Fourth Quarter, 2007
Before getting into our topics for the fourth quarter newsletter, please make note of our new email protocol. To communicate with any member of SIMI, please address your email to the person’s first name at shefinvestment.com (example: [email protected]). In addition, we request that you fill in the enclosed data sheet to help us insure that our personal records are up to date. Please mail or fax (770-953-3586) the completed sheet to us at your earliest convenience. Thank you!
How bad a year was it in the U.S. stock market? A broad index based investor had a relatively unexceptional year, but losses were avoided. The Russell 3000 Index had a total return of 5.2%. The S&P 500 Index total return was 5.5%. Not great, but certainly not disheartening. Beneath the surface however, economic turbulence abounded. Companies having significant foreign sales exposure experienced returns in the high teens to mid 20% range. At the opposite end of the spectrum, financial stocks, as measured by the Financial Sector Index, (banks, brokers, consumer finance) decreased in value by 21%. The continuing turmoil in U.S. financial markets has brought many large banks, brokers, and insurance companies to valuation levels not seen in the last one to two decades. We are now acquiring shares of such companies on a selective basis when dividend yields approach 5-6% and/or P/E ratios fall to 10 or below.
In a moment of panic (our opinion) the Fed has abruptly changed its focus to: 1) fighting a potential recession and 2) helping the banking system restore its liquidity and profitability by engineering a dramatic drop in short-term interest rates. One of the side effects of the Fed’s current policy is showing up in a surge in mortgage applications, particularly for refinancings. Today, interest rates on “conforming loans” (those below $417,000), have fallen below 6%. In the past, mortgage interest rates below 6% have triggered significant refinancings and home purchases. The stock market, of course, has picked up on this as evidenced by the homebuilders’ Exchange Traded Fund (ETF) registering a 22% gain through February 21st from its low on January 10th (versus a 4% loss for the S&P 500 Index).
This budding optimism towards the home builders has not yet spilled over into the price action of financial stocks because of the still-growing malaise in the residential mortgage market. Investor optimism for home builders may gather a great deal more momentum if Congress allows the two large government sponsored mortgage purchasers, Fannie Mae and Freddie Mac, to increase the ceiling for conforming loans allowed into their programs. This time however, sub-prime and highly-leveraged prospective borrowers are pretty much being excluded from participating simply because there are virtually no investors willing to purchase their loans. As one bank official put it: “underwriting standards are back in vogue.”
The exciting thing for us is to locate investment opportunities which emerge from investors’ emotional responses to the news around them. Irrational behavior explodes at or near market peaks and bottoms creating extraordinary investment opportunities. We think we may be near the point of maximum negative sentiment/positive valuation for financial stocks and homebuilders, causing us to initiate or increase positions in these industries on your behalf. That’s not to say that the daily news reports won’t get worse. We are saying however, that markets appear to have priced in the bad news that is today’s common knowledge.
Only a few months ago the common understanding was that excess global liquidity was driving up the price of all assets – financial and commodity. Now we are experiencing a spreading credit crunch where banks are being forced to curtail their lending activities. So which is it – excess liquidity or credit crunch? Actually, both appear to exist simultaneously but in different sectors of the economy. Financial institutions are hurting because of their prior lending excesses. Billions of dollars of poorly structured mortgage loans have caused dramatic declines in the value of these securities during the past year and are expected to continue for the next 12-18 months. These dubious assets are forcing many financial institutions to raise new capital in order to remain solvent. Because financial institutions need to improve their balance sheets with new capital, they are less able to loan money today to American families and small businesses. Hence the credit crunch.
Larger, non-financial companies have other sources of capital for growth and expansion into new markets. For these companies, both here and abroad, liquidity abounds and the outlook has been and remains quite bright. For example, the Wall Street Journal states that earnings for non-financial companies in the S&P 500 were up approximately 11% for the fourth quarter. When the financial stocks are added back to index results, earnings for the entire S&P 500 Index were down 19% for the quarter. The S&P 500 Index is primarily a large cap growth index where international sales represent a material portion (estimated at 40%) of company total sales. The international theme continues to dominate our investment strategies.
More than ever before, the economic growth action is in the world’s developing economies. One of the more interesting illustrations of this phenomenon can be found on the website of the International Monetary Fund (www.imf.org). On its homepage, there is a “data mapper” map of the world presenting economic growth rate projections by country, for 2007. Relatively strong growth is projected almost everywhere around the world, with three exceptions: North America, Western Europe, and Japan.
Emerging markets continue to present some of the best long-term investment opportunities which, in our opinion, dwarf the current financial ills of North America, Western Europe, and Japan. Shipping; infrastructure development; food; potable water; mining and mineral consumption; wanting a piece of the “good life” as illustrated through the internet, all represent areas of long-term growth and investment opportunity for investors at home and abroad. Finally, it’s worth noting that developing economies now account for a larger share of the world GDP than does the U.S. The world is experiencing an almost incomprehensible tidal wave of economic growth today which we expect to continue for many years to come.
Our investment themes for 2007
One of our major investment themes continues to be investment in companies servicing global markets, with an emphasis on emerging markets.
Global economic expansion has resulted in a growing list of scarcities. A few examples include oil, coal, precious metals, various agricultural products, various industrial minerals, electricity and potable water. We continue to seek out investments in or related to these industries or economic sectors.
A second theme calls for reduced exposure to dollar-based investments. The dollar remains under attack around the world. For example:
- Gulf oil countries, in possession of 22% of the world’s oil, are increasingly unhappy with their currencies pegged to the dollar and their oil priced in a declining dollar. Kuwait ended its currency’s peg to the dollar in May, 2007.
- United Arab Emirates (UAE) is considering changing its currency peg from the U.S. dollar to a basket of currencies where the dollar is only a component. Bloomberg news reports that the UAE Central Bank now has a strategy of moving 10% of its reserves into Euros.
- The International Monetary Fund has stated that the dollar now represents 63.8% of world currency reserves, compared to 72.6% of world reserves in 2001.
- China and Russia want growing roles for their currencies in international trade, believing that they are the emerging global financial super powers.
Implications to U.S. consumers and the economy of the dollar’s loss of its reserve status are potentially disastrous. The price of oil, for example, would likely shoot upward over time in a similar manner to how the cost of goods purchased with Euros converted from dollars has increased 66% in the past 6 years.
What markets are telling us today
We look at a number of broad market indicators which reveal how global investors perceive the world will be faring in the next three to six months, perhaps longer. We all know that markets are discounting mechanisms. What is currently known is already reflected in security valuations. What is perceived for the future is reflected in current price action.
Consider the following:
- Pursuant to Dow Theory, a technical indicator of stock price movement, if the Dow Jones Industrial Average (DJIA) is hitting new lows, but the Dow Transportation Average doesn’t confirm the trend by also falling to new lows, then the idea that we are in a bear market is suspect. The same is true if the Transports are hitting new lows without confirmation from the Industrials. Presently (February 22, 2020) the DJIA is 410 points (3.4%) above its former closing low on January 22, 2020 and the Transportation Index is 541 points (13.1%) above its closing low on January 17, 2020. As we write this report the stock market is indicating that these two important averages do not foresee significant recessionary problems ahead in spite of $90-$100 oil and a weakening economy!
- The CRB Rind Index is a global commodities index which measures price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. Presently, this index is hovering around its all time high, indicating that global growth is expected to remain robust.
- The prevailing wisdom (almost always a contra-indicator) that a weakening U.S. economy would result in a dramatic decline in the price of oil has not materialized either. Since October, 2007, oil has traded in the range of $90-$100 per barrel, where it remains today. Energy stocks remain within 10% of their all time highs, reinforcing the view that our economy is not about to fall into a black hole.
- Copper, perhaps the most basic industrial mineral, is now at the upper end of its trading range of the past twelve months. Here again, markets are painting a picture of strength in global growth.
- As previously described, home building stocks have rallied from their lows of early January. The homebuilders ETF has gained 30% during the past five weeks. Thus the market is telling us that recovery for the home builders is coming into focus.
The list goes on, but we believe we have made our point. In order for our domestic stock markets to resume a bear market mode, there will need to be new, and quite negative, information on the economy which is not currently factored into the market’s collective mind.
Once again, we have written a fairly long letter and we sincerely hope that you find our insights and opinions to be of interest. If you have any questions, or simply wish to discuss its contents, please don’t hesitate to call us. We hope 2007 will be a wonderful year for you and we are looking forward to continuing our service of your investment needs.
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