2007 Markets Review and Some Thoughts on 2008

2007 Financial Markets Review

Equity Markets

Needless to say 2007, particularly the second half, was a difficult one in the financial markets. The S+P 500 (total return) ended 2007 +5.49%. The mortgage crisis, first evident in the credit markets, spread to the equity markets as stocks of financial institutions were decimated by massive writeoffs of mortgage related securities on the balance sheets of those companies. The S+P financials index fell 20.84% for the year. Housing stocks suffered severe declines as well.
While the housing market seems far from recovery, the large capital infusions from foreigners into major financial institutions indicates that at least some investors see values in the financial sector. We remain skeptical; the “known unknowns” of more writedowns due to mortgage losses, credit problems in the corporate debt markets, losses in derivatives, or other areas makes us remain cautious.
The impact of the financial stocks’ losses in the equity markets hit value stocks particularly hard as that group carried higher weighting in those sectors. The Russell 1000 large cap value index was -.17% , small cap value was -9.78% for 2007 In contrast export oriented technology stocks led the large cap growth to strong outperformance, posting a gain of 11.81% .

Among other sectors the global growth theme particularly in India and China made materials and commodity stocks a top performing sector. For 2007 Energy stocks (S+P index) rose 32.38% rose materials stocks + 19.98%. Commodities themselves rose as well: oil reaching close to $100, gold rising and agricultural commodities hitting multi year highs.

Internationally, developed and emerging markets diverged. The EAFE (Europe and Far East) index (etf EFA) 9.97 %. Here again the crisis in the credit markets and the large writedowns for financial institutions hit that sector. As a consequence the EAFE growth index (etf efg) was up 15.03% while value (efv) was up only 5.56%. Emerging markets were the star performer investors expressed their confidence in the BRIC countries (Brazil, Russia, India and China) and the MSCI emerging market index (etf seem) rose.33.08%.

Credit Markets

In the credit markets the impact of the mortgage crisis and the threat of recession led to three easing moves by the Fed since September, reducing short term interest rates by 1%. This had little impact on the core of the crisis, which was the availability of credit and level of spreads between treasury bonds and other securities. As a consequence the Fed and other central banks established credit facilities to inject liquidity to limited success. As the year ends limited availability and high costs of credit remain a feature of the markets, and prices of the riskiest credit instruments trade at large spreads over treasuries.

Portfolio Review

Our portfolios shifted a bit from their overweighting in value stocks towards growth stocks in domestic and EAFE markets in response to the first signs of the crisis in financial institutions. Nonetheless, we maintained a core position in value stocks based on their long term record of strong performance. Significant weightings internationally both in developed and emerging international markets helped our performance. We also maintained positions in energy and basic materials throughout the year which was clearly a positive contribution. The REIT positions which we view as core diversifiers suffered along with the rest of real estate.

2008 Outlook

Looking into 2008 US markets continue to face the cloud of recession and the ongoing problems in the financial services and housing/construction industries. These factors are likely to limit market gains. Continued interest rate cuts by the Fed are likely, but as was the case in 2007 will have little stimulative impact.
We would view the most likely scenario for US market returns in 2008 as below, or at best equal to the lower end of US long term stock returns ( 8%- 11). Developed markets, also experiencing similar conditions in the financial sector will likely produce similar returns, with US investors gaining a bit from a lower dollar.
We view last year’s performance in emerging markets as highly unlikely to repeat. The same could be said for energy and commodities. The key question is whether these markets will experience a sharp correction or just a much lower positive return.

It is not uncommon for falls of 20% within a quarter for emerging markets and significant short term falls in commodity prices. We would not be surprised by continued volatility but think resilient investors will be rewarded by an outperformance of emerging markets relative to developed markets here and abroad and thus should maintain a long term allocation to these markets .For similar reasons, a relatively small portion of portfolios should be in stocks tied to energy and other commodities.

In the credit markets, continued Fed easing will take short term interest rates lower. However, long term rates are unlikely to decline. The most important question is how long current anomalies in credit markets continue .Corporate bonds and cds are trading at historically high spreads relative to treasury bonds. Municipal bonds currently have yields at virtually the same rates as treasury bonds of the same maturity. Neither of these relationships is likely to continue for long and investors would be well rewarded to taking advantage of them.