Depressed market conditions worsened during September as tight credit markets and a lack of liquidity in the global financial system caused a further escalation in investor risk aversion. Equity markets performed very poorly in September with the All Share Index losing 13% or R530 billion of its value. The Resource sector experienced the most pressure, losing 21% during the month. It is now the worst performing sector over the last 12months, followed by Financials with a loss of 17%and Industrials down 14%. All in all, there is nowhere to hide.

Markets are panic stricken and the question now being raised is how severely the global economy will be impacted. The China-Western decoupling theorists have quietened-up and the probability of a synchronized global downswing is rising. Recent dataflow from China already supports this view. Emerging markets, the stalwart of the last few years, has experienced one of their worst quarters as investors are starting to doubt the sustainability of growth rates in this part of the world.

Whilst all this economic news is significant, it is also important to appreciate that share markets across the globe have already responded to these factors. Some companies on the local bourse are being sold at fire sale prices and investors with the appropriate time frame are currently facing opportunities to acquire high quality companies at very attractive prices. Long term value investing has over time proven to be the best investment approach and one we at Alphen vehemently stick to. Markets can stay cheap for long periods of time, but eventually value gets recognised. Entrepeneurs do not launch private businesses with the expectation to unlock value in12 months, yet investors in the stock market often have these irrational expectations.

As the prices of quality assets decline, the "margin of safety" for new investors in these assets actually increases. This means that the risk of capital loss diminishes, which is why depressed asset prices should be viewed as buying opportunities rather than selling opportunities.

Market forecasting is, in our opinion, inaccurate and an error-filled approach to investing. For those that attempt this methodology, the current volatility we believe must be making successful investing, literally impossible.

A much more accurate and wise approach is to understand that long-term investing has proven to be the correct and successful approach to making money. We thus caution investors to be patient and to be realistic with their short-term return expectations and to remain cognisant that buying undervalued assets, always leads to positive real returns over time.

The PSG Alphen Flexible Fund's asset allocation is skewed towards those equities, which we believe are trading below their fair values and we expect superior returns from these companies relative to cash in the years ahead. The foreign exposure in the fund remains overweight in cash presently, which is outperforming other financial assets. Offshore exposure has certainly assisted during a period when the downside risk to the domestic currency increased significantly as a result of the increased risk of capital outflows out of South Africa, in line with other emerging markets.

We have remained underweight in bonds as the bond market is pricing in a significant reduction in interest rates, which is likely to be less aggressive than the market's current expectation. For bonds to deliver similar returns to cash in the next 12 months, the long bond yield to maturity needs to fall to 8%, the current yield is 8.9%. Given the current currency and inflation risks that are unfolding, long bond yields are unlikely to decline to these levels in the near term. We therefore favour cash relative to bonds.

Every bear market tends to have its own unique characteristics, but all of them begin during a phase of extreme optimism and end during a period of extreme pessimism. This time will be no different. We have witnessed in most of the JSE a severe bear market over the past year, but it has been masked by the positive performance of commodity counters.

The out-performance of Resources relative to the rest of the market during the last few months has been the most extreme since the seventies, which tells an important story of inflationary pressures that have reached levels last seen when the Federal Reserve Bank embarked on its inflation-fighting mission in the late seventies. Physical commodities usually are a safe place to hide when inflation is rampant. However, this has tended to change quickly in the past when marginal buyers, these are the real drivers of share prices, flee as they get wind of an economic slowdown. Global slowdowns are never a good time to hold commodities. We claim to have no omniscient insights into when commodities will correct, but we do believe that a market consisting of two sectors with such bi-polar performances cannot exist perpetually.

At face value, making a call on equities relative to other asset classes is certainly not an easy task at the moment as the JSE hardly looks cheap at an index level and again as mentioned above, this is ascribable to the performance of resource shares. Based on the valuation level of the ALSI, one would be inclined to take the view that a significant underweight exposure to equities is warranted. This idea would be confirmed too if the valuation metrics of price-to-book, price-to-earnings and dividend yield were considered. In all instances, the market does not look cheap! However, delving deeper into the underlying sectors of our market clearly reveals huge value and excellent long-term buying opportunities that we feel will smartly outperform cash given a reasonable time period.

This is an environment where stagflation fears are dominating headlines and investor psyches and asset prices are falling as people become more pessimistic and focus exclusively on short-term capital preservation strategies. Fear is so evident that assets are being sold at all costs, even if it involves locking in losses or selling at depressed prices. The best buying opportunities always occur though during these periods of irrational selling and we are actively lifting equity exposure within all our portfolios.

Our focus remains on companies with the ability to pass-on price increases and therefore maintain profit margins, but where the ratings have imploded, in line with the broader financial and industrial indices.

Bonds remain an asset class that we have avoided and their dismal performance during the last quarter with a total return of -5% speaks to why we have done so. Over six months, the performance of -6.7% does not look much better. We have been negative on bonds for quite a while and struggled to understand why they did not reflect the potential for currency weakness considering South Africa's large current account deficit as well as the inflationary pulses emerging domestically and globally. Until the end of 2007, interest rate sensitive assets, and particularly bonds, had held up well relative to previous cycles. This changed rapidly in 2008 as domestic as well as global inflationary pressures accelerated significantly and the South African Reserve Bank's rhetoric and actions drove bond yields higher. The 10 year SA government bond yield has increased from 8.35% in December 2007 to its current level of 10.69%.

As mentioned above, we have not owned any bonds for the last few years and in the short-term there is no need to rush back into this asset class. At some point bonds will again look attractive; our cue for building a position will be determined by clear indications of potential monetary easing which will coincide with a more constructive picture for inflation. The bond market traditionally preempts the turn in inflation and interest rates, but given the longevity of the current inflationary cycle as well as the fact that inflationary pressures have spilled-over to non-food-and energy related items, investors are likely to be very cautious before aggressively investing in interest rate sensitive instruments such as gilts. Furthermore, the fact that SA bonds price off offshore bond yields, remains important as bond yields in the US have in our view been too resilient to inflation and some weakness should be expected. Thus, as far as we are concerned, the risk-return trade-off still favours cash.

Thus in summary, we remain overweight cash, we are building equity positions steadily, we are not bond or property bulls and are maintaining our offshore exposure.

2007 was a tale of two halves for both equities and bonds. Equities delivered a 15.2% total return during the first six months of 2007, but managed to generate only 3.5% during the second half. Bonds had a very meager year and all of their 4.3% return for 2007 was generated in the second half. Cash delivered 10.1% for the year, a real return of almost 4%. After lagging equity returns over the prior three years, Listed Property made a stellar comeback to the top of the asset allocation charts with a total return of 26.5% for the year. Two thirds of this return was also generated in the first half of 2007.

2007 was one of the more volatile periods of the past four years. The year was characterized by mounting risks to equity markets, yet market participants continued to buy the dips, which proved dangerous in the second half. General mining stocks were amongst the star performers with a total return of almost 40% during 2007 which can largely be explained by a similar number for growth in earnings. Generally, 2007 proved to be a year where investing on the basis of earnings and price momentum was the best strategy. Valuation levels were largely ignored and the out-performers during 2007 were most often the more expensive shares. Consequently it should come as no surprise that the exceptionally strong earnings momentum in construction companies and resource producers resulted in phenomenal outperformance by these sectors, while the generally cheaper domestic industrial and financial companies have showed lower returns as a result of their lower earnings growth and their exposure to rising interest rates.

Relative growth rates should continue to play a meaningful role in the relative sectoral returns, but earnings growth across the market is likely to converge in the next two years as the earnings base of commodity producers increases which will result in slower growth rates than the 30%-plus trend of the last two years. On the other hand, earnings of local finance and industrial companies should sustain an earnings growth trend of mid-teen levels over the next two to three years, in line with nominal GDP. Yet domestic finance and industrials trade at a significant discount to the market and relative to their historical levels. This is understandable given the impact of rising interest rates, but we expect to make strong returns from this part of the market once the rate cycle has peaked. The JSE as a whole continues to offer value in the long run, but negative sentiment spilling over from US growth fears and the credit crisis could potentially stall returns in the short term.

Since 2005 bonds have delivered an impressive performance, considering the current interest rate up-cycle when compared to previous cycles over the last 25 years. The yield on the 10 year bond has increased only by 15% since its low point in 2005, while interest rates have risen by almost 40% since the bottom in 2005. The strength of the domestic bond market during the last six months of 2007 can be ascribed to the strong performance of the US bond market on the back of growth concerns in the US.

The resilience of the rand, despite increased global risk aversion, as well as the widening of the interest rate differential between South Africa and the US has lent additional support to the bond market. On a long term view bond returns will remain at the back of the pack, however we believe that the rand remains vulnerable to the high Current Account Deficit and currency weakness would also sustain relatively high inflation numbers. We do not favour bonds at this stage of the cycle, especially as cash offers excellent returns at no risk. The yield differential between money market rates of 11% and the South African 10 year bond yield of 8.6% makes a cash investment very compelling. This should probably change as the interest rate cycle peaks in 2008.

Cash returns gained momentum during 2007 as interest rates continued to rise throughout the year. Cash was an excellent performing asset class for 2007, producing a return of 10% for the year. We might have seen the last of the rate hikes at the December Monetary Policy Committee meeting, given our expectations of a roll-over in inflation towards the second half of 2008. The Reserve Bank's reaction will be largely dependent though on the extent to which inflation will fall back within the target band of 3% to 6%. Until clarity is reached on the latter, interest rates will remain at elevated levels, which will result in attractive cash yields. While sentiment is negative towards financial assets and risks remain elevated, we will continue to favour cash as an attractive alternative. Preference Shares are also offering value at current levels, given our view that interest rates have peaked. This is an area where the fund has limited exposure and we plan to build further positions overtime.

The fund had a flat second half of 2007, underperforming the benchmark by 2.5%. Admittedly, we bought cheap interest rate senstitive stocks early and this cost us some performance during the last three months of 2007. We do, however, believe that valuations are attractive enough that any further equity price falls based on negative sentiment provide great buying opportunities. We see this as playing an important role in sustaining this fund's superb nine year track record. The negative effect of the US slowdown, increasing global geopolitical unrest and the potential for a cyclical (short-term) slowdown in domestic growth rates could be a dampener for 2008 equity returns. Sentiment aside though, valuations on segments of the JSE are attractive enough to remain around benchmark weightings in equities at present.

Adrian Clayton