Insights
Market Commentary - 4th Quarter/Year End 2007
Bi-polar best characterized the financial markets in 2007! Having recovered yet again from the depressive levels evident in late August, the fourth quarter brought about conditions where volatility ran rampant and investor confidence plunged to near manic levels amid uncertainty and fear. Though the quarter and year overall ended in rather lackluster fashion, one would have never believed that the Dow Jones Industrial Average would have ended the year in positive territory given the investor anxiety that prevailed during the second half of the year. During the fourth quarter, the Dow Jones Industrial Average dropped 4.5% to 13264.82., while the S&P 500 Index declined 3.8% and the NASDAQ Composite declined 1.8%. For the year overall, however, the Dow was up 6.4%, the S&P returned 3.5% and the NASDAQ rose a remarkable 9.8%. The following chart illustrates both the 4th quarter and full year results of the major equity indices:
A look at the chart below validates the rollercoaster ride for the year, with considerably greater movement during the 4th quarter.
Dow Jones Industrial Average
Source: YahooCharts.com
While most are surely tired of hearing about the sub-prime debacle and the ramifications leading to one of the worst housing markets since the 1930s, it’s obvious that the media feasted on these circumstances, further exacerbating the widespread “sky is falling” scenario. This in turn fostered a fire sale in many securities, including many of which had nothing to do with the sub-prime problems. Securities in the Real Estate and Financial sectors were the most deeply affected, given their direct implications, and some of the more recognizable names such as Citicorp and Merrill Lynch each dropped by more than 40% by the time the year had come to a close.
Home Building, as a group, declined a whopping 59.6%, followed closely by the Thrifts and Mortgage Finance sector, which was off just over 51%. The Real Estate Management sector, on average, fell 36.4%, and Regional Banks by -31.5%. Department Stores, Apparel & Accessories and Home Improvement Retail also posted losses of -35.2%, 31% and 29.7%, respectively. On a positive note, further evidencing the split personality of the market, the Materials and Energy sectors performed well based on business momentum and relative earnings expectations, while Utilities and Commodities also made the list of those sectors which helped saved the day for most portfolio managers.
Another area of dramatic diversion, was reflected via the variances reported in the performance between the value and growth components of the equity market, not only during the fourth quarter, but for the year overall. Growth stocks were the clear winners during 2007, reversing the dominance that has been enjoyed in value stocks over the past 6 years. This scenario, in part, was due to earnings growth of the larger multi-national growth companies which are historically been better prepared to weather conditions suggestive of slower economic growth.
Sector |
4th Qtr |
2007 |
Large Cap Growth |
-0.03 |
14.17 |
Large Cap Value |
-4.72 |
2.25 |
Mid Cap Growth |
-1.06 |
16.48 |
Mid Cap Value |
-5.05 |
1.98 |
Small Cap Growth |
-3.19 |
8.69 |
Small Cap Value |
-6.72 |
-5.55 |
Source: Barrons
During 2007, and the fourth quarter in particular, the Federal Reserve was clearly in an accommodating mode, reducing interest rates and adding more liquidity into the banking system in an attempt to mitigate the effects of what was indeed a severe credit crisis. Central banks coordinated efforts in similar fashion to inject much needed liquidity into the system as the meltdown in the sub-prime arena had spread globally.
Innovative funding strategies using aggressive CDO (Collateralized Debt Obligation) structures, which were sold primarily to and through hedge funds and other financial institutions, were clearly among the instigating factors which allowed individuals to obtain mortgages cheaper and easier. This in turn effectively drove home prices higher and created a booming business for mortgage lenders who, through greed, became lax, and in many cases, downright deceptive in their lending practices.
With billions of dollars of mortgages having already reset in 2007 and billions more anticipated to reset in 2008, economic uncertainty and the overall health of the Country became the top priority for the new Federal Reserve Chairman Bernanke. While short term interest rates during 2006 had been at levels above those of long term rates (otherwise known as an inverted yield curve), 2007 brought about the return of a more normal yield curve, as the Federal Reserve aggressively moved short term rates considerably lower than long term rates. Note the chart below which illustrates the magnitude of change which occurred at the very short end of the yield curve.
US Treasury Yields (%) |
3-Mo |
6-Mo |
2-yr |
5-yr |
10-yr |
30-yr |
December 29, 2006 |
5.01 |
5.08 |
4.81 |
4.69 |
4.70 |
4.81 |
September 30, 2007 |
3.46 |
4.16 |
3.99 |
4.25 |
4.59 |
4.87 |
December 31, 2007 |
3.24 |
3.39 |
3.05 |
3.44 |
4.02 |
4.45 |
Chg in Yield (9/30 – 12/31) |
-0.22 |
-0.77 |
-0.94 |
-0.81 |
-0.57 |
-0.42 |
Chg in Yield (2007 - yr) |
-1.77 |
-1.60 |
-1.76 |
-1.25 |
-0.68 |
-0.36 |
Source: Bloomberg
Over the course of the year, 3 month Treasury Bill yields declined by 177 (5.01%-3.24%) basis points. A typical analysis of the yield curve generally references the difference between the two-year and ten-year yields. Accordingly, note that the difference at the beginning of 2007 was -11 basis points (creating an inverted yield curve). This difference increased to +60 basis points at the end of September, before widening further in the fourth quarter to 108 basis points by year end 2007.
Interestingly, an inverted yield curve is typically a precursor of recession, and a normal, positively sloped curve suggestive of economic growth. We’ve now moved back to a normal positive curve, yet haven’t formally experienced a recession….causing many economists to wonder if this cycle will be different!
Nevertheless, during the 12-months ended 12/31/07, the Lehman Aggregate Index, a broad measure of U.S. fixed income securities returned 6.97%. This reflected another atypical phenomena, where the bond market return was almost double the return of equities, as represented by the S&P 500 Index!! While US Treasuries performed well in 2007, due in part to a flight to quality, spread product, that is, mortgages and corporate bonds, had notably lower performance as spread differentials versus the 5 year Treasury Bond widened considerably. The chart below reflects the performance of the US bond markets, including the emerging markets, further evidencing the fact that leadership in the market is constantly changing.
Source: ING
Despite widening spreads and the move away from lower quality credits, high yield bond performance, while the least attractive fixed income sector, still remained in positive territory for the year overall! Emerging markets, which dominated bond market performance in the previous 4 years, with double digit results, slipped relative to Treasuries for the leadership position in 2007.
The US Dollar, gold and commodity prices also played an important role in 2007. Natural resources rose 7.1% in the fourth quarter and 36.6% for the year. Oil prices were on the verge of breaking through $100/bbl at year end (up from roughly $60/bbl at the beginning of the year). With no clear alternative source of energy in sight, one wouldn’t expect any decline in oil prices to be significant. Given the continued robust energy demands from China, India and the other emerging market economies, oil still seems cheap, especially when compared to a “cup” of Starbucks coffee!! Wheat, corn and soybeans were up 153%, 113% and 99% respectively, year over year in 2007, while gold found its way back to break above the monthly highs established back in the early 1980s!
The US Dollar Index, on the other hand, weakened overall by 9.3% in 2007, and by 38% since 2002. Relative to other country’s currencies (chart below is as of 12/6/07), the dollar declined most against the Canadian dollar in 2007.
The US currency has had abysmal performance, virtually reflecting an economy that has become mature, and to some, even frail. Imagine….the Taj Mahal in India actually refused to accept the US Dollar as payment for entry!!! One positive for a lower Dollar, however, is that US exports have continued to rise due to the Dollar’s weakness, becoming one of the major drivers of US growth.
On the subject of economic growth, here too one sees bi-polarity. An increasing number of economists are forecasting recession. Others acknowledge that though Gross Domestic Product (GDP) growth may have slowed in the fourth quarter to 1% or less, the first half of 2008 will likely remain in a slow growth mode, before picking up again in the second half of 2008. Either way, it’s clear that both the unemployment rate and the consumer price index have begun to rise.
Source: Bureau of labor statistics
As we look to the future, once again we remind our clients that diversification is one of the most effective strategies, particularly in periods where a defensive posture seems apparent. We expect that the housing market dilemma has not yet run its course. According to analysts at Credit Suisse Group, more than 30% of borrowers with sub-prime adjustable rate mortgages are behind on their payments before their loans reset at a higher rate. Given the near record level of inventories, analysts project that 775,000 homes with $143 billion of mortgage debt will go into foreclosure in the next two years.
Source: S&P/Case-Shiller
Keep in mind, that once again, the media has done an exemplary job of beating down investor confidence levels, sensationalizing and creating pessimistic headlines that are often out of proportion to the news that is being reported. That said, we wouldn’t be surprised to see the markets remain sloppy and volatile over the next few months. Note also, that stocks don’t always decline during recessionary periods as evidenced in the chart below.
Against this backdrop we are continuing to focus on defensive sectors of the market, such as consumer staples, utilities and telecommunications, which are among those sectors that tend to do well in an economic downturn. We also believe that large cap stocks are still in a better position than small and mid cap stocks to weather a possible period of slow growth and believe that exposure to the international markets remains warranted. We would advise caution, however, as Europe, and some of the other countries which have a higher correlation with the US economy (see below) may also be on the verge of an economic downturn, while some of the emerging economies such as China, India and Russia have grown such that their stock markets may be poised for consolidation.
US Economic Growth Correlations with Foreign Countries
While much of 2007 may have been shrouded in uncertainty, each cloud has a silver lining. There are strategies and products that accommodate bear markets as well as bull markets, and we encourage our clients to be open during the course of the year to new ideas and products that are best suited to their individual objectives and the market’s long term (secular) trends. We intend to include more information on such strategies and products on our website in the future and welcome your thoughts and ideas. As always, don’t hesitate to contact us if we can be of assistance or if you have any questions.