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HERON CAPITAL MANAGEMENT
STOCK MARKET COMMENTARY
December 6th, 2007 |
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November 2007 was the worst month for our strategy since September 2001.
By the end of October, we thought that the worst of the sub-prime crisis was behind us as many of the aggressive lenders (Countrywide, American Home Mortgage) in this space had already hit the wall. However, starting with Citigroup's announcement on November 1st, a long list of larger institutions announced that they too would take substantial losses on mortgage related securities (commonly referred to as CDO's or collateralized debt obligations.) If we knew that these securities were junk, we had to assume that Citigroup, Bear Stearns, Merrill Lynch, Morgan Stanley, Bank of America, Washington Mutual (and other banks) knew they were junk also. Apparently, either the risk systems of those firms failed entirely, or else the banks knew the risks but couldn't resist the speculative returns.
From February, when the bad news first became widespread, Merrill Lynch declined 39%, Citigroup 38%, Freddie Mac 47%, and MBIA 62%, but most of the loss occurred in the last two months. For relatively solid companies with hundreds of thousands of employees, and revenues in the ten's of billions, the sell-off is pretty excessive.
Our allocation strategy is to focus on the three fastest growing components of the S&P 500, namely technology, healthcare and financial services. We typically allocate 25% of our client's stock exposure to each of these sectors, compared to an overall weighting of 17%, 12% and 18% respectively for these sectors in the S&P 500. Year to date, the total return on the S&P 500 is 6.9%, technology gaining 15.0%, healthcare gaining 2.9%, but financial services down 15.7%. Prior to a monster short covering rally in the last 4 days of the month, about half our accounts were negative on the year. Even with the subsequent recovery, on average we're still trailing the S&P 500.
Our strategy assumes the occasional blind-side event, whether a financial crisis as we see now, the Katrina hurricane, or even the 9/11 attacks. As we never buy securities on margin, we can ride out the storm and wait for values to recover. Also, for our clients that have automatic monthly distributions coming out of their accounts, we hold 6-12 months of cash in short-intermediate government bonds so that no matter what happens in stocks, those distributions are assured.
Recession?
In the last several weeks, quite a few commentators have raised the specter of a recession in 2008. The official definition of a recession is 2 consecutive quarters of negative growth. The US skimmed recession in 2001 (three non-consecutive quarters of negative growth). Prior to that, two quarters in 1990-1991 qualified as a recession. At that time, the Savings & Loan industry was staggered by ill considered investments in "junk" corporate bonds, and housing prices fell 6.8% as lenders were unable to make loans. Also, oil prices spiked following Saddam Hussein's invasion of Kuwait in August 1990. So it seems like history is repeating itself. Indeed, Moody's model of the probability of recession jumped from the 15-16% level through summer 2007 to a recent 47%. Business and consumer confidence is uniformly glum. So even though there are quite a few offsetting bullish factors, the economy may fall into recession because people believe that a recession is inevitable.
We're not convinced that a recession is guaranteed, but the bottom line is that we just have to see over the next three months whether the credit crisis is contained, or whether further pain is in store. Previously, we said that the housing slowdown would reduce US GDP growth by about a percent/year for the next three years. This estimate is in line with a recent Federal Reserve Forecast of 1.8-2.5% economic growth in 2008.
Actions to address the credit crisis
Part of the problem of dealing with CDO's is that the market for these securities is "thin" (there aren't many buyers and sellers, or frequent sales.) Typically the securities are issued, stashed away in portfolios to hold to maturity and traded very little after the first few months. Valuing the securities usually depends on "model" prices, which can be considerably higher than what a counterparty might be willing to pay. In turbulent circumstances as we have now, the model might say "$100", but the offer is "$60." Over the last six months, as market participants have liquidated portfolios at "fire sale" prices, other participants are forced to mark their securities to market, which often triggers additional liquidation, not to mention downgrades from the rating agencies.
To provide a floor to the market, several banks, under pressure from the Federal Reserve, are making progress putting together a "SIV" (special investment vehicle) fund to absorb the supply of CDO's, similar to the Resolution Trust Company which performed a similar function for real estate assets from 1989-1995. Also, the US Treasury is working with Congress to create legislation to "freeze" the low initial rates on adjustable rate mortgages for an additional 2-5 years. The bond holders are better served receiving a below-market rate of interest than forcing borrowers into foreclosure, which can cost up to 25% of the principal value of the mortgage (thereby reducing the principal value of the security.)
What's next for US stocks?
The nightmare scenario is another two years period where the S&P 500 fell 55% and the NASDAQ fell 85%, as we saw in 2000-2. For this bear market to reoccur, the stock market would have to start from the level of 110% overvalued that we saw in January 2000. By the Fed Model, assuming 10 year treasuries stay around 4% and earnings grow 9% in 2008, the stock market is currently undervalued by 29%. The market is fairly valued right now only if treasuries rise to 5.75%, earnings shrink 14%, or some combination of those two parameters.
Also, we believe the market is due for some sector rotation. The top three sectors for the year and the last 5 years are: energy, reflecting the quadrupling of oil prices since 2002; utilities, reflecting a flight to relatively secure dividends this year; materials, benefiting from record high prices for gold, copper, steel etc.
| Sector |
YTD Return |
5 Year Total Return |
Market Cap ($Billion) |
% of total market |
| Energy |
27.868% |
238.448% |
1,560.11 |
11.7% |
| Utilities |
22.293% |
189.551% |
480.10 |
3.6% |
| Materials |
22.872% |
137.075% |
439.83 |
3.3% |
| Industrials |
12.944% |
99.428% |
1,492.45 |
11.2% |
| Information Technology |
16.367% |
75.755% |
2,233.79 |
16.8% |
| Telecommunications |
8.413% |
74.066% |
456.91 |
3.4% |
| Consumer Staples |
15.729% |
64.357% |
1,463.92 |
11.0% |
| Financial |
-13.961% |
54.329% |
2,417.32 |
18.1% |
| Consumer Discretionary |
-9.731% |
48.004% |
1,171.42 |
8.8% |
| Healthcare |
10.774% |
44.091% |
1,618.76 |
12.1% |
| S&P 500 |
6.869% |
78.830% |
13,334.61 |
100.0% |
Healthcare has the worst 5 year return, reflecting lawsuits against the major drug companies and the cost of bringing new medicines to market. Consumer discretionary lags because of problems in the housing and automobile industries. Financials were looking pretty good until 2007. Notice that because financials (currently 18% of the S&P 500 and 22% earlier this year) are down so sharply, the S&P 500 lags all but two sectors.
Consumer Staples is always a slow growing sector (toothpaste, laundry detergent, groceries.) Technology and Telecommunications stocks, while well off the lows of 2002, still lag the overall market and still would have to double to take out highs set in 2000.
One of the maxims of investing is "mean reversion," which means that a period of out performance is usually followed by a period of under performance. Energy and Materials look pretty risky to us if a US recession, or even a slow-down, is in the cards. The Commodity Research Bureau Index hit a recent high November 6th (not far from an all-time high set May 2006) but is not trending lower. Oil is trading at $88.51 after peaking November 23 at 98.18. We're neutral on utilities for now. Yes, the dividends are attractive, but money may flow out of that sector as financials regain their footing (and as bond yields start backing up.)
The outlook for healthcare remains cloudy, given the likely Democratic control of the Presidency and Congress will mean major initiatives in that sector. Technology continues to be the sleeper sector (growth in earnings dramatically exceeding gains in stock prices).
Financials will probably score a major recovery in 2008, as occurred after the last financial crisis in 1990. Split adjusted, Citigroup traded at $1.50 in November 1990. Even after falling from a peak of $55.70 at year end 2006, a bold investor (think Saudi Prince Alwaleed bin Talal, who owns 4% of Citigroup from his 1990 investment) is still sitting on handsome gains with the stock at $33.75.
State of the dollar
The other interesting development of the last month is that the US dollar, which fell 37% from a decade high in July 2001 to an all-time low November 32rd, has rallied sharply in the last two weeks. It's too soon to be sure that the 6 year down-trend has reversed, but surging US exports certainly will have a positive effect on the trade deficit.
Also, although the Fed is likely to cut rates 25 BP next week, perhaps even 50 BP, other central banks are starting to cut rates (including so far the Bank of England and the Bank of Canada, but the European Central Bank not yet.) As the rate differential narrows among US trading partners, the pressure on the dollar eases. Should economic growth remain high in the US and the dollar stabilize or go higher, then we would expect a wave of investment into US companies and their stocks.
Strategy
It's been a long and challenging year. We realized a lot of capital gains earlier this year on positions in companies that were bought out. Unexpectedly, we have unrealized losses in our financials service stocks with less than a month to go. Through year end, we'll take those losses if we can offset our clients gains, and will probably redeploy the cash almost immediately. Yes, stocks are very volatile right now, but a bargain is a bargain.
As always please don't hesitate to call with concerns.
Yours sincerely,
David Edwards
President |
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Heron Capital Management is a registered investment advisor providing fully managed investment services to individuals, families, trusts, defined benefit plans and corporations.
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HERON CAPITAL MANAGEMENT
(800) 99-HERON | |
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