Challenging end to a challenging year

US Stock Market

The modest 5.5% gain in the S&P 500 for the year disguised the slaughter in financial services (down 18.5%) and consumer discretionary (down 13.2% - primarily home builders and cars, but also retail.)  Energy stocks soared in 2007, (up 34.4%), followed by materials stocks (up 22.5%).  Utility stocks did surprisingly well (up 19.4% as yield seeking investors fled out of financials.) 

The collapse in financial stocks hit our strategy particularly hard as we generally have 25% of our assets in this relatively safe sector.  The last time financials did so poorly was in 1990-91 (combination of the Asian Currency Crisis and the collapse of the junk bond market in the United States.)  In 2007, we avoided those firms (Countrywide, American Home Mortgage) that were clearly overexposed to sub-prime - the surprise to us was that banks we regarded as far too sophisticated to be involved with sub-prime (Citigroup, Bank of American, Morgan Stanley, Merrill Lynch, for example,) were in fact hip deep in this market. 

Announced losses so far total nearly $100 billion, with probably another $100 billion to be announced in Q1 2008.  We took a look back through brokerage analyst research published through October to see if anyone had flagged sub-prime exposure as a concern for these banks - answer: no one until the banks themselves announced problems in November.  Either the banks' risk management systems failed utterly, or else senior management knew the risks but chose to ignore them. 

By comparison, the 9/11 attacks and Hurricane Katrina each cost about $100 billion.  In an economy with real and financial assets exceeding $30 trillion, losses of this magnitude are sustainable.  US GDP is 5.3% larger than in Q3 2005 (post-Katrina), 17.6% larger than Q4 2001 (aftermath of 9/11 attack), and 65.6% larger than Q2 1991 (aftermath of junk bond market failure.) 

What can't be underestimated is the psychological impact of falling home prices.  Looking at the Case Shiller National Housing Index, prices fell 7.2% between November 1989 and January 1996 and did not make new highs until January 1998.  Local markets experienced greater or lesser pain.  From January 1998 through June 2006, US house prices gained an average of 173%, but from that peak have fallen 7.3%.  We expect house prices to fall another 7-8% over the next 2 years before stabilizing.  As we pointed out in previous commentary, home purchases with borrowed money are leveraged transactions, so a net fall of 15-20% in value wipes out the home owner's equity.  The sharp increase in the foreclosure rate over the last year indicates that home owners are walking away from negative equity situations.

It is cold comfort to people owning real estate, but there are advantages to the overall economy of falling home prices.  If the rate of change in housing prices significantly exceeds growth in income or even general inflation (up 29.0% over the last 10 years,) the "affordability" of housing goes way down.  Falling prices over two years, or stable prices over the next 8-10 years, allows families currently shut out of home ownership to get in.  A sharp contraction in spending on housing keeps inflation down in general, which give the Federal Reserve more room to cut rates.

Prospects of a 2008 US Recession

Many commentators are calling for a recession in the US in 2008.  The last official recession was in 1990-91, which as we have noted above, corresponded with the collapse of the junk bond market and a real estate slow down, so similar to today's situation.  The jobs report on January 4^th showed the smallest increase in jobs since July 2003, and even more worrisomely a leap in the unemployment rate from 4.7% to 5.0%, the biggest jump since 2001.  The Moody's model of the "Probability of Recession" climbed from 15% in July to a recent 52% in December.  The next release in mid January will probably show an even higher probability.  On the other hand, the Bloomberg survey of 63 economists show median expectations of growth of 1.0% in Q4 2007 (down from 4.9% in Q3 2007), 1.5% in Q1 2008, 2.1% in Q2, 2.5% in Q3 and 2.7% in Q4.  These estimates have been coming down steadily over the past three months, but still don't indicate recession.  Previously we had forecast growth for 2008 in the 2-2.5% range, and we're lowering that to 2%.

Earnings estimates for the S&P 500, excluding financials, look good.  For example, estimates for non-financial earnings in the reports coming out starting next week show a gain of 12.4%.  Add back the financials, which in many cases are expected to show losses, and the earnings growth shows a decline of 4.5%.  For all of 2008, earnings growth is projected to be strongest in Technology, Financials, Telecomms and Healthcare.  Financials get a "snap back" effect after this year's abysmal decline of 19.0%.  Earnings growth is expected to slow the most in Energy, Utilities and Materials.  If growth slows as expected, prices will decline for commodities faster than in any other sector.

Top down review of the Heron Capital Management investment strategy

We had a pretty good year through October 2007 but got clobbered in the last two months of the year.  It doesn't happen often that we misread the economic situation so badly, but when it does, we review our entire strategy top to bottom to see what was overlooked and what could be improved.

Core stock asset allocation strategy

We allocate an average 23% of assets each to financial services, healthcare and technology.  Those are the fastest growing sectors of the economy, so it makes sense to place assets where the growth in earnings is the fastest.  Since 1989, when the current sector indexes were established, healthcare has grown an average of 10.3%, technology 10.1% and financial services 8.9%.  Energy leaped to the front of the sector scorecard this year, with gains since 1989 averaging 11.5%.  However, through 2003, prior to the current liftoff in energy prices, gains averaged only 6.2% year.  Historically, we've allocated only 5% to energy, increasing this year to 8%.

Description	QTD Return	YTD Return	5 Year Total Return	Since 1989	Market Cap ($Billion)	Sector Weights	HMCI Weighting
S&P 500 ENERGY INDEX	4.4%	34.4%	261.9%	11.5%	1,680.51	12.9%	8.0%
S&P 500 HEALTH CARE IDX	0.0%	7.3%	43.7%	10.3%	1,560.72	12.0%	23.0%
S&P 500 INFO TECH INDEX	0.1%	16.3%	92.1%	10.1%	2,196.66	16.9%	23.0%
S&P 500 CONS STAPLES IDX	3.8%	14.4%	63.7%	9.3%	1,418.67	10.9%	5.0%
S&P 500 FINANCIALS INDEX	-14.3%	-18.5%	50.3%	8.9%	2,225.33	17.1%	23.0%
S&P 500 INDUSTRIALS IDX	-4.6%	12.0%	102.5%	8.8%	1,465.12	11.3%	5.0%
S&P 500 CONS DISCRET IDX	-10.0%	-13.2%	50.0%	7.0%	1,094.87	8.4%	5.0%
S&P 500 MATERIALS INDEX	0.1%	22.5%	138.6%	6.7%	438.87	3.4%	4.0%
S&P 500 UTILITIES INDEX	7.5%	19.4%	164.5%	4.6%	460.18	3.5%	2.0%
S&P 500 TELECOM IDX	-5.1%	11.9%	85.7%	3.3%	462.80	3.6%	2.0%
S&P 500 INDEX	-3.3%	5.5%	82.7%	8.9%	13,003.71	100.0%	100.0%

At the other end of the scale, Telecommunication stocks have performed the worst, with annual gains of only 3.3% since 1989, utilities gaining 4.6%, and materials 6.75%.  We generally allocate no more than 5% to these sectors.  Overall the S&P 500 gained 8.9%/year since 1989.  We have long observed that 50% of a portfolio's return comes from being in the market, 30% from the sector allocation and 20% from the selection of individual companies.  What we see in hindsight of the last 5 years is that we have overweighted the underperforming sectors and underweighted the outperforming sectors.  However, we picked good companies within those sectors, so trailed the overall stock market but not by much. 

The obvious question is: should we dramatically increase our energy exposure?  The answer to that is, only if we think oil is going to quadruple over the next 5 years as it did over the past 5.  $400 oil is possible by 2013, but that is a very low probability event.  Adjusted for inflation, oil hit an all-time low in 1998 at $11/barrel, and started the current rally from $23 in 2002.  The all-time inflation adjusted high was $100.28 set in 1979 after the Iranian revolution shut down exports from that country.  The forecast range we've seen for 2008 is $85-115, with outliers at $75 and $135.  Oil tagged $100 earlier this week, last traded at $97.91.  Currently, we have our energy exposure mostly in drillers and equipment providers, as those companies are hired by the majors to find new and develop new sources of crude.

Fixed income allocation strategy

For our clients who are drawing down assets for retirement or to supplement their incomes, we allocate 20-40% of the client's assets to fixed income, usually divided between low yielding government or municipal bonds, and higher yielding corporate bonds.  In the current environment, government bonds are holding or increasing in value but corporate bonds are falling in price as the yield spread (difference in current yield between corporates and treasuries) increases.  We also have assets in corporate bond type stocks, including REIT's and preferred stock.  The prices of those securities fell 20% in November and December as investors panicked about the risk of dividend cuts.  It's now possible to get double digit yields in those securities IF the dividends remain intact.

Rebalancing strategy

At least once every two years, possible as often as once a year, we rebalance our clients' portfolios back to our core allocations.  Since rebalancing usually entails taking profits, we look to take offsetting losses if available.

Tax strategy

Our clients' portfolios are a mix of taxable and retirement portfolios.  Capital gains don't matter in, for example, IRA accounts, but most of our clients' assets are in their taxable portfolios.  We look to buy companies that we can hold for five years, preferably forever.  We'll take profits if a company exceeds, for example, 8% of a portfolio because of growth or to rebalance back to the core sector allocations.  We won't buy any stock "for a trade" (i.e. a holding period of less than a year.)  Trading costs at this point are pretty negligible, but paying the short term capital gains rates of 39% is pretty brutal compared to the long term rate of 15%, which is further divided by the holding period.  For example the tax load on a position held for 5 years works out to 3%/year.

Discounting good and bad news

A sure fire strategy to buy high and sell low is to buy on good news and sell on bad news.  Right now, everything looks golden for First Solar, which was one of the top performing stocks of 2007 gaining 795%.  But that stock is priced to perfection, with a prospective Price/Earnings ratio of 211, a Price/Sales ratio of 52.7 and a PEG ratio (P/E divided by forward growth rate) of 3.43.  Citigroup looks like dog meat, but with a forward P/E of 14.5, P/S of 0.80 and dividend yield of 7.65%, there's not much downside risk.  Even if the dividend is cut in half (we'll know later this month) the stock would yield more than 99% of the companies in the S&P 500.

Quantitative scoring

To remove as much emotion from our investing as possible, we periodically rank all the stocks in our portfolio, by sector, by which companies have the best combination of forward Price/Earnings, Price/Sales, Price/Book, widest operating margins, forward growth rates and PE/G ratios, as well as some technical factors that indicate whether a stock is at the top or bottom of its trading range.  As we rebalance, we'll choose from the stocks that have the highest scores, which often means buying the stocks with the worst price performance over the previous 6 months.

Dealing with Market Volatility

Stock market volatility doubled in the second half of 2007.  In 2006, there were only two trading days where the stock market gained at least 2%, no days of 2% or more losses.  In 2007, there were 6 days where the stock market rallied 2% or more, 12 days where the stock market fell by 2% or more, all but two of those days following the termination of the "down tick" rule in July 2007.  This rule, dating from the 1930's, prevents traders from jamming down on a stock by repeated short sales in a falling market.  It may be a coincidence that volatility has soared since this rule ended, but we doubt it. 

S&P 500 - 2006-2008

This chart shows two years of S&P 500 data.  The market had 4 major sell offs in this time frame; from the left, the outbreak of the Israel/Lebanese war in May-July 2006, followed by three major breaks in 2007 as the CDO crisis unfolded.  The latest downturn - 6.9% since December 10^th - is on the back of alarming reports regarding retail sales and manufacturing, as well as the poor jobs report.  Yet, the market is so fundamentally cheap that buyers step in every time we approach 1400.  With the last trade at 1411.63 in the S&P 500, no sense in selling now. 

We try to invest cash into the market when intra-day movements are relatively calm.  Money that our clients need in the next 6-12 months is held in money markets and short term government bonds funds, 1-5 years, in corporate bond and preferred stock.  Only money not needed for at least 5 years is in stocks.  This way, no matter what the stock market does, our clients have their cash when they need it.

Currency exchange rates

The dollar index, which is a trade weighted basket of the Euro, British Pound, Japanese Yen and other currencies, hit an all-time low November 23^rd.  Since then the dollar rallied 5% and then fell back against the Euro and Yen, but gained 6.4% against the Pound.  A stable dollar at these levels has already significantly boosted US exports.  The dollar probably won't make a sustained rally against other currencies until the Fed finishes lowering rates (we expect several more times this year.)

Dollar Index - 1970-2008

The dollar fell through the 1970's as the US switched primarily to a service economy and from the OPEC oil shocks of the 1970's.  Interest rates soared under the Volcker Fed to choke off inflation, which pushed the dollar to an all-time high.  As rates settled back so did the dollar, entering a trading range from 1987 to 1999.  When the Euro was implemented as the primary European currency in 1999, it slid initially 30% against the dollar through October 2000.  From that low level, the Euro gained 79.8% over the next seven years, primarily because European interest rates remained higher than US dollar rates, but also as countries have diversified their foreign currency holdings out of the dollar.  By the Economist's measure of purchasing power parity, the dollar is about 20% undervalued relative to Europe.

International investing

From time to time clients ask whether we should get out of US stocks, which have underperformed most other stocks markets since 2000, and invest overseas.  The major challenge of overseas investing is figuring out currency direction.  For example, over the past 20 years, the DAX (German stock market) gained 11.0%/year in Euros, 12.0% in USD, while the S&P 500 gained 11.8% in USD so essentially the same return.  However, in shorter time frames, markets can outperform net of the currency effect.  In dollar terms, the S&P 500 outperformed the DAX 18.0% to 14.2% in USD in the 10 years from January 1998 through December 1997.  From the bottom of the Euro in October 2000, the DAX gained just 3.3%/year in Euros, but 10.1%/year in dollars.  Over the same time frame, the S&P 500 returned 3.3%/year, so matching the return in local currency but handily outperforming in dollars.  It's possible, but unlikely, that European stock markets would be so currency advantaged over the next 7 years.

Emerging market investing

In 2007, the Chinese stock market represented by the Shanghai A-Share Index rose 96.6% in local terms, 110.3% in US dollars, while the Shanghai B-Share Index rose 163% in local currency, 182% in US dollars.  It's awfully tempting to go after those returns (Brazil, India, Turkey and Egypt were also hot in 2007.)  The biggest problem with investing in these markets is that the gains are primarily driven by capital inflows.  Valuations of stocks in these markets are far more expensive than in developed markets, so if the capital inflows become outflows, emerging markets get torpedoed.  The hottest performing market in 2005 was Saudi Arabia - up 103.6%.  Since year end 2005, however, that market fell 53.1% so essentially back to where it was three years ago.  The grand daddy of all emerging markets was Japan, which peaked at 38,915 in December 1989.  From that level, the Nikkei fell 79.9% through April 2003, and even after doubling over the past 4 years, still remains 60.7% below the all time high.

In a perfect world, we'd be able to jump into these markets using ETF's and jump out just as the markets break.  In reality, investors often jump into these markets way too late.  According to AMG Data Services, which tracks money flows in mutual funds, virtually every category of stock fund is losing assets right now except emerging market funds and energy funds.  Literally, investors are selling low in every other category and buying high in the two best performing categories of 2007.  Historically, these fund flows are contrary indicators of subsequent 12 month performance.

Fed Policy

We're not the first to comment that the Fed is between the rock of escalating inflation and the hard place of a slowing economy.  It's widely expected that the Fed will cut another 25BP on January 31^st, perhaps even 50 BP.  But these cuts have had little effect so far, because banks are unwilling or unable to lend, so corporate lending rates are actually going UP (the same spread widening we see in corporate bond yields.)  The Fed is employing other money market strategies to boost lending, with mixed success so far.  Fixed mortgage rates are actually lower now than a year ago, but who cares if no one is buying a house?

Many commentators are screaming that the Fed needs to "do something" to save over-extended builders and banks.  We think, actually, that the Fed doesn't mind if a few builders and banks entered bankruptcy, which would encourage the survivors to do their job better (i.e. be more conservative) in the future.

US Politics

We projected last fall that Hilary Clinton would win the Democratic nomination and ultimately the presidency.  Her third place finish last night in Iowa does not change our opinion.  The Republican candidates are utterly in disarray, so we have no expectations of a Republican win of the presidency or a change of control in Congress.  There are some murmurings that New York mayor Michael Bloomberg will shortly enter the race as an independent, but we're highly skeptical that he can launch a successful campaign with 10 months to go.  The Bush Presidency is the lamest of lame ducks right now, but Congress is equally unable to drive the political process, so we have no expectations of significant legislation in the next 13 months.

Commodities

Gold soared 6.8%, oil 6.3% and the CRB commodity index 3.1%, new all-times highs, following the assassination of Benazir Bhutto in Pakistan.  Commodities eased back after the release of the jobs report, but high materials prices mean that the Fed can't relax about inflation.  We've commented before that the phenomenal returns in commodities over the last five years are related to world wide demand, but also to a flow of funds from endowments and pension plans into this sector.  If the US economy indeed slows this year, we don't see how crude oil prices can go much higher.  Violence in Nigeria has caused oil production there to fall 20% in the past year.  Venezuela continues to produce less oil in each passing year as its infrastructure falls apart.  However Iraqi oil production recently exceeded pre-war levels and continues to build.

Terrorism and Iraq

There have been no successful terrorist attacks in the West since the July 2005 London Underground attack.  Hard to believe, but whether because of the "surge," whether because of behind the scenes negotiations, or whether because of exhaustion of Sunni and Shia Militants in Iraq, the level of violence in Iraq has declined steadily since July 2007 and is now below the levels of late 2004 when the insurgency first took root.  Civilian and coalition casualties peaked in the first half of 2007.

Strategy

One of the most reliable concepts in successful investing is "mean reversion."  Different markets, sectors, assets classes may under or outperform others over short and even medium time frames.  Over medium and long time frames, however, a period of outperformance is usually followed by a period of underperformance.  The greater the magnitude and the longer the period, the greater the magnitude and length of time of the reversal.  When we see how well US housing has performed since 2000, we confidently can predict that housing will do poorly over the next 5, 7, even 10 years now that the trend has reversed.  When we see how badly a stock market sector has done in the past (for example, technology stocks down 75.8% in 2000-2002) the great the confidence we have in a rebound (92.2% since January 2003.)

Financials like Citigroup look very inviting now, and in another month we'll feel comfortable buying them again.  We took all available tax loss sales in December and immediately reinvested the cash.  The first three days of 2008 looked terrible, with the S&P 500 down 3.5%, the NASDAQ down 5.2%.  But with the overall market undervalued by 27% (assuming 9% growth in 2008 S&P 500 earnings and a 4.25% yield on the 10 year treasury,) we're putting money to work in stocks now.