Review & Outlook

Our take on the investing, financial, & economic themes of the day

Fourth Quarter

9 January, 2008 by admin in Quarterly Letters

Despite sharp sell-offs in the third and fourth quarters, the stock market ended 2007 with a respectable gain of 5.5%. In the first three trading days of 2008, however, the market lost one half of its 2007 gains. It is unclear what is behind the volatility; explanations include a change in stock market leadership, a change in short selling rules, heightened political uncertainty. Whatever the reason for the volatility, it can distract one from the long-term plan. So too for the constant media din of streaming news, forecasts and commentary. If investors can just ignore the distractions and keep the long-term commitment to stocks and low portfolio turnover to keep expenses down, they will prosper in these volatile markets.

Will the current slowdown turn into a full blown recession? Every day the answer seems to change, and the markets lurch in a different direction. But if the answer to the question is “yes,” it is not the end of the world. Recessions historically occur about one quarter of the time. They are the main spring of one of our systems greatest strengths: its ability to correct its own excesses. But the headlines in the financial press, and a number of presidential candidates, would have you believe that we are poised on the edge of the precipice. We are not. The stock market is trading at 14 times 2008 earnings, which puts it solidly in the “average” range on the historic valuation scale.

I mentioned the self-correcting mechanism of our system. In 2007 the excess that came to be corrected – – perhaps I should say is being corrected – – was that of easiness. I am referring to the easy thinking that put some two million people into homes they could not afford. It is a good thing, certainly, to own your own home, but it is just as important, maybe more important, how the goal is accomplished. Government policy makers over the past twelve or so years behaved as though easy credit could replace or at least speed up the process of saving, sacrifice and postponed gratification that leads to home ownership. Easy credit, it turns out, is no replacement for these virtues. You cannot build wealth by encouraging people to go into debt.

And then there was the easy thinking of banks and mortgage brokers. They thought, wrongly, that innovative financial engineering could somehow manipulate an asset bubble into predictable and profitable outcomes. Bubbles don’t work that way. The banks should have known better. Now they do. That’s another essential lesson that’s well behind us, and we can move on, stronger than before.

I spoke above about the self-correcting mechanism of the markets and how this is one of the good features of our system. What is bad about the arrangement, however, is that the self-correcting mechanism usually overshoots its mark, and can hurt innocent people who had nothing to do with the excess in the first place. Who has been hurt from the easy credit/easy thinking of policy makers and bankers? So far just the banks and the mortgage bankers. They have written down over $100 billion. As for innocent bystanders, the press is struggling to find them. (Indeed if the banks wrote down $100 billion, then someone got a windfall.) Of the eight industrial sectors that make up the Standard & Poor’s stock universe, only the two sectors containing banking and homebuilding suffered losses last year. The rest of the economy – – the other six of the eight S&P sectors – – actually ended the year in great shape, with high credit ratings and strong balance sheets and income statements.

What is on our worry list? Certainly a terrorist attack. It is unquantifiable, but in what has been called a hundred year war, the threat remains a constant. And then there are the disruptions of $100 a barrel oil. One thinks of the major government-induced dislocations in the late 1970s, the last time oil reached this price level. If the federal government decides to intervene in the market, it is likely to prolong the problems, as it did in the late 1970s. Related to the high price of fuel is the high price of food. We were dismayed recently to learn that a cucumber costs $1, an orange $.99, and scallions $1.29. Inflation, long subdued, appears to be threatening a comeback.

To sum up, there are problems as we set off into the New Year, but there are great investment opportunities as well. An obvious opportunity is the banking and finance sector. The news media is working overtime on how badly prominent members of the sector behaved in the housing bubble. Investors don’t want to have anything to do with the sector. Therein lies the opportunity. And in the world at large the two most populous nations, India and China, are overnight industrializing their economies, creating demand for practically everything in their wake. Thus economies are changing, which is the first requirement for a healthy stock market.

Analysts expect domestic corporate earnings to grow about 15% in 2008. It is hard to imagine stocks turning much lower when investors are this defensive and corporate earnings are still so strong. If someone made us predict the investment outcomes of 2008, stocks would exceed their 2007 return of 5.5%, maybe even equal their historic annual return of 10%. We cannot be so sanguine about bonds, which appear to have little room for error. If they earn their meager coupons (the ten-year Treasury yields less than 4%), they will be lucky. Thus we pick big-capitalization blue-chip equities, especially of the growth style, to win the performance race in 2008, albeit with a good deal of up and down along the way.

Sincerely,

Mark O’Brien