Economic Environment
Many of the red flags in the economy mentioned in the previous report unfortunately came to light in the fourth quarter of 2007. Continued weakness in the housing market and high energy and food prices may have finally started to weigh on consumer spending, a major driver in the economy. Oil prices ended the quarter at record highs, continuing an upward trend sparked by growing worldwide demand. Fourth quarter earnings for the S&P 500 companies are expected to decline 7.7% from a year ago, compared with expectations of increases of over 10% seen as recently as mid-October 2007. This would be the first year-over-year decline in earnings of the S&P 500 seen in five years.
According to a Bloomberg poll, 71% of Americans expect a recession and in December, even former Federal Reserve Board Chairman Alan Greenspan upped his recession likelihood to 50%, saying that the economy is “getting close to stall speed.” Whether or not we are headed (or already in) to a recession may be an open point still, but what is clear is that the economic expansion we have experienced over the last several years may be nearing an end, or at the very least, a considerable slowing.
This view is backed up by the actions taken by the Federal Reserve Board during the quarter. The Fed cut rates twice during the quarter to 4.25% and Fed Chairman Ben Bernanke has already come out in 2008 saying that the economic outlook has taken a turn for the worse in the early days of the new year and that the Fed stands ready to act aggressively to ward off further weakening. This has prompted many analysts to believe that future interest rate cuts are inevitable.
Since the Fed’s rate cuts, the already weak U.S. dollar has fallen to a new all-time low, which has led to a rise in import prices. Add in high energy and food prices, and inflation readings that are already on the upper end of the Fed’s comfort range of 1 to 2 percent, and it is clear that the Fed will be closely monitoring upward pressure on inflation.
Though I have touched on the housing market in the last two quarterly reports, I would be remiss to not at least mention that the worst may not yet be behind us. To put things in perspective, the last housing correction we had started in 1990 and lasted three years with an 8.3% cumulative decline, as measured by Case-Shiller®. Our current correction is now just over one year old with a 4.8% decline. Meanwhile the inflation in real estate prices is far greater than the one that occurred in the late 1980’s, as it has been fueled by looser credit, more leverage and 10 months worth of inventory currently on the market.
Despite the perception of a hanging gloom over the economy, it is not all bad news. The economy has continued to create jobs at a steady rate and unemployment remains low. Despite the December report that showed unemployment jumping to 5.0%, historically this is still well below the average rate of 5.6% since 1950. 3.8 million non-farm payroll jobs have been created in the last 24 months, which has kept our economy moving forward. Interestingly, we have never had a recession without unemployment claims spiking, which has many analysts concerned about the December uptick.
Whereas the weak dollar has led to increased import prices, on the flip side, exports continue to be strong and help pace the economy. Exports have grown more than 10% in the past year. Much of that growth has come from China, our fourth-largest export market, which has grown 17% this year. U.S. trading customers are showing a strong demand for technology, industrial goods and high-level services.
We believe the markets continually and efficiently digest all factors, including those few discussed above. This mass of information is then discounted into the prices of securities traded in increasingly unrestricted fashion across the globe. Within such a scope, short to intermediate term volatility is inevitable. For this reason, we continue to suggest that you remain committed to an investment policy which dictates that only funds not needed for the near to intermediate term be directed toward growth. Funds that are required for the near to intermediate term, (generally defined as within the next seven years), should be maintained in cash and fixed income holdings. Regardless of the near-term performance of various markets, this will allow you to weather the inevitable downsides that are inherent in equity investing, while maintaining the propensity to participate in the equally inevitable recoveries.
Equity Markets
Based on the economic environment discussed above, it is likely no surprise that domestic equity returns were negative across the board in the fourth quarter. Domestically, this extended across all capitalizations and styles of management. For the year, the growth style of equity management generally outperformed value across all capitalization sectors for the first time since 1999. Also, large capitalization domestic issues outpaced their mid and small cap counterparts for the first time since 1998. Interestingly, growth equities all produced positive annual returns, while value equities were all negative.
However, despite the volatile year in the markets and myriad worrisome economic news, the S&P 500 finished the year up 5.5%. From the low in the market in 2002, the S&P 500 has increased 89% as of December 31, 2007. Based on this fact, one would expect a corresponding increase in price-to-earnings (P/E) ratio (measure of the price of the stock to earnings per share). However, just the opposite is true as the trailing P/E ratio of the S&P 500 has actually dropped from 25.3 in October 2002 to 16.9 as of year end, a 33% decline, suggesting strong corresponding earnings to these equity price increases.
Emerging markets continued to provide very strong returns as it was the only benchmark sector to produce positive returns during the fourth quarter. For the full year, the emerging markets were by far the strongest performers providing a 36.5% return. These international emerging markets have now led all world market benchmark sectors for six of the last seven years. Such performance increases the relative exposure of this sector within the growth component. Further, it tends to cause us to reduce the targeted exposure within the suggested benchmark weighting for the sector.
Real estate investment trust exposure reflected the weakest returns for the quarter and the year. Consumer-related sectors such as hotels, residential and retail were the major sources of weakness for the index. The reallocations initiated last quarter reduce the overall REIT exposure through a significant drop in targeted domestic REIT exposure. Although the international REIT exposure was not spared from the domestic fallout in this area, the weaker dollar did bolster those returns slightly.
Even in light of some dampening of returns seen during the quarter, the full-year statistics still reflect very strong numbers in most categories. Developed international countries were the beneficiary of a weak U.S. dollar, as the EAFE doubled the quarterly and annual returns of the S&P 500. Mutual fund flows into international equities continued to outpace U.S. flows, although both have slowed, as money has been moved into fixed income and liquidity vehicles.
For the firm model growth component, the following chart will show the period returns for the various benchmark sectors and their representative index.
Benchmark Sector |
Index |
3 Month Return |
12 Month Return |
|
Large-capitalization Domestic |
S&P 500 |
-3.3% |
5.5% |
|
Mid-capitalization Domestic |
S&P 400 |
-2.7% |
7.9% |
|
Small-capitalization Domestic |
Russell 2000 |
-4.6% |
-1.6% |
|
Developed International Mrkts |
MSCI EAFE |
-1.8% |
11.1% |
|
Emerging International Mrkts |
MSCI EMF |
3.4% |
36.5% |
|
Real Estate Investment Trust |
DJ Wilshire REIT |
-13.5% |
-17.6% |