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Market Insight- Fourth Quarter 2008
Stocks managed to post a modest gain during 2007, despite the turbulence in the last three months of the year. The S&P 500 returned 5.48% for the full year, but decreased -3.33% during the fourth quarter. Stocks experienced unprecedented volatility throughout the year as investors pondered weakness in the housing industry, concerns over financial companies, the sub-prime mortgage mess and the possibility of a weaker economy. As an example of the volatility experienced by capital market investors in general, the two best performing asset classes in 2007 were U.S. Treasury bonds and emerging markets. There is a certain irony in the fact that these two asset classes, usually perceived as the least and most risky respectively, were among the best performers. As we discuss in our Market Commentary, the stock market, as measured by the S&P 500, was a very challenging opponent during 2007. Performance of the S&P 500 during the year was very narrow and dominated by a handful of stocks. The average stock in the S&P 500 gained only 1.26%. Three equities which we chose to avoid due to their lofty valuations, contributed close to 2% of the S&P 500’s meager return: Apple Computer gained 133% during 2007 while high-flyer Google was up over 50% and Amazon rose 135%. Of the eight economic sectors into which we categorize equity investments, two, Consumer Discretionary and Financials were significant losers, decreasing -6% and -13% respectively during the year, while two others, Technology and Energy, were at the other end of the spectrum, gaining 25% and 36%, respectively. Our D&B equity composite fell modestly short of
our performance goals during the year, as we stuck to our disciplines which we
have found to be successful over full market cycles in the past. We primarily
avoided risk, we did not over or underweight specific economic sectors and we
invested generally in high-quality companies with strong track records, while
not taking large risk positions in any one stock. We generally tracked the index
during the first three quarters of the year, but lagged the S&P 500 during the
fourth quarter.
[top] Fixed income investors again experienced strong gains across the Treasury yield curve as investors continued to migrate to ultra-safe securities. The benchmark ten-year U.S. Treasury note rose sharply in value during the quarter as the yield declined to 4.03% from 4.59% at the end of September. For the full year, 10-year Treasuries returned 8.65%. Short-term interest rates, as measured by the three-month U.S. Treasury bill, also moved lower and ended the quarter at 3.24%, down significantly from the 3.80% level three months prior and well below the 4.25% Federal Funds rate. Our outlook for the next few quarters is for slowing economic growth, although we believe the U.S. economy will avoid slipping into a recession. Clearly, the first half of 2008 will see negligible growth in GDP, but by mid-year, the effects of declining Fed Funds rates and the resumption of more normalized credit markets should provide the impetus for renewed economic growth closer to the long-term trend. Equity markets are experiencing their second consecutive quarter of negative earnings comparisons which is weighing on stock prices. We believe many companies took significant writedowns in the third and fourth quarter earnings releases meaning earnings growth should resume in the spring and help to push markets higher over the remainder of the year. Economic Comments Economic data reported during the fourth quarter showed the economy slowing significantly. Housing and autos continue to be the weakest areas of the economy, but recently we have seen a slowing in both manufacturing and employment. The Federal Reserve has been reducing interest rates for the past four months and may need to move faster to help the economy regain its footing. While the Federal Reserve continues to talk about signs of inflation, we believe slowing economic growth is currently a larger concern. We expect economic growth, as measured by the GDP, to slow to a rate of 1% to 2% in 2008, as compared to the 3% average over the last four years. Every Fed tightening cycle in the past 50 years has been followed by a financial crisis. A financial crisis almost always compounds an economic slowdown, and we are currently witnessing that situation. The economy is weak, and some people are talking about a recession and feeling bearish. Federal Reserve Chairman Bernanke signaled a shift in emphasis for the Fed in his recent speech. Our interpretation of his comments suggests a significant reduction in the Federal Funds rate during the first quarter of 2008, as well as a lower end-point on the Federal Funds rate. The market is currently pricing in a Federal Funds rate of approximately 2.0% by the end of 2008. We believe the Fed Funds rate will be reduced to about 2.5% by June 2008 which will benefit many borrowers and help to revive many of the lending markets. We caution that with two-year Treasury notes making a new cycle low below 2.10%, many believe that the Federal Reserve’s short-term actions may not matter. Until the yield on the two-year note begins to move higher, fixed income investors are showing their belief the economy will worsen from here. Capital Markets The investment case for equities in 2008 is clouded and many are pointing to the sharp declines in the first two weeks of the year as a sign of further declines to come. When comparing U.S. equities to nearly every other financial asset, the stock market appears undervalued at this point. Treasuries are yielding less than 4% across the yield curve, commodities are at an all-time high, and foreign markets have far outperformed U.S. markets during the past several years. Currently, earnings expectations for the S&P 500 approximate $92. While this is below the $101 estimate as recently as August 2007, we think it is a reasonable estimate and factors in the current period of below market potential growth. However, with the percentage of stocks at 52-week lows hitting levels seen only twice since 2000, a near-term bounce in the equity markets is quite likely. Aside from Energy, the only sectors looking healthy are defensive in nature (Healthcare, Staples and Utilities). Despite commodity prices setting new highs on a regular basis, forward inflation expectations (as measured by the 5-yr forward TIPS spread) are declining. The current estimate for fourth quarter 2007 S&P 500 earnings are for a decline of 14%. This figure will likely continue to trend lower during the actual reporting season. We believe actual earnings will show a decline of 20% or more. Many companies – particularly financials – will use the occasion to take significant writedowns. Financials and Basic Materials are expected to show the worst earnings comparisons. We continue to prefer large-cap companies for the portfolios we manage because of their broader base of customers and global presence. In addition, these companies have the ability to survive even significant economic downturns due to their financial strength and ability to draw on funding sources that are not available to smaller companies. While this does not necessarily mean their stock prices will do any better than their smaller competitors during the short-term, it gives us comfort to know they will be standing when the current economic slowdown is over. As some of the weaker competitors fail during slowdowns, these larger companies can gain market share. Oil prices touched $100 in 2007 and have since retreated to below $90. Many analysts point to demand growth by China and other developing countries as a reason for the fivefold increase in oil prices this decade. While third-world demand has increased meaningfully, there continues to be significant speculative activity in the oil futures markets which is artificially boosting the commodity price. We have watched the price of oil, metals, and other raw materials rise significantly over the past few years and fear that investors in these hard assets are getting caught in a speculative bubble that will end as every previous bubble has. While we do not profess to know what will cause the bubble to burst, it is well known that China has focused on keeping its economy growing rapidly in anticipation of their hosting the 2008 Summer Olympics. With this event less than seven months away, we may see China begin efforts to slow its economic growth towards mid-year. If so, the effect on commodities prices could be considerable. Conclusion We are clearly in a challenging period for equity investors. While the market has shown positive returns for the past five calendar years, in several of these years the returns have been below the long-term average. As the Federal Reserve attempts to engineer a mid-cycle slowdown, the economy is being buffeted by the fallout from the mortgage crisis and high energy prices. The combination of these factors, along with the increasing effect of hedge funds in the marketplace, mean the volatility and uncertainty may linger for some time. While we had a good year in 2007, we fell modestly short of our performance goals. We believe our investment discipline helped client portfolios to earn modest positive returns in one of the most volatile and narrowest markets in several years. Some holdings saw significant declines in price, but we avoided those previous highfliers that were driven into bankruptcy and became worthless. The stock market was very narrow last year. Basic Materials, Energy and a small number of technology companies accounted for the entire return of the benchmark index. Three companies are noteworthy for a brief discussion. We did not own these three companies because their valuations were above what we believed were warranted and the risk in owning these companies was too high for our investment discipline. Apple, Amazon and Google are all very strong companies with solid business models. Yet the market had rewarded each stock with a valuation far above what we believed was the intrinsic value. That did not prevent the companies from moving significantly higher during 2007. A significant portion of the underperformance of our client portfolios during 2007 came from not owning these three companies. Again, we have no argument with the businesses these companies are in, nor in their management or business models. It comes down to valuation, and our discipline kept us away from these companies. Time will tell if we were correct to avoid those names, but clearly during 2007, investors that owned these three stocks performed better, while taking significant risks. As your investment manager, we carefully monitor the potential risks within client portfolios and position the holdings to best protect against a significant negative event. We have never strived to achieve the highest returns because this would entail levels of risk magnitudes higher than our clients would be comfortable undertaking. We believe our clients are best served when we achieve positive returns in up markets, and fiercely protect the downside in falling markets. Over a full market cycle, this strategy will result in above-market returns with less risk. [top] |
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