News - February 2008

The news surrounding the economy and the financial markets has reached a crescendo, as evidenced by the late night talk shows’ focus on these issues. For example, the nightly satirical newscast, “The Daily Show with Jon Stewart,” has run several major segments humorously depicting the news media coverage of the slumping stock market, the mortgage crisis, and the slowing economy. Even with all of the inane political activity lately, they have set aside time to poke fun at the pundits and networks dedicated to reporting on the financial news.

A common phenomenon associated with the economic storylines is that, by the time these narratives reach the front page of the newspapers and the covers of the weekly news magazines, they have been accounted for. Thus, a casual observer of the financial markets or the economy may be encouraged to react based on events that have already been reflected in the markets.

As news of a soaring housing market or stock market makes the headlines, investors may feel obligated to get in the game. Conversely, if the news is negative, investors may feel compelled to avoid stocks or real estate. Reacting to the fear or exuberance generated by the headlines can often lead an investor to make poor investment decisions. We don’t necessarily blame the news media for reporting these events as much as the reactions that the news media may be inspiring, whether intentional or not.

One reason that it may not pay off to respond to the headlines is that analysts often try to use economic statistics to extrapolate predictions of stock market returns. In actuality, it’s probably the stock and other financial markets which are the leading indicators, rather than the inverse. We have seen the stock market sell off rather significantly recently only to be followed by some rather unenthusiastic economic reports on employment, consumer spending and economic growth.

All economic signs are indicating that we are in the midst of a dramatic change in economic growth compared to the level of prosperity enjoyed since 2003. However, it’s still not certain whether an official recession will develop or whether we are going to experience very slow growth and for how long. This lack of certainty is, in part, the source of the extreme volatility of the markets in early 2008.

The government reported that non-farm payrolls declined in January for the first time since 2003, as 17,000 jobs were lost for the month of January. The labor department also reported that the jobs created in 2007 were 376,000 less than originally reported, although the unemployment rate remains a respectable 4.9%. The preliminary Gross Domestic Product reported for the 4^th quarter was a mere 0.6%, although some had predicted a negative GDP recording by this point.

It appears that the employment and GDP data points are what encouraged the Federal Reserve to lower the Fed Funds Rate by 1.25% within the span of a week. The surprise 75 basis point cut was announced on January 22^nd following a sharp decline in foreign markets on January 21^st and 22^nd (the U.S. markets were closed on January 21^st for the Martin Luther King holiday).

The sell-off in the global markets may have also been a factor in the Fed’s decision to cut rates. The U.S. markets were poised to sell off as much as 5% on the morning of January 22^nd, but the Federal Reserve interest rate cut mitigated those losses. By the end of the day, the widely followed Dow Jones Industrial Average ended up losing just over one percent. The Dow 30 Industrials actually rallied in the neighborhood of 1,000 points from the inter-day low on January 22^nd through the end of the month, which included another 50 basis point reduction in interest rates by the Federal Reserve on January 28th.

Despite the rebound toward the end of the month, January 2008 was still rather uncomfortable and unsettling for equity investors. The S&P 500 was down 6% for the month while the Dow Industrials lost 4.5% and the NASDAQ fared worse at negative 9.8% for the month of January. The S&P 500, Dow Industrial Average and the Small Cap Index all bounced significantly after the January 22^nd trough, while technology stocks saw a somewhat muted rebound over the last several days of the month.

Contrary to last year’s trend, the value indexes (large, mid, and small cap) have all performed significantly better than their growth counterparts over the first month in 2008. The value indexes also produced negative returns for the month of January, but the losses were generally half of the loss for the growth stocks. This is a trend to watch as value stocks tend to do better while the economy is slowing and towards the beginning of the economic cycle. This is the first monthly period since December of 2006 that the value funds significantly outperformed the corresponding growth indices.

The U.S. markets outperformed the international markets for the month of January. The developed international market index was down 7.85% for the month of January while the emerging markets index was off 8.92%, as calculated by investing in the respective exchange traded funds. The U.S. dollar has stabilized somewhat, although it still remains, as of January 31^st 2008, near all-time lows compared to the Euro.

Financials have shown some signs of bottoming as a popular financial services exchange traded fund finished the month of January with positive performance of 0.73% for the month, erasing a 12% loss from January 18^th through January 31^st. It’s a highly contested position by pundits, economists and analysts as to whether or not the financials have indeed bottomed temporarily or permanently. Only time will validate which side of the argument is correct.

Retailer and homebuilder stocks also produced positive returns for investors for the first month of 2008 as the retailers ETF returned 1.92% while the homebuilders ETF returned a rather impressive 5.17% for the month of January. Commodity prices were mixed as the uncertainty in the markets continued to inspire investors to buy gold, pushing prices up to $935 per ounce from $837 as of December 31^st, while oil prices fell about $5 for the month as future fuel demand is questioned due to a potentially slowing economy.

There have been six recessions since 1970, and in five out of six cases, the stock market performance produced significantly positive returns during the six months immediately following the recession. During these five periods, stocks (as measured by the S&P 500) gained an average of 15.3% over the six month periods immediately after the recession. In these instances it was clear that stocks rebounded well before the actual economic statistics validated a recovery. In fact, in three cases there were actually stock market gains during the official recession.

The most recent recession of 2001, the lone outlier of the past six recessions, saw negative performance in stocks before, during and after the official recession. Obviously this period, being the most recent, is foremost in our minds. However, it is a good exercise to point out the historical numbers of recessions past. The high valuations for stocks compared to their earnings leading up to the 2000-2002 bear market forebode a much more dangerous position for the markets than we have today. In our view, current valuations are very reasonable today as the S&P 500 is priced only at 14 or 15 times 2008 earnings estimates.

Each period of stock market performance and the corresponding economic cycle is unique unto itself. Unfortunately, the exact timing of economic and stock market events is very unpredictable. Many experts will offer their predictions only to be vindicated at some point and declare their soothsayer-ship. We don’t believe that anyone can consistently predict these events, especially the timing of such things. The pessimists tend to warn of calamitous events regardless of what the market is indicating just the same as the optimists continually dismiss any warning in the market or the economy.

Whether you are an optimist or pessimist, we are assured that each point will be vindicated in the future again. This is not the last slowdown or recession we will see, and we are certain that the economy and the stock market will rebound in due time. Just last October, the S&P 500 and the Dow Jones Industrial Average hit all-time record highs; we are confident that those levels will be reached again. It’s the patient and diligent investors who will profit handsomely in between now and then.

Thank you again for visiting RollinsFinancial.com. We hope this update has been useful to you. Please email us and provide us with your thoughts and comments.