Commentary For December 2007

“I will tell you how to become rich. Close the doors.  Be fearful when others are greedy. Be greedy when others are fearful.”  Warren Buffett.

At a cocktail party, a very market savvy investor friend proclaims that oil is going to $200 a barrel and he is selling all of his Berkshire Hathaway stock to fund his purchase.(“Be fearful when others are greedy.”)  This savvy investor is writing a book about the evils of greed and there is no safe investment; even Berkshire Hathaway carries huge unknown risks.(“Be greedy when others are fearful.”)

UBS, a global financial services firm, publishes monthly the Index of Investor Optimism. The index measures investors’ feelings about the direction of the overall economy and has just completed its 117th month.  It was established in October 1996 with a baseline value of 124.  The high and low were 178 and 5, which were achieved in January 2000 and March 2003, respectively. 

At its peak, you couldn’t have picked a much more positive scenario: the stock market (S&P 500) was up 220% over the prior 5 years, the potential of the Internet was unlimited, the federal government had a budget surplus ($150 billion) for the first time since 1969., and the U.S. dollar was equal to $1 Euro.  Contrast this with March of 2003, when we invaded Iraq, the U.S. dollar was equal to $.92 Euro and we had a budget deficit of over $350 billion.  Each period demonstrated a time of extreme investor optimism and pessimism.  In January 2000, we couldn’t have found a time when we felt more secure about the economy and investing in stock.  Conversely in 2003, we had a bunker mentality as there was a real concern for our national security as U. S. citizens and the “wheels were falling off the cart.”

One small problem: someone forgot to tell the stock market, because the returns (using S&P 500) for the next 12 and 36 months, for January 2000 and March 2003 were <1.00%> and <36%> and 35% and 61%, respectively.  All of this goes to say that there is no safety in extreme optimism or pessimism consensus, unless used as a reverse indicator.

The most recent value of the index stands at 50.  Pessimistic investors would argue that the current level is justified in light of the subprime debacle, the write-off of over $90 billion by large financial firms, the decline in home prices, increase in home foreclosures and the dollar’s decline against the Euro with a current exchange rate of  $.68. An optimistic perspective would argue that our deficit is 67% of where it was in March 2003.    The U.S. economy, in spite of the credit crisis, continues to have real growth with the highest increase in productivity (6.3%) since the third quarter of 2003. There have only been 10 periods out of the 117 where the value of investor optimism was 50 or lower. The subsequent 12 and 36-month median returns were 16% and 44%, respectively. There are no guarantees, but the reliability of this index as a reverse indictor during extreme periods is probably better than the paperback version of the book by that savvy investor friend, “How to Avoid the Next Armageddon, Not Even Warren Buffett is Safe”.

Much has been written and said about the weak U.S. dollar and its demise leading to the U.S.  becoming a second tier country. It is worth noting that this is not the first time the dollar has been a weak currency. In 1985, the exchange rate of the dollar to the yen was 238.  The dollar weakened against the yen when in April 1995 the rate was 80 yen to the dollar, almost tripling the value of the yen and making its economy almost equal to the U.S. in value.  The current exchange rate is 112 yen to the dollar.  We are still at the top of our game.   

2007 has turned out to be the exception to the second part of the third year of a presidential election. Research shows that, historically, the third year of a presidential term is usually the best for U.S. equities, having generated positive returns 18 out of the 20 times since 1926; with 16 of 18 periods delivering double-digit returns. The third year of a presidential term is teed up to put the economy in the best position to get elected. 2007 met the first hurdle of being positive but faulted on the second hurdle falling short of double-digits (S&P 500: 5.49%).  The good news is that traditionally, the fourth year of a presidential term is the second best year with a 70%+ chance of being positive with the average return in lower double digits.  Maybe the reason the fourth year is the second best is that Congress is out trying to get elected and not in Washington passing any laws that would inhibit economic growth.

We have been talking about growth outperforming value over the next few years. 2007 will be remembered as a year where growth significantly outperformed value.  Combining the large, mid and small cap growth and value categories (per Morningstar) they returned 12.02% and <1.30%>, respectively.  While we have been talking about this coming reversion, it accelerated in 2007 due to the sub-prime & credit crunch hitting financial stocks so hard, which further distorted the difference in performance between value & growth because value investors typically carry a much large allocation to financial stocks. For example, the financial sector, which makes up 18% of the S&P 500, was down almost 21%. For 2007, the S&P was up 5.49%, but if you excluded the financial sector’s losses the return would have been 3.50%+ higher. 

For 2007 the returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE and Lehman Brothers Aggregate Bond indexes were 5.49%, 10.70%, <1.55>%, 11.17% and 7.00%, respectively.  For the same period, our Stock, Aggressive Stock, Balanced and Fixed account returns were 8.90 %, 9.45%, 8.10% and 7.34%, respectively.

Congratulations go to Bill Gross and his portfolio managers of the PIMCO Total Return Bond Fund who were named Morningstar’s 2007 Bond Manager of the Year.  They are the first three-time winner in any category since its inception.  What makes them so deserving of this award is their ability to forecast macro trends. In 2006, they forecasted a slow down in housing, resulting in declining interest rates.  As a consequence, they increased their weighting in government bonds and reduced weightings in corporate and mortgaged backed securities.  This caused a drag on their performance in 2006 and the first half of 2007. It even reached a point that a consultant accused them of being “irresponsibly conservative.” Boy if that wasn’t a confirmation that they were right, you only had to see the carnage created by the subprime debacle and subsequent credit crunch. Over the last six months of 2007 they generated a return of 8.55%, outperforming their peer by an astounding 4.21% return.  We understand our clients’ perspective that when you invest in bonds you want to know that it is the conservative portion of your portfolio and that undue risks are not being taken to create small, incremental returns.