Market Perspective Full Year 2007
And Outlook
Two related factors played a key role in 2007’s change of fortune: 1) the deepening U.S. housing slump and associated losses on sub-prime mortgages, 2) and the global credit crunch, both of which took away much of the fuel of prior years’ economic expansion. There was some good news to go along with the bad: the global economy continued to expand, most corporate earnings kept growing, and the world’s central banks generally acted aggressively to improve confidence and credit availability. Nonetheless, without a doubt, investors entered 2008 with a very significant increase in risk aversion and uncertainty.
Economic Review
Despite the many dire headlines during the summer, U.S. GDP grew at the robust pace of 4.9% during the third quarter (reported and revised throughout the fourth quarter), with a healthy contribution from consumer spending and exports. Investment spending and government spending also grew in the third quarter. In the fourth quarter, growth of consumer spending moderated, but payrolls continued to grow, and unemployment remained low. Notwithstanding strong results for the U.S. economy as recently as November, it appeared increasingly fragile, as evidenced by weak reports at yearend. For example, December retail sales fell .4% from November. For all of 2007, sales rose 4.2%, the smallest increase since a 2.4% gain in 2002. Also, the Labor Department reported that job growth was an anemic 18,000 in December, which compared with an average of about 115,000 per month for the first 11 months of 2007 and almost 200,000 per month on average in 2006.
In all respects, the U.S. residential housing markets continued to falter in 2007. The number of housing starts and building permits, along with the volume of new and existing homes sold, continued to plummet. Consequently, the median price of new and existing homes sold in the U.S. continued to drop.
Popping of the U.S. housing bubble has been largely the result of exposure and elimination of excessive use of sub-prime mortgages as well as generally lax home loan underwriting and teaser adjustable rates to create a “fiction” of housing affordability when in reality many would-be buyers were priced out of the market. Creative financing and even borrower fraud were an attempt to capture the American dream by buyers who were really financially unqualified for home ownership or at least were under-qualified for the more expensive houses they sought. This and other related phenomena, such as secondary marketing of packages of loans whose risks were far greater than presumed, have been well chronicled in the media. The result has been a dramatic reduction in the availability of home financing which has severely contracted home demand, coupled with huge increases in mortgage defaults which have hurt financial institutions and created an additional supply of homes for sale on an “involuntary” basis.
There have been several important secondary impacts of the subprime/housing debacle, all of which have reduced U.S. economic activity. They include:
1. Home refinancings have dropped dramatically as a consequence of equity contraction from slumping home prices, stricter appraisals, and tighter underwriting. Higher interest rates in 2006 and the early part of 2007 also increased the cost of servicing home equity lines. These phenomena have constricted one of the major cash sources used for on-going higher U.S. consumer spending, namely borrowing against one’s home.
2. Decreases of employment in construction and within financial institutions buffeted by subprime loan losses have reduced personal incomes and increased the fiscal strain on state governments.
3. The credit squeeze has extended beyond mortgages and home equity lines of credit to include other types of credit, most notably 1) commercial paper borrowings used by bank and non-bank financial institutions and large businesses, and 2) loans to small businesses, many of which lack access to public capital markets and depend upon bank loans for their business expansion and job creation.
Partly offsetting the gloomy report on housing and credit, businesses in industries other than housing and finance remain sound and profitable so far. Though overall corporate profits were declining in the second half of the year, much was attributable to steep losses at financial firms, homebuilders, and some consumer-oriented companies. Inventories are rising very moderately, manufacturing activity, especially for exports, has picked up, and the Institute for Supply Management (ISM) index of business sentiment remains, albeit barely in healthy territory (above 50) despite pulling back since June. The Index of Leading Economic Indicators has remained flat, hence undecided, for almost two years.
Energy prices rose between 12% and 20% during the quarter, as oil prices approached $100 per barrel. For the full year, crude oil, heating oil, and gasoline prices rose between 50% and 65%. Precious metals also continued to charge ahead, led by gold, which rose 12% to $833 per ounce for the quarter, bringing the full year appreciation to 31%. Base metals, such as aluminum and copper, were mostly lower during the quarter, and widely varied for the full year. Agricultural commodities prices were also mixed for the quarter and the year.
The sharp rise in oil prices helped drive headline inflation (Consumer Price Index) above 4% for the year (to 4.1%). Core inflation rates (consumer price indices without food and energy factors) were also higher at 2.4%, but remain just below the Fed’s 2.5% “tolerable” maximum.
The U.S. dollar declined versus most major foreign currencies in 2007 and also versus several emerging market currencies as well. In fact, the dollar has declined in five of the past six years. The J. P. Morgan Dollar Index indicated a 6.8% decline of the dollar versus 19 currencies of our major trading partners. The dollar’s 2.7% drop versus the euro for the quarter brought its comparative loss for the year to almost 10%. A similar 2.9% drop versus the yen pulled its full-year decline to 6.2%. Against the Chinese yuan, the dollar declined approximately 6.4% in 2007, as the Chinese have allowed their currency to gradually revalue upward. In 2006, the decline was 3.4%. The adjustment has not been enough to put much of a dent in the huge U.S. trade deficit with China, but it is a continued move in the right direction. Further, the overall U.S. balance of payments deficit, though still high, was narrowing during 2007, caused by solid increases of U.S. exports helped by the falling dollar. Finally, there were a few exceptions to significant dollar weakness: the dollar rose modestly versus the British pound and South Korean won in the fourth quarter, so that its performance relative to these currencies for the year was close to even.
Ailing credit and housing markets, combined with a depreciating U.S. dollar and increasing inflation, have forced the Federal Reserve into a balancing act. The Fed had been rather “gently” easing interest rates in order to facilitate liquidity in the credit and housing markets and stimulate the economy without further substantially weakening the U.S. dollar relative to foreign currencies and potentially heightening inflationary pressures. As of January 22nd, the Fed surprised markets by a dramatic three-quarters of 1 percent reduction in its key target rate one week before its regularly scheduled meeting. The Fed lowered the federal funds rate from 4.25% to 3.50%, which marked the biggest reduction for overnight loans on record going back to 1990. It also marked the first time the Fed changed rates
between meetings since 2001, when the U.S. central bank was battling the combined impacts of a recession and the 9/11 terrorist attacks. Clearly, at least for now, the Fed has targeted recession as a bigger threat to economic health than inflation. The large rate decrease will be a real boon to overextended borrowers because many should see decreases in their loan servicing costs within weeks.
Foreign central banks have been facing about the same dilemma as the Fed. Much in the UK is paralleling the U.S. on a delayed basis as home prices have begun to fall, reflecting a slowing economy and an overextended consumer facing soaring energy costs. Also, as in the U.S., a recent years trend of extensive adjustable rate mortgage borrowing will cause many homeowners to face higher debt service soon as rates reset in historically unprecedented volume. In Europe, growth is also slowing for many of the same reasons, recently prompting the European Central Bank to institute urgent programs to significantly ease credit and shore up financial institutions in its attempt to avoid economic stagnation. Finally, the Bank of Japan has continued very low interest rates in an attempt to re-invigorate the Japanese economy, which has been in the doldrums for many years and retreated in 2007 after showing some hopeful signs in 2006.
As in prior years, an important factor sustaining the health of the U.S. economy and corporate profits, especially for multi-national companies, has been the reasonable strength of foreign developed economies and the strong growth of several emerging economies. Such emerging markets economies as China and India continued to grow at rates close to 10%. Overall, the global GDP is estimated to have grown approximately 4% in 2007, the fifth consecutive year that it has grown more than 3.5%.
Equity Review
After peaking in mid-July, markets became increasingly volatile and trended downward for the balance of the year. They lost some but not all of their first half gains. The broad U.S. stock market rose 5.7% in 2007 as measured by the Wilshire 5000 Index, its worst year since the bear market ending in 2002. The S&P 500 Index of blue chip stocks was up 5.5%, and the Russell 2000 Index of small-cap stocks lost 1.6%.
Because corporations continued to deliver healthy earnings growth, the average price-to-earnings (P/E) ratio of S&P stocks was about 17 based on estimated earnings per share for 2007, down from 19 at the end of 2002, as earnings have risen faster than stock prices. A P/E ratio of 16 is about average for blue chip stocks since 1935, which means the market is in the middle range of its historical valuation – neither extremely cheap, nor very pricy.
Among the more common ways to differentiate among stocks is by size (larger capitalization versus smaller) and by style (value versus growth). For the full year, growth style indices provided satisfying gains while value style indices retreated, with large-caps faring better than small-caps. For the extreme example, the Russell 1000 Growth Index returned 11.8% for the year, while the Russell 2000® Value Index returned -9.8%. Large-cap stocks are measured by the Russell 1000 Index, and they outperformed small-cap stocks as measured by the Russell 2000 Index. Ignoring style considerations, large-caps returned 5.8%, and small-caps returned -1.6%. The higher performance of small caps had characterized markets since the Internet Bubble burst in 2000, and this year’s results represent a very dramatic turn of events.
As suggested above, growth stocks finally outperformed value stocks. Large-cap growth funds beat large-cap value funds by about 12 percentage points. Similarly, small-cap growth funds outperformed small-cap value funds by about 14 percentage points. The preference for value stocks had also persisted since the Internet Bubble burst in parallel with the small-cap preference noted above, so the value-growth comparison also underwent a huge reversal in 2007. Please note that classifications of mutual funds by style have their limitations.
Longer-term data continue to reflect the extent of the 2000-2002 bear market correction, especially among larger capitalization and growth-oriented stocks. The table below shows annualized
eight-year returns for 2000 – 2007:
| Value | Growth | |
| Large Cap Mutual Funds | 6.6% | -8.2% |
| Small Cap Mutual Funds | 13.5% | 1.0% |
As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. The unwinding of the tremendous disparity this decade between the performance of small value funds and large growth funds, which began in 2007, as described above, may continue in 2008 and for many years to come.
Comparing sectors, it was a year of extreme disparity. The energy sector was again a top performing sector at around 40%. Technology recovered from prior years’ poor performance and also performed well, gaining about 16%. After very good results for seven years in a row, REIT’s and other real estate securities had their run stopped and were the worst performing sector in 2007, incurring a loss of almost 15%. Finally, stocks of banks, brokerages, and other financial institutions were hammered by the subprime crisis and credit crunch, causing the financials sector to lose almost 12% for the year.
In 2007, the weak returns for broad, capitalization-weighted market indexes were indeed representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 2,906 stocks advanced and 4,962 stocks declined. The corresponding advance/decline ratio of .59 lands at about the bottom of the 18-year period we have been tracking; only 1994 was lower.
As reviewed in the past, the advance/decline ratio has its limitations. An important shortcoming of the advance/decline ratio is that it provides no information about the magnitude of the advances and declines. Additionally, it is a purely technical indicator and does not involve evaluation of myriad fundamental factors such as economic conditions, corporate profitability, and geopolitical considerations. In spite of the issues, the history of the advance/decline ratio correctly suggested that prices of U.S. stocks had run too high in the 2003-2006 rally. With advances more than double declines in 2006, and considering the high ratios in 2003-2004, stocks entered 2007 “priced for perfection,” which is the expression used to indicate considerable downside potential for U.S. stocks should any significant negatives develop. Indeed mortgage and liquidity crises hurt some corporate earnings and investor confidence as well, resulting in mediocre U.S. equity returns.
For the fifth straight year, foreign stock markets generally outperformed the U.S. market, but for many countries higher returns were primarily due to currency gains for the U.S. investor. As indicated above, for U.S. investors, local returns were enhanced by the fall in the U.S. dollar throughout 2007, which lost about 6.8% verses 19 currencies tracked by the J.P. Morgan Dollar Index. The MSCI EAFE Index, which covers developed markets outside of the U.S. and Canada, returned 11.1% in U.S. dollars, with growth styles significantly beating their value counterparts as in the U.S. Nonetheless, it is important to note that MSCI EAFE only returned 1.2% in local currency terms. Accordingly, before currency gains, such overseas markets as France, UK, and Japan performed worse than the U.S. As suggested in the economic review, UK and Europe encountered many of the same obstacles to business activity and corporate profitability as the U.S. though they were buoyed by growing exports. Japan also enjoyed strong exports, but its domestic economy was stalled by weak consumer confidence. As indicated in the data table on the next page, the average mutual fund investing in international stocks returned 12.2% for the year, somewhat in excess of the MSCI EAFE return of 11.2% in U.S. dollars.
In the UK and Europe, earnings growth moderated relative to 2006 but was still faster than lackluster stock price appreciation. As a result, price/earnings ratios declined from the prior year and valuations actually improved. Viewing all foreign developed markets as a whole, according to MSCI, the ratio of price to trailing earnings for the MSCI EAFE Index was 14.6 at year end, more than a point below its level at the end of 2006, and also below the same ratio for the MSCI USA Index.
Emerging markets stocks continued their stellar multi-year performance. China and India benefited from a combination of growing domestic demand and continuing strong overseas trade. Increasing commodities prices translated into market gains for Russia, Brazil, and Venezuela. The MSCI Emerging Markets Index returned 36.5% in U.S. dollars. U.S. investors also benefited from currency gains, but unlike developed foreign countries, emerging markets also performed well from a domestic perspective; the MSCI Emerging Markets Index returned 30.4% in 2007 in local currencies. Over the last five years, emerging markets stocks have provided a spectacular return of 33.6% per year in U.S. dollars. Returns of emerging markets mutual funds have kept pace.
Stock price appreciation has been so dramatic in emerging markets that corporate earnings growth, though very strong, has not kept up. As a result, overall price/earnings ratios of emerging markets have escalated to the point that they now exceed those of most developed countries. Some have questioned whether valuations (as measured by price/earnings ratios) have gotten out of line and whether the “growth story” is strong enough to justify such high ratios versus those in developed countries in consideration of historically high political, social, and economic risks of emerging countries.
Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:
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Stock Fund Managers Versus Indexes
Active U.S. stock pickers beat the S&P 500 Index in 2007, meaning they have beaten a passive or indexing approach for seven of the past nine years. This result was particularly surprising given that small caps, which are usually favored by stock pickers and typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, had much worse results than large caps for the year. A detailed explanation is beyond the scope of this review, but we observed during 2006 a considerable style drift among active managers toward larger capitalization stocks and toward more growth-oriented stocks. This drift positioned the funds advantageously for 2007 because the adjustments were away from what turned out to be the year’s worst performing stocks (as noted several pages earlier, growth beat value in 2007 and large beat small). As reported above, active international stock pickers also outperformed the EAFE index of developed country market returns. The outperformance may have resulted primarily because most diversified foreign funds include some emerging market stocks, which had very high returns for the year. Finally, it is noteworthy that active stock pickers were able to overcome fees for management of typically 1-2% per year versus zero cost for indexes.
Alternative Strategies
The six openend funds we used during most of 2007 provided a combined return of about 5.7% for the year, about even with the returns of most U.S. stocks and bonds but below those for foreign stocks and bonds. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced a decrease in 2007 return of about .13% (13 basis points) across the portfolio but an increase in stability due to limited correlation of results with stock and bond markets. It should be noted that alternative strategies are particularly effective in down markets, and they had their best quarters compared with traditional asset classes when stocks were at their worst during 2007.
Results for indexes of hedge fund performance in 2007 compiled by Credit Suisse/Tremont, Hedge Fund Research, and Dow Jones were generally inconsistent and not helpful in evaluating performance of the six alternative strategy funds. Results available to us for three private limited partnership programs employing unregistered hedge funds suggest the six funds had somewhat lower returns than hedge funds, which one would expect because hedge fund managers employ at least some leverage and usually have a lower amount of assets under management, which aids flexibility and concentration into best ideas, both of which can benefit returns.
Fixed Income Review
It was another tale of two bond markets in 2007. In the year’s first eight months, the Federal Reserve maintained its target interest rate at 5.25%. Modest bond returns during this period reflected interest income yields, partly offset by some price declines as worsening fears about inflation and the subprime problems began to pressure bond prices across the maturity spectrum. For the balance of the year, risk reshaped the bond markets. Treasury yields plummeted as prices rose when investors rushed to buy the safest assets during the subprime crisis and ensuing credit crunch. As fears intensified, investors demanded to be paid more for riskier investments. Accordingly, the difference between yields on corporate bonds and Treasury bonds widened sharply, hurting overall returns on the former. Meanwhile the Fed lowered its target rate three times by yearend, a total of 100 basis points, to head off economic and financial market woes. As a result, the Treasury yield curve, which had been little changed and fairly flat through August, steepened by virtue of rate drops that were more pronounced at the short end. In summary, government bonds had a quite good year due to price gains associated with investors’ flight to safety and the Fed’s moves, and credit bonds such as corporates had good but lower returns as the increase in risk premiums offset the benefits of the Fed-sponsored lower interest rate environment.
Overall in 2007, U.S. bonds generally earned single digit returns, with returns for longer maturity bonds most aided by rate trends but returns for riskier bonds diminished by increasing risk aversion. The Lehman Brothers U.S. Aggregate Bond Index rose 7.0% versus a gain of 4.3% in 2006. Returns for municipal bonds were hurt by concerns over the financial health of several insurers whose guarantees bolster the credit ratings of many smaller issuers. Finally, high yield bond mutual funds had a poor year due to the credit crunch and weakening economy; the 2007 return was barely in the black at 1.5%.
Aided by currency gains, unhedged foreign bond investors found generally superior results. They earned 11.5% as measured by the Citigroup Non-U.S. World Government Bond Index.
Though there was much concern about the availability of home mortgages, rates actually declined during the year. They responded to the Fed’s actions, albeit slower and less than intended, and thirty-year fixed rates ended 2007 at about 5.7%, or near to a five-year low.
The following table and footnotes present fixed income results:
| Annualized Return* | |||||
| One Year |
Five Years | ||||
| U.S. Bonds | |||||
| Lehman Brothers Intermediate Gov't Bond Index** | 8.5% | 3.7% | |||
| Lehman Brothers Intermediate Credit Index *** | 5.6% | 4.5% | |||
| Intermediate Municipal Bond Mutual Funds (National) | 2.7% | 3.1% | |||
| High Yield Bond Mutual Funds | 1.5% | 9.5% | |||
| Foreign Bonds | |||||
| Citigroup Non-U.S. World Gov't Bond Index # | 11.5% | 7.5% | |||
* Mutual fund return data are from Morningstar.
** Lehman Brothers index of U.S. Treasury bond total returns (i.e., interest plus or minus change in
price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
*** Lehman Brothers index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years.
# Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have the highest weightings). Returns are converted to US dollars.
Key Issues and Outlook for 2008
We don’t favor market predictions, especially in absolute terms. As you know, we argue that the future is unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are against trying to time the market. However, we will identify factors and issues that are important in 2008 and beyond. These are typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future. Examples involve such key factors as global economic strength, energy consumption and price trends, Chinese currency policy, the level of foreign investment in U.S. assets that allow us to finance our on-going balance of payments and Federal budget deficits (also known as the twin deficits), and relative valuations of major securities markets. Thus, we will venture a general outlook and some comments regarding relative performance.
To save time, we are presenting a condensed version this year. The reader is referred to previous years’ outlooks for expanded analysis and discussion of key issues.
The first key issue is the strength of the U.S. and global economy, an important issue every year. The future course of the global economy and the outlook for corporate profits will have a significant impact on global stock and bond markets. The issue boils down to two main questions: 1) Will high energy costs and the U.S. housing slump and credit crunch cause a serious slowdown in U.S. consumer spending and thus the U.S. economy, and 2) if so, have the key emerging markets economies, particularly China and India, managed to sufficiently decouple from the U.S. economy to remain robust in spite of a U.S. recession? Cutting deeper, one could argue that the first question (about U.S. consumption) begs the question about the length and depth of the U.S. housing slump. If a bottom is reached soon, that could go a long way to avoiding a U.S. recession, and the Fed and Congress are certainly “pulling” out all the stops to keep the economy growing. In any case, if emerging economies slump, China in particular, along with the U.S., the continuing health of the global economy is impossible.
The second key issue for 2008 is the direction of the U.S. dollar. If the greenback continues depreciating, unhedged U.S. investors will enjoy currency gains as occurred in 2007. However, upward price pressure from higher cost imports could encourage more U.S. inflation than the Fed can tolerate, forcing it to scale back actions intended to stimulate our economy.
The outlook for interest rates and the shape of the U.S. yield curve are again significant issues, especially later in 2008, when the Fed may need to increase rates if inflation becomes a threat. Of course, global interest rates have their effect on overseas economic activity and the strength of foreign currencies versus ours. Further, we note the interrelated nature of these issues. As indicated elsewhere, the future strength of U.S. and foreign economies depends to a considerable extent on the moves of the various central banks, including the Fed, UK, EU, and Chinese authorities.
We also have to again mention the challenging geopolitical situation and the U.S. Presidential and Congressional elections in November.
Much more so than in previous years, investor and consumer psychology will play an important role. With very few exceptions, the level of volatility in global financial markets for years had been very low until last year. Specifically between 2000-2002, when bursting of the internet bubble caused a very deep 3-year bear market, and 2007, the markets experienced a four-year period of almost unprecedented stability, calmness, and steady, gradual increases of stock prices and global economic activity. Additionally, most homeowners in the U.S. and many other parts of the globe saw huge increases in home prices, adding greatly to their personal wealth and sense of financial well-being. For investors, this benign and profitable period encouraged not only a complacency about risk but also an increasing appetite for risk. For homeowners, cash-out refinancings and home equity lines became the source of an over increasing appetite for consumption. However, as we progressed through 2007, a number of inconvenient truths were revealed. They included awareness that we had achieved an unsustainable and somewhat artificial boom in real estate prices in the U.S. based on irresponsible, easy credit, and this artificial boom was also true to a considerable degree abroad; that much of the excessive pile-up of debt both here and in many developed countries, was indeed bad debt; that we faced the very real threat of global warming; that we faced global capacity constraints from high growth, pressuring energy and commodity prices; and that we faced the on-going cost and challenges of fighting Islamic extremism and terrorism. In summary, these all converged to substitute fear and retrenchment for complacency and greed as we progressed through 2007. The early part of 2008 has witnessed a similar fear and risk aversion and associated market volatility.
The final key issue (every year) is the level of inflation and resource usage worldwide. To a large degree, these levels will determine the fate of tangible asset prices and in turn the returns of real estate and energy funds and inflation indexed bonds. The inflation rate also impacts the financials sector as well as the broader markets for stocks and bonds. The issue hinges on policies set by central banks, as usual, and a balance between the mitigating impact of low cost manufactured goods from emerging economies versus the multiple upward pressures on prices globally.
In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, historical patterns and averages will ultimately prevail. Keeping in mind the historical perspective and some favorable long-term secular trends, here is a summary of our 2008 outlook, which is really just an educated guess; if you desire additional details, please call:
1. Notwithstanding efforts of public officials, the highest probability attaches to a forecast that the U.S. economy will slip into a mild but prolonged recession. This will be due to a continuing and deep bear market in house prices, which will take a number of years to resolve, gradually but inevitably eroding the cash-out value of one of the baby boomers’ biggest retirement assets. This, in turn, will result in a more cautious consumer who is less willing to leverage and more inclined to save. The outlook is for “only” a mild recession because overseas, the global economy seems to be on a decent footing, thanks especially to expected continued strength in emerging economies.
2. Equity valuations are not extreme, which leads one to believe that future economic weakness is generally already discounted in stock prices. The primary factor restraining valuations in the U.S. is the legitimate concern that many companies, especially those with limited exports, will not improve or even sustain the profit growth they have achieved over the past few years. The trend headed into 2007 had already far exceeded most profit expansions, and corporate profits are increasingly vulnerable given the U.S. economy’s landing is not projected to be “soft.” Viewed from January 1, 2008, returns for U.S. stocks will likely range from about breakeven to modestly in the red. Viewed from the low levels already reached toward the end of January, 2008 results will likely be in mid-single digits and may even approach long-run historical averages.
3. Inflation will stay contained based on the U.S. slowdown. Although losing some of its punch, the continuing access to low labor costs in emerging economies such as China and India via globalization of production and distribution capabilities suggests that the secular reduction of the world economy’s inflation propensities that emerged over ten years ago remains in force.
4. With inflation contained, and the Fed easing credit, U.S. interest rates will not be a threat to U.S. stock or bond markets. More rate cuts by the Fed to continue to fight recession will further steepen the yield curve. Given low Treasury yields and increasing but not high risk premiums for credit bonds (in other words, credit bond yields remain fairly low), we expect continued unexciting but positive total returns for most bonds, but the risks of a bond debacle are also low, as long as one maintains high credit quality.
5. The outlook is again good for foreign stocks and bonds. Developed countries overseas offer reasonably solid economic conditions and lower market valuations compared with U.S. securities. Emerging markets local currency returns must come down but should remain attractive based on high growth of their economies and a reasonable opportunity of currency gains. Developed markets may also benefit from currency gains.
As usual, we have found it difficult to develop an outlook for the coming year. We have limited time and resources for the relevant research. Also, the outlook makes a number of assumptions which may prove incorrect. The outlook puts considerable faith in sound decision-making by government officials! Additionally, the outlook assumes the absence of 1) major external shocks, and 2) no more than passing panic and irrationality among investors and consumers. Finally, the outlook selects certain factors for emphasis which may prove to be wrong.
Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets. As usual, geopolitical risks could wreak havoc with these predictions, and there is always the risk of the totally unexpected. If the concerns expressed below manifest themselves earlier than expected, results in 2008 could be considerably worse, or at least different, than indicated above.
Beyond 2008
As for the outlook beyond 2008, we have the same concerns expressed in previous years. The first concern stems from the belief that the tax-cuts and deficit spree of the Bush administration, which have juiced up the economy, will exact a price in later stagnation. The various potential remedies for our growing debt levels and trade deficits are tax increases, spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are currently deferring. Further, as some 77 million baby boomers begin to retire this decade, U.S. Social Security and Medicare will begin to move into the red as well, eventually by trillions of dollars. Some analysts predict no pro-growth strategy can make up such shortages and warn that mounting U.S. debt jeopardizes global financial stability.
According to Fed chairman Bernanke, spiraling government spending could lead to a vicious cycle of even bigger federal budget deficits. “The longer we wait, the more severe, the more draconian, the more difficult the objectives are going to be” in responding to the crisis, he said.
Unfortunately, the same Bernanke has just instituted much easier credit to “bail out” thousands on Wall Street, millions on Main Street, and multitudes of politicians who have failed to exercise appropriate financial/fiscal discipline. It seems we are unwilling take our medicine and prefer to postpone the day of reckoning.
The second concern stems from the global imbalance of aggregate demand and investment versus saving. We have exported some of our strong demand for products and services to bolster the world’s economy, and foreigners have returned the favor by deferring their consumption and increasing their savings to offset our lack thereof. How long this “co-dependency” or “symbiotic relationship” can last is one of the larger long-term uncertainties facing the global economy.
The third concern relates to deterioration in American education and vocation training, which is undermining our competitiveness globally. We also have a related concern about the type of jobs being created by the U.S. economy. Let us hope that December was not typical, when the only significant job gains occurred in food-service and health care in the private sector, plus gains via more government jobs in the public sector. More government, plus more fast food and elder care, are not the means for a dynamic, competitive future U.S. economy.
Implications for Asset Allocation
Because an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications need to be discounted or even completely ignored. Accordingly, we plan to maintain stock and bond allocations approximately at long-term targets and avoid making active bets, as usual. We plan to position bond maturities at a neutral position between short and long. Additionally, we plan some overweighting of alternative strategies to hedge the risks of the weakening U.S. economy. We will also attempt to profit from a declining dollar and higher growth opportunities abroad by overweighting international securities. We are bullish on oil and gas for the long run but plan to modestly reduce positions in tangibles stocks for the short run.
Relevance of Market Review and Outlook for the Strategic Allocator
Before concluding, let’s address the relevance of a review and outlook and clarify why we are planning only fine-tuning and not major allocation changes, as follows:
1. Asset allocation is a long-term approach utilized to manage long-term money according to long-term historical evidence. Asset allocation defined in this manner requires a disciplined adherence to a relatively fixed asset mix. It is also quite contrarian, because when an asset class proportion declines due to relatively poor performance, the asset allocator buys more. Hence, asset allocation entails periodically selling your winners and buying your losers to maintain the strategic balance. This rebalancing is done periodically and “religiously” and is definitely not “market timing” or “chasing performance.” Therefore, near-term outlooks are of little interest to the strategic asset allocator.
2. An outlook is really a best guess over 6-18 months, which is not a long-term period. Thus, most outlooks support tactical maneuvering for short-term gain. Most outlooks are also trend following, not contrarian. It is human nature to expect continuation of recent trends. It takes a brave soul to predict a reversal. We try to develop our outlook to avoid this common problem, but we are human, too.
3. As described in the Outlook Scorecard section below, our outlook is not too reliable. Thus, it is not a sound basis for big bets. We could make cohesive, plausible arguments for predictions that would be both much more negative and much more positive than those above.
4. Caves & Associates prepares a market review so we do not blindly follow history or ignore the markets. We also stay abreast of the latest research that might shed new light on historical bases for portfolio design. We monitor market trends, but mainly to be able to properly evaluate mutual fund managers’ performance and explain the performance of client portfolios. Finally, we prepare an outlook because the exercise has a small possibility of allowing us to foresee major problems requiring extraordinary strategies. Thus, it's prudent, and part of our responsibility to clients.
Outlook Scorecard and Impact on Results
Last year was the ninth time we attempted something resembling an outlook. A scorecard is in order to see if we are gaining anything from the effort.
Our past report cards have been generally favorable: we have had more predictions right than wrong, and our errors have not been harmful to returns. Fortunately, we can say the same for our 2007 outlook.
Last year, we made a number of economic and market predictions. Some were a bit vague or suggested merely relative performance, but we’ll try to provide an accurate assessment.
Each year one major surprise lurks. In 2004, it was the surprising strength of U.S. bonds, in 2005, the very unexpected strength of the U.S. dollar, and in 2006 the continuation of two long streaks many expected to end: 1) very strong U.S. corporate profits and stock prices notwithstanding the beginning of the housing downturn, and 2) the continued outperformance of smaller capitalization, value-oriented stocks. Again in 2007 there were surprises, and as a result, many of our predictions veered off the mark by yearend. The main one, of course, was the rather calamitous surfacing of subprime mortgages as a financial disaster. A credit crunch quickly followed as fear and risk aversion took over for risk-taking and leverage. Accordingly, the subprime/credit crisis turned global stock markets on their ear from mid-year on.
Therefore, the summary assessment of the predictions of last year’s outlook is that they were quite accurate through August but became increasingly off the mark as yearend approached. Without an elaborate evaluation, we’ll first note that our U.S. economy forecast was a bit too optimistic but corporate profits did remain quite strong except in sectors most affected by the subprime/credit crises. Thus, U.S. stock underperformed the prediction, but only somewhat. Additionally, the prediction of little change in the level and shape of the U.S. yield curve was increasingly inaccurate due to the Fed’s rate cutting actions, which lowered and steepened the curve.
As for accurate predictions, U.S. bonds did deliver the forecast “unexciting but positive returns.” Further, the outlook accurately predicted the continued weakening of the U.S. dollar (and the resulting boost to foreign investments) as well as successful containment of core inflation (the dollar actually weakened more than expected and total inflation significantly exceeded core inflation, but we’ll give ourselves the benefit of the doubt on these two).
Because of considerable overweighting of foreign stocks and bonds, portfolio strategies were largely successful in 2007. We used unhedged international positions, thus enjoying strong currency gains. Further, during the full year we underweighted U.S. bonds because we were unexcited about their prospects. We also underweighted international bonds for part of the year. Both underweightings aided results in a year that stocks beat bonds in spite of the former sputtering late in the year. Further, we removed our usual overweight of U.S. value stocks and became overweight growth at mid-year thus taking some advantage of the market’s increasing favoritism for larger capitalization growth stocks. Additionally, during the year we kept our tangibles allocation at or above target, but we appropriately revised the composition of the tangibles allocation to increase oil and gas and decrease real estate securities. Finally, we were underweight junk bonds all year and incurred no direct negative impact from the subprime/credit crises.
To note unfavorable portfolio strategies, our use of alternative strategies hurt results modestly because they were outperformed by traditional stock and bond investments, as described above. Additionally, the Fed’s actions leading to a surge of bond returns at yearend meant that the use of tactical cash detracted slightly from returns. We were also positioned a bit short overall on the bond maturity spectrum during the latter part of the year, causing our portfolios to enjoy less bond price appreciation that was occurring due to the downward shift of the yield curve.
Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated by and large. As evidence, Morningstar has just named its 2007 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual fund ratings). As in 2006, several of the winners were well represented in the portfolios of Caves & Associates clients.
We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or market timing. Over the long run, we are convinced that correct predictions will be largely offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets. Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term, tactical approach.