnings forecasts, by an average of 17%. Valuations based on trailing earnings are also, with current PE ratios averaging around 12, a level not seen in several decades. Lastly, for the first time in, dividend yields on the S&P 500 are actually higher than the yield on the 10 year treasury bond.

So the question then becomes, if companies are making so much money why has the market lost close to 15% over the last several weeks, and more importantly, where should we positioning ourselves going forward? In terms of the latter, I think the answer is two fold. Yes, the economy does appear to be slowing though some macroeconomic factors remain positive; witness last week’s unemployment number. With memories of the falls of 2008 still fresh in our heads, it is not surprising that investors have been quick to pull the trigger and sell. Yet at the same time there does appear tobe an element of irrational “dis-exuberance” (with apologies to Allen Greenspan) if not outright panic in the markets’ reaction to recent events.

As regards the latter question, I believe that the last thing investors should be doing in this type of frantic environment is selling. A number of fine companies (some of which we own) are now selling at PE ratios in the single digits with dividend yields, based on current prices in the 5%range. For long term investors these types of securities should not onlybe held, but added to, if one can accept the volatility. We have seen these types of panics in the past and often they are followed by vigorous bounce backs. In fact, we had a correction of similar size last summer andthe market snapped back. As disciplined investors we want to sell when stocks are expensive not when they are on sale, as increasingly seems to be the case. As a friend who runs one of the major investment banks said to me during the depths of the last crisis “when our stock was selling at 12 we could not find a buyer, now that it has risen to 30 everyone wants to own it”. We want to be buyers at 12 and sellers at 30, not the other way around.

However the risk remains that all of this could turn into a self fulfilling prophecy. When markets plummet, it is only natural that investors retrench and companies examine their spending plans. If this turns out to be short term phenomena the damage will be slight. However with limited policy options available to the government, the longer the downturn persists,the more lasting will be the potential damage to the real economy. Nonetheless, with markets already having dropped precipitously, for long term investors there will be numerous opportunities ahead and we intend to take advantage of them.