Wednesday, September 5, 2007

News - August 2007

When is the market merely correcting versus predicting upcoming economic difficulty or even a recession? Corrections can be great buying opportunities where additional equity investments are rewarded. To the contrary, it could be that the cause of the correction is a foreboding sign of systematic economic issues that validate the correction. Amid the uncertainties, one thing we know for certain is that when the market corrects 10% within a few weeks (as they did in July), it is signaling that risk levels have been elevated. Additional investments can be rewarded handsomely. Of course, accompanying those possible rewards is increased risk, which is either real or perceived.

Navigating these questions and making investment decisions based on the data and risk assessments is at the crux of what an investment advisor is about. Even the most accomplished investment analyst or commentator cannot with any certainty time these events, correctly predict the degree of a correction or with complete accuracy provide an analysis of how the events will unfold for the broader economy over a longer period of time. It’s more appropriate to provide probabilities on how these events will play out, realizing that any scenario is not absolutely certain.

The current correction is reminiscent of the corrections in the late 1990’s. In 1997 it was the “Asian Contagion” and in 1998 there was the Long Term Capital Management hedge fund that collapsed because of issues with Russian debt. The US stock market reacted sharply to both of these events, but the corrections did not last, as they did not have a great effect on the US economy. Looking back, those who invested in those uncertain times were rewarded handsomely (and relatively quickly). Remember how the markets sold off in February, 2007 due to the Chinese sell off, but recovered rather quickly to reach all-time highs?

There is a possibility that the current correction could be more significant due to its relation to home real estate prices. Homes and real estate are significant assets for most consumers and investors. But again, there are a number of opinions and variables to be considered when evaluating the current situation. What will be the effect of a prolonged period of falling home prices, if that materializes? Will falling or stagnating prices, if any, have an effect on the broader economy if they are felt regionally, not nationally?

Unlike the potential reduction in home prices, the “sub-prime” and credit issues hampering the banking and lending institutions are not expected to have a great impact on the broader economy. The financial firms who make loans, securitize mortgage loans, sell derivatives of these products, or make any investments in these products are likely to suffer some negative effects. The amount of “sub-prime” loans and lack of liquidity are relatively insignificant issues that should be resolved quickly without a major lasting effect. However, there are many other sectors of the economy that will feel a greater effect based on the level of housing prices.

The homebuilders are the most obvious group of companies that will be impacted by tougher lending standards and sluggish or falling home prices. They have already seen their profits evaporate and are now reporting losses on a quarterly basis. Other retailers may not see their profits disappear, but the expected growth in profits may not materialize.

Over the last month, market volatility was even higher, evidenced by 14 days of 100 point moves for the Dow Industrials. Despite all of the concerns over the past few months, the market was actually slightly positive for the month of August. The Dow gained 1.3% for the month while the S&P was up 1.5%; the NASDAQ achieved a gain of more than 2.1%; and the small cap stocks showed some strength gaining 2.3%. Thus far for 2007, the Dow remains a leading index at a positive 8.7%; the S&P 500 is at 5.2%; the NASDAQ is at 8%; and the small cap stocks are up only 1.4% for the year.

We have continued to see a shift from “value” investing towards “growth”. Within sub-sectors of large-, mid- and small-cap stocks, the growth subsets are well outperforming the value stocks for the month and for the year. This trend, which we have discussed before, is typical in the economic cycle. As the overall growth rate of the economy begins to slow, it becomes more difficult for slower growing companies (“value” companies) to achieve earnings expansion. Hence, investors tend to prefer those companies that are innovating and have the potential to organically grow their profits.

Mid-cap stocks, which have been in the “sweet spot” for much of the recent buyout activity, have underperformed for the month. As some of the recent takeovers have come into question due to the tightening credit environment, we have seen the mid-cap stocks struggle.

International stocks did not make it into positive territory during the month, as both the developed foreign market index and the emerging markets were down 1.6% and 0.6% respectively. Foreign investments may have been weak partly due to the fact that there was such a great “flight to quality” over the past month. Short-term US treasuries were in demand as yields fell to under 3.5% during the middle of the month, ending at just over 4.0% on August 31st. This “flight to quality” may have helped the dollar gain some strength, which is a detriment to the foreign currencies and, therefore, investments in foreign equities.

These low treasury yields are implying some significant Federal Reserve actions to lower interest rates over the next few months. Potentially aided by the prospect of lower rates, Financials and Real Estate have reversed their downward trend for now, with gains of 1.5% and 6.4% respectively for the month of August.

While September is historically a difficult month for the stock market, there are some reasons to be optimistic. First, we expect Ben Bernanke and his FOMC mates to follow through and lower the Fed funds rate, which will hopefully slow the rising rate of home foreclosures. It only seems fair that if the Fed is willing to help the big banks who are struggling with credit issues by lowering the discount rate, then they have an imperative obligation to also assist those single family homeowners and consumers who are also struggling. We are not condoning irresponsible lending or borrowing, but we do support the Fed taking action to take some of the sting out of the current situation.

Insiders purchasing shares of stock is another reason for us to be optimistic this fall. The level of insider buying has some analysts citing that these are the most bullish insider purchases since the fall of 2002. Obviously, the executives and CEO’s would not be aggressively buying their company stock unless they believed their prospects were good. Some of the buying has been concentrated in the financial sector, which has suffered the most because of the sub-prime fallout.

We do see some increased risks to the economy and our investments as we navigate though this uncertain period, and as such, we are a bit more cautious in the near term. Over the long term, we expect the lower interest rates to stabilize the credit markets and housing prices. We may see some disruptions in certain sectors most closely related to these issues, but the long-term effects should be minimal. A slightly more conservative portfolio with an increased emphasis on fixed income investments and consumer staples investments may be appropriate for a relatively risk averse investor.

We are also excited to be approaching the best time of year for equity investments – November through May of each year. Fortunately, that seasonally strong time of year is just around the corner.

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