Investment Updates
Market Updates: 2007 Year End Review
The year of 2007 is destined to be a memorable one for investors. The Dow Jones Industrial Average hit a record high 34 times and notched milestones of 13,000 and 14,000. However, this march upward was anything but smooth. Since the summer months, volatility has been a regular part of the picture, triggered by fears of huge waves of mortgage defaults. Banks, Wall Street firms, insurance companies and others have tallied up tens of billions in losses from bad bets on complicated mortgage securities. Such fear sent the U.S. stock market on a roller-coaster ride which left many investors with whiplash after experiencing over 20 daily swings larger than 2%, which is far above the three to four swings of that magnitude typical of the past few years.
As you know, we provide market commentary anytime the market moves in excess of 1%. Looking back on 2007, we e-mailed over 35 different eflash articles in an effort to “weed through the noise” of 2007’s volatility. In such a volatile year where equities were up only 3.53% before dividends, or 4.9% on a net-total-return basis as defined by the S&P 500 Index, the 2007 composite returns for our Balanced Income, Balanced and Balanced Growth strategies had better performance than the equity market as a whole with less risk. Moreover, clients in our more aggressively managed strategies such as Strategic Growth Opportunities and Individual Equities experienced a return that was over two times greater than their respective benchmarks.
Retirement Advisors of America has maintained a value oriented bias since the firm’s inception over 25 years ago. The value style of investing focuses on finding growth at a reasonable price, as defined by such metrics as price to earnings, price to cash flow and price to book. While value investing has been proven to provide better returns while taking less risk over the last 5, 10 and 15 year time periods, we also realize that at times growth investing will outperform, as it did in 1998, 1999 and 2007. For the first time since 1999, the growth style of investing outperformed the value style of investing. Moreover, international investing outperformed growth investing. Because of our commitment to prudent diversification and downside protection, we were invested in these two areas, despite being more of a value oriented investment firm. As we saw in late 2007, there was a crossover from value to growth investing. Because it is impossible to precisely predict which strategy will outperform in the year(s) ahead we have always maintained that a balance of growth and value works best for our clients over a longer time period.
At our last Investment Policy Committee meeting we rebalanced our domestic portfolios to have a 55% value and 45% growth orientation. We are interested in having more growth exposure in your portfolios going forward because this gives us more exposure to multi-national corporations, which derive more of their revenue and profitability from abroad. With our belief that the U.S. economy will slow down a bit in 2008, having more growth exposure should benefit these types of companies as our weaker currency will make their goods and services sold abroad more affordable and attractive to foreign buyers.
On the equity side, the average large cap value manager as defined by Lipper Analytical Services was up only 2.2% for the year. While defensive value managers produced solid results during the first half of the year, they experienced hardship during the choppy markets of late 2007. In spite of our defensive nature and value orientation, for our clients that were invested for the entire year we managed to outperform not only the average value investor but also the overall equity market as defined by the S&P 500.
From a fixed income viewpoint, the Lehman Bros Aggregate Bond Index had a red hot year for 2007. If you were willing to place 100% of your assets in the fixed income market for 2007, you could have earned a return above 6%. However, history shows that on average equities outperform fixed income which is why we maintain a blend of equities and fixed income relative to your risk tolerance. Like our approach to equities, we realize that no one can be in the right place at the right time all of the time. While our fixed income strategy trailed our benchmark for the year, over the last several years our fixed income positioning has added consistent value to our portfolio.
As you know, one of our major goals for our clients is to produce a return that exceeds your withdrawal rate. We are pleased that for the vast majority of our clients this was the case for 2007. Going forward, we see the portfolio(s) more balanced between value and growth with a strong representation to multi-national companies which are exposed to more growth potential from the foreign markets.
As we enter into 2008, the markets are focused on the question of a recession. While we believe that we will narrowly escape this outcome, until the markets are convinced of this we will continue this roller-coaster ride of volatility. In addition, the markets are hoping for continued relief from the Federal Reserve Board in the form of lower interest rates. This is needed to ease pressures in the monetary markets. Nonetheless, we do not believe the conditions for a bear market exist. Among other things, one of the requirements would be for the Fed to be tightening interest rates rather than easing them, as we expect them to continue doing. Valuations in the U.S. equity markets and other foreign markets are reasonable, interest rates are coming down and there is still plenty of buying power on the sidelines waiting for the credit crunch to show some resolution. We expect equity prices to be higher a year from now, even though the business and liquidity cycle is approaching a more mature stage where selection and positioning will be keys to investment returns.
We have been bullish on the markets for the last 4 years due to our belief that the Fed will be able to engineer monetary reflation, where easy money allows the economy to grow at a sustainable rate. The main risk we see to this view is if inflation is embedded into our system (we don’t think so at this time) it will cause the Fed to reverse course and start raising interest rates. This will cut off the monetary reflation that is needed to pick up the economy. In terms of market implications, it would depend on the underlying economic environment. If growth was weak, then it would be bearish for stocks but good for bonds. However, if inflation was rising in an environment of stronger economic activity, then stocks would do okay (bonds would not) for a while because earnings expectations would presumably be rising. This ending would be bearish as monetary conditions progressively tightened.
Other potential risks to the stock market include: (1) the Fed mistakenly feels that inflation is still here and keeps interest rates too high, thus creating a policy mistake, (2) the ongoing strains on the banking system and the credit markets. Unfortunately, the markets have not been able to understand the full extent of the problem due to the lack of transparency surrounding mortgage related products and the pricing of these assets, and (3) a major growth deceleration in China, which has been a big provider of international growth. Obviously, this is not an exhaustive list of risks as there are geo-political risks (hard to quantify) and election year risks which should not be too meaningful for 2008, regardless of the outcome.
Our two main equity themes for 2008 can best be summed up as global and growth. We will maintain and possibly increase our global exposure as we believe that the non-U.S. markets will continue to outperform our U.S. markets in 2008. Due to currency risks, we have to be cautious on how much exposure we achieve, because if the dollar starts to strengthen against other currencies, then this could subtract from our international managers’ total returns. When profits are harder to come by and credit is tight, investors favor companies in excellent financial shape that can deliver solid earnings, boost dividend payouts and have minimal borrowing needs. These businesses come in all sectors and sizes, but they tend to be larger, established companies that ideally have a global footprint. Stock funds reflected this sentiment specifically in the last quarter of 2007 as growth oriented strategies soared, while bigger companies were generally better investments than smaller rivals. We will continue to invest in large cap growth funds and may even increase our exposure from its current level in 2008.
We remain upbeat on equities, but the market will remain at risk until some positive economic spark arrives, most likely by a shift in Fed rhetoric from an anti-inflationary point of view to a more pro-growth stance, as well as some resolution to the credit crunch.
We appreciate you as a client and as always, please do no hesitate to contact us with questions about the economy, your portfolio(s) or any other issue.
Retirement Advisors of America, Ltd.