DECEMBER 3, 2007
DECEMBER 2007 COMMENTS - MORE TURMOIL RELATED TO REALTY
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The recent weakness in the equity markets is reflecting concerns that the US economy is slowing. Most of the blame for slowing economic growth is centered on the weak housing market and the instruments that fueled the recent housing boom. Lax lending standards and the drive to create more profits at lending institutions laid the foundation for the current financial crunch. For a comparable period one need look no further back than the early Nineties when a similar downturn occurred in housing that created a credit crunch. Although that period witnessed the demise of many of the traditional savings and loans, similarly commercial banks were squeezed and credit standards quickly tightened. Reflecting back on that period, the US economy endured a brief and shallow recession with stock prices on the decline for six months in 1990. Today's credit crunch bears a similar pattern although today's housing price retreat seems a bit more widespread than the early 90's experience.
- The Federal Reserve has attempted to ease the crunch with two interest rates cuts and by injecting liquidity into the banking system. While the Fed Chief Ben Bernanke has indicated a reluctance to ease further, we believe that it is almost inevitable that more rate cuts will be needed to shake financial markets of the jitters. Bernanke is watching inflation issues that have been simmering in the economy such as the increased cost of imports (from the dollar's drop), and the high cost of oil and related products, both of which potentially can fuel inflation. So far, inflation has not been a problem and we believe the current consumer spending slowdown will convince the Fed that easing is necessary to prevent a contraction in the US economy.
- While markets that are in a corrective phase are never comfortable, the right course is to maintain exposure to equities, which have since 1950 produced average annual returns of 11%. That time period included several housing market declines including the late 70's and the early 90's. This time, we believe, will be no different. Credit crunches cause temporary disallocations and we are seeing that now having gone from easy credit to tight credit. This will reverse in due course and our strategy of finding companies with great franchises, high return on equity and high free cash flow will mean that our holdings will receive the premium they deserve.
EQUITY MARKET OUTLOOK - MORE PRESSURE FROM ECONOMIC CONCERNS
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The equity markets have been under pressure since making a marginal new high in October. Investors' focus on the issues facing financial institutions continues unabated. At the end of November, indications of a future Federal Reserve interest rate cut sent the markets briefly higher. While we believe lower interest rates are the tonic for the weakening economy, speculating in financial issues with exposure to housing and the instruments used to finance the housing sector is premature. The resets related to adjustable rate mortgages do not peak until mid-2008 and we believe there will be more disappointments for the financial institutions that hold the paper.
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The markets are forward looking and if history remains true, the stock market will begin to discount the recovery we expect in the second half of next year. While housing's problems have certain sectors under pressure, our portfolios remain exposed to companies that will benefit from the weak dollar and the related increasing demand for our products overseas. The United States will benefit greatly from the increasingly competitive advantage our products will enjoy with the weakened dollar. This will translate into higher earnings for our internationally diversified equity holdings.
THIS MONTH'S FOCUS - FIXED INCOME POTPOURRI
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The Fed. To date, the Fed has reduced the funds rate by a total of 75 basis points to 4.50%, beginning on 9/18/07, and most market participants expect another 25 basis point cut to be announced on Tuesday, 12/11. The unemployment rate has begun to rise, and there is a very strong negative correlation between the fed funds and unemployment rates-implying that if the job picture worsens, the Fed will reduce rates more.
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The Yield Curve. As recently as late February, yields on 2- and 30-year maturity Treasuries were about equal at 4.65%, and the yield curve was said to be "flat". Now, the yield curve is "upward sloping", with the 30-year yielding about 125 basis points more than the 2-year. History suggests that the more the fed funds rate is cut by the Fed, the more upward sloping the yield curve will become.
- Housing. The bad news is that inventories appear to be about 75% above normal levels. However, the good news is that housing starts are now at an annual rate of about 1.2 million units, while the estimated rate to keep up with demographic demand for housing is about 1.550 million units. So, once the backlog of inventory is worked off, it appears reasonable that housing starts may stage a significant rebound, and this has been the case many times in the past.
- Municipal Bonds. Recently, municipal bond "insurers" turned their attention to insuring products much riskier than traditional municipal bonds for the additional premium. Now that many of these more exotic securities have done poorly in the market and threatened the capital of the insurers, the municipal yield curve steepened as market participants became concerned that the insurers were in serious financial distress. Most recently, however, the insurers have generally indicated a willingness to seek the additional capital necessary to maintain their "AAA" insurance financial strength ratings.
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Please feel free to contact us with any questions you may have on this or any other topic.