Stock markets delivered a fifth straight annual positive return in 2007, but increased volatility and a negative fourth quarter depressed already low market sentiment. For the year, the MSCI World Index returned +9.0%.
Volatility is the norm for stock markets, which regularly slip, slide, or charge ahead. 2004, 2005, and parts of 2006 were uncharacteristically docile, but 2007 saw an end to the calm.
For most investors, 2007 was difficult to navigate. Aside from taking wild bets in narrow categories and getting lucky, success required making a few big decisions correctly to beat equity benchmarks and deliver nicely positive absolute returns.
Sectors positioned to benefit from high global demand for resources and economic growth performed well. Sector weakness was isolated to a few areas, as seven out of ten sectors within the MSCI World Index posted double-digit returns globally. Financials and Consumer Discretionary stocks were particularly weak as grim headlines about subprime, credit crunches, and ailing homebuilders dominated the news.
Geographically, 2007 was again a year where overall foreign stocks outperformed while US stocks had tepid but positive returns.
*Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Though 2008 got off to a rocky start, Fisher Investments remains confident world stocks should perform fine overall. This year indeed featured one of history’s worst “first fifteen days.” But Fisher Investments sees this as merely a continuation of a correction started last year rather than an indication of poor forward-looking results. In fact, examining the next nine worst prior starts for the S&P 500 since 1928, in no instance did the market end down-a-lot. Instead they ended up-a-lot, up-a-little, and even down-a-little, but never down-a-lot.
Results for global stocks were even more encouraging. History simply doesn’t support the belief a rocky start to January must lead to terrible annual returns. Of course, there is always a first for everything and things do happen in markets beyond our ability to envision them. But counter to many people’s view, a bad start to the year is not consistent with a terrible year.
While Fisher Investments has been correct since 2003 that stock markets would be positive and offer better returns than most bond or cash alternatives, the top end of our forecasted ranges were consistently over-optimistic. And that was true in 2007 where we forecast a +10% to 40% market return and the MSCI World Index was +9%.
Perhaps in 2008 sentiment will catch up with fundamentals and stocks will enjoy a roaring good year. But it’s also quite possible the historically long stretch of cheerless sentiment persists and ho-hum returns will continue. Either way, Fisher Investments believes staying in stocks is the right course.
Fisher Investments portfolio management process is always guided by our “Four Market Conditions” framework, which aids us in tactical asset allocation decision-making. In most markets (Down-a-Little, Up-a-Little, and Up-a-Lot) Fisher Investments generally prescribes fully investing in equities. But in a market forecasted to decline 20% or more over a lengthy period (Down-a-Lot), we generally advise a defensive strategy for capital preservation.** The “Down-a-Lot” scenario seems to us least likely in 2008.
2008 seems an unlikely year for a “Down-a-Lot” scenario. First, recall the typical “recipe” for a bear market: Euphoric sentiment and negative fundamentals not already widely recognized. Today’s market sentiment is pessimistic. Recession fears, earnings growth worries, and talk of an aging bull market pervade. Negatives such as a soft housing market and credit problems in the financial world are widely known and thus already reflected in stock prices. The stock market is a discounter of widely known information, so without a powerful, new negative force emerging Fisher Investments finds it highly unlikely a bear market will materialize.
Today’s investment environment looks a lot like a decade ago (1997-98, not 2000-02). Today foreign stocks in general are leaders where US stocks were then, Emerging Markets are the hot category in place of Tech, and subprime and the credit crunch worries are believed to be an “American Contagion” similar to the “Asian Contagion” of a decade ago. If 1998’s stock market returns repeat as well, 2008 could be a great year.
The bullish drivers Fisher Investments highlighted in 2007 should largely continue into 2008. Current market jitters seem based on the same old pessimistic stories of years past. Housing woes, subprime, high oil prices, US dollar weakness, global imbalances, all rippling to economic weakness—none are news anymore. Instead, our view is the stock market is primed for upside surprise, especially if the global economy led by non-US forces remains as resilient as we expect.
Global GDP Growth Should Continue to Outpace Expectations
Global GDP growth has consistently outpaced expectations in recent years, and Fisher Investments believes that trend will continue in 2008.
Folks are persistently overly focused on the US economy. As a percent of global GDP, the US accounts for about 26%, which is significant, but not nearly even half the developed world! (Source: International Monetary Fund.) Today’s economy is global and vastly interconnected, and the outlook for the global economy is again strong for 2008. As global GDP continues its growth, it’s most likely the US economy will be dragged along with it.
Further, if we pick apart US GDP and examine its components, we find a healthy picture. In the twelve months ending September 30th of last year (the last final revision as of this writing), the US economy had grown 4.3%, with an accelerating trend in Q2 and Q3. (Source: Bureau of Economic Analysis.) The preliminary US GDP report for the fourth quarter is being viewed widely as a massive deterioration in economic strength. But as Ken Fisher details at length in his book, The Only Three Questions That Count, GDP is an often inaccurate and variable statistic, particularly on a quarterly basis. Quarterly GDP results are something like a broken car speedometer that’s always five mph off—the problem is you’re not sure in which direction it’s wrong at any given time.
Consumer spending, nonresidential construction, government spending, imports, and exports are all growing. Today’s headlines highlight the weakening housing market as a recession catalyst, yet residential construction accounts for less than 4.5% of GDP. (Source: Bureau of Economic Analysis.) It’s simply too small to have the impact many fear.
Just as important, where residential housing construction has sagged lately, commercial real estate construction is still on a roll, largely making up for housing’s weakness.
Consumer spending is by far the largest contributor to GDP. Despite media proclamations of a grim holiday shopping season, spending grew at a nice clip in 2007. A related and widely held belief is spending, and therefore GDP growth, will stagnate due to the rising cost of energy. But in truth, disposable income per capita since 2002 has grown in far greater proportion to energy consumption costs. Today, rising energy costs impact consumers’ pocketbooks much less than in decades past.
Earnings Breather Not a Bear Harbinger
US corporate earnings growth turned negative in the third quarter of 2007 and expectations are similarly dour for the fourth. But a closer look at the numbers reveals a different story. Excluding a few industries (Homebuilders, Financials, and a few huge write-offs in the auto industry), earnings growth was fine. There have been plenty of instances historically where earnings growth has flattened only to reaccelerate shortly thereafter, including the 1997-1999 period, and in fact, forward earnings forecasts for 2008 are currently at all-time highs.***
It’s worth taking a closer look at Financials’ earnings, which continue making headlines due to billions worth of asset write-downs tied to problems in the securitized debt markets. Recent increases in subprime mortgage defaults have raised concerns about the debt products containing these loans. Because many collateralized debt obligations (CDOs) hold subprime mortgages, CDOs in general have been shunned by investors. Many of the big Financials companies hold large sums of these and other similar securities and have written down their values. Thus, Financials stocks have taken a pounding as many fear the assets are imperiled.
CDOs have always been difficult to price in the open market because they don’t trade as regularly as stocks. As a result, investors often use complicated models and esoteric indexes to estimate the value of CDOs based on assumed values of the underlying assets, along with many other factors. This type of pricing has been called into question as the secondary market for debt products withered in recent months. Just what are these securities worth anyhow? Have they been far overvalued for some time?
We believe today’s asset write-downs are more a result of the weak market for these investment vehicles than a severe deterioration in their true underlying value. The market is not very liquid today and companies are forced to mark down assets to their perceived market value. But that doesn’t mean the assets are worthless. Far from it.
There’s a large difference between not being able to sell a security quickly and the actual value of the assets in that security. In other words, the loans themselves aren’t all in bad shape, but nobody currently wants to buy them packaged as CDOs or similar products. Eventually, some of these products could very well be dismantled and the parts sold because the individual components are worth more alone than they are together.
Think of it as you would the housing market. A couple years ago, in the hottest growth areas, many folks could actually sell a home the same day they put it on the market! Just because you can’t do that today doesn’t mean your house is worthless. It might mean demand is a little weaker and even your house is worth slightly less today, but it certainly doesn’t follow that your house has turned into a rotting pumpkin.
The important thing to note is the asset write-downs making headlines today aren’t losses in the sense companies are hemorrhaging cash. (2007 Financials operating earnings are still expected to be the second best on record.)***
Excluding mark-to-market asset write-downs, Financials’ operating earnings were strong all year. This is of paramount importance because operating earnings are often a better indication of a company’s ability to earn on an ongoing basis than bottom line earnings-per-share. That’s because operating earnings do not count non-recurring items, only recurring revenue and expenses tied to a firm’s core business.
To really get this concept, let’s look at a few specifics. Citigroup, a company which took a $10 billion net loss in the fourth quarter and more than $22 billion in asset write-downs (non-recurring items) for the year still managed to earn $3.6 billion in 2007. That implies operating earnings somewhere in at least the $25 billion dollar range. That’s a very impressive number. It’s a similar story for many of the big US banks and financial institutions.
This isn’t to say Citi’s or any of the Financials’ asset write-downs don’t count. Of course they do. But it’s key to recognize those losses will not continue in perpetuity, rather, the underlying businesses, which are ongoing, remain healthy and thriving.
What matters for stock performance relative to earnings is beating expectations. Extremely dour expectations are priced into stocks today despite a host of positives including a stronger-than-expected global economy and the magnitude of share buybacks. Fisher Investments expects aggregate earnings growth to reaccelerate in 2008.
Credit and Liquidity Remain Plentiful
While there’s no denying trouble exists in capital markets tied to securitized loans, the widely expected credit crunch and liquidity crisis have not broadly materialized—while there is an overabundance of talk that they have.
Rising default rates and higher bond yields are a requisite for a true credit crisis, yet both have yet to occur. Contrary to popular conception, aggregate bond default rates remain near historical lows and yields on investment-grade debt have actually fallen. In fact, mortgage rates are again hitting lows. Only yields on the highest-risk debt, commonly referred to as “junk bonds,” have seen rising yields. However, junk bonds are a relatively narrow part of the overall debt market and their yields remain well below historical averages.
On balance, capital markets are functioning smoothly. Even those financial institutions experiencing turbulence have received ample capital infusions from a variety of sources like central banks, sovereign wealth funds (SWFs), and other outside parties. In Fisher Investments’ view, the Fed and other central banks have acted appropriately and have been highly responsive to capital markets’ needs. There is plenty of central banking liquidity for those who require it.
Contrary to popular belief, bank lending rose in 2007—even as liquidity concerns mounted in the latter half of the year. US banks have deftly weathered the liquidity storm thus far but have also positioned themselves to resume profitability more quickly than most expect.
The Fed released its 2007 data on aggregate US bank lending, and the results will surprise many. 2007 bank lending rose a stellar 10.8% from 2006—the fourth consecutive year of double-digit lending growth. The fourth quarter (the peak of the so-called liquidity crisis) resulted in 3.2% lending growth from the third quarter. (Source: Federal Reserve.) This is a powerful demonstration of the strength of US banks in the face of turmoil. Simply, this is an impossible outcome if a liquidity crisis truly existed.
Just as impressive, all categories of US bank loans experienced an increase in 2007. The strongest segment was Commercial and Industrial lending at +21% from a year earlier, while the weakest was Revolving Home Equity (no surprise). And even that still managed to post a +3.2% gain. (Source: Federal Reserve.)
And there’s a subtler and just as interesting feature to today’s banking environment. While many surmise today’s US banking sector is similar to Japan’s Financials sector woes of the late 90s, Fisher Investments sees stark and important differences. In the 90s, the Fed advised Japanese regulators to write off bad loans, recapitalize, and resume business. Japanese banks resisted for almost a decade, causing the trouble to linger. When they finally did clean up their balance sheets, economic growth resumed. US banks seem to have learned the lesson—they’ve already recognized potential losses and sought new capital.
Banks had a choice to either shrink their balance sheets by reining in lending or attracting equity capital to continue operations in the face of recent credit market turbulence. Most chose the latter via sovereign wealth fund investments, preferred share offerings, borrowing directly from the Fed, and so on.
Already, the big banks have gotten their acts together, taken their lumps, and still have balance sheets flush with cash. This is precisely the opposite of Japanese Financials’ precarious position ten years ago, and yet another demonstration of more fully developed, well-functioning capital markets today. (And anyway, Japanese banking problems ten years ago weren’t enough to bring down global markets for the year in the first place!)
Taking place today is a reallocation of capital rather than a liquidity crisis. In recent years, a lot of credit financing capital went to lower quality bonds. What we’re seeing today is a reallocation of capital away from junk and toward investment grade (or, less risky) borrowers. It’s cheaper today for investment grade companies to borrow than it was last summer. That’s not a crisis at all, just a shift in who gets access to the money. What’s more, the vast majority of dollars lent each year is investment grade debt. That means the overall corporate lending environment has actually improved over the last few months in spite of erosion in the high yield markets.
In sum, this is compelling evidence today’s financial and economic world is much healthier than most folks imagine.
High Share Buyback and Merger Activity Will Continue
Merger and share buyback activity posted another record year in 2007. Media commentary and conventional wisdom center largely on the notion acquisitions and share buybacks are bad. This is measurably false.
Mergers and share buybacks are a bullish driver because they decrease overall equity supply. Holding demand constant, shrinking equity supply should bolster prices. This highly bullish phenomenon began a few years ago, and Fisher Investments sees little reason it will abate in 2008.
As outlined in past outlooks, earnings yields (the inverse of the P/E ratio, or E/P) remain well above comparable bond yields. This historically rare environment is highly advantageous for companies wishing to borrow cheaply and execute share buybacks or acquisitions—both of which can boost corporate earnings and bolster stock prices.
While 2008’s acquisition and share buyback activity may or may not exceed 2007, fundamentals remain intact for another big year. As yields on so-called “junk bonds” rose in the second half of 2007, many declared an end to the wave of big private equity deals (which largely finance their transactions with this type of debt). Though this may prove true, it misses the larger picture. Corporate balance sheets are flush with cash and higher-rated firms still enjoy very favorable borrowing conditions—a fertile environment for strategic acquisitions and share buybacks.
Yen Carry Trade
In 2007, Fisher Investments noted an interesting phenomenon. The exchange rate between the yen and the euro and daily changes in the MSCI World Index correlated strongly. On days the yen strengthened to the euro, stocks dropped. When the euro strengthened, stocks rose. Even intra-day exchange rate changes closely tracked stocks. The correlation is also nearly as strong for single stock markets, like Germany’s DAX, UK’s FTSE, and the S&P 500.
The primary driver behind this relationship is the Bank of Japan’s ultra-low interest rates. Investors can borrow in Japan at low rates and buy currency of higher yielding nations elsewhere—in essence selling yen, buying euro (or some other currency), and then buying some higher yielding asset. The difference between Japan’s low rate and higher rates elsewhere is profit. It’s a self-fulfilling transaction—as investors sell yen it keeps yen low relative to euro and perpetuates the incentive to keep selling yen and buying euro. This is known as the yen-carry trade.
When investors borrow money it increases global money supply. In Japan’s case, the yen-carry trade keeps money flowing into global markets. As long as Japan keeps rates relatively low, it provides an additional source of global liquidity that can find its way to stocks and push markets higher.
The Bank of Japan has intentionally kept interest rates low for years to fend off deflation. If policy suddenly shifts in Japan and rates are raised significantly, yen would rise, killing the carry trade. Investors would unwind their bets, taking money out of global stocks and sending it back to Japan. Stocks and higher-yielding countries’ currencies could fall. Investors today are focused on a weak dollar, but if this relationship remains intact, a more legitimate risk is a strong yen.
However, there’s little reason to expect the Bank of Japan will tighten its monetary policy any time soon. As long as the yen stays weak, there’s diminished risk of unwinding carry trades.
*Forecast as of February 6, 2008. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
**Nothing herein constitutes investment advice or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Market Information is impersonal and not tailored to the circumstances or investment needs of any specific person.
***Written as of February 6, 2008. Figures and forecasts have not been updated.
Much of the current bull market has been dominated by small cap and value stocks, but a shift has occurred. Historically, large cap stocks outperform for an extended time in the later stages of a bull following a period of small cap dominance. In the current cycle, the transition began in mid-2006 and became more pronounced in the second half of 2007. Fisher Investments believes this trend will persist in 2008.
As the shift continues, skeptics will be bothered by the fact fewer and fewer stocks are beating the market, citing the number of stocks underperforming compared to relatively fewer making gains as a justification for a bearish posture. This is typically referred to as negative “market breadth.” Technical traders believe times of negative market breadth are a harbinger for negative markets. But times where market breadth turns negative doesn’t necessarily predict a down stock market. The last time breadth turned negative was 1998—a period when the previous bull market had yet far to run.
Stock markets are composed mostly of small cap stocks by number but relatively few large caps. In fact, of the universe of nearly 25,000 global stocks, only 81 are larger than the weighted average market capitalization of the MSCI World Index. Though they’re the minority by count, those 81 companies are so massive by cap they pull the smaller companies up to the average. Thus, when big cap stocks lead, fewer companies will outperform the market.
This may sound convoluted, but the math is simple. A companies’ weight in an index is determined by its market capitalization. So, a company as huge as Exxon Mobil, which is about $500 billion in size, dwarfs many times the very small companies of a few hundred million dollars at the other end of the spectrum. Thus, Exxon carries a very large weight in the index. The sum of the largest stocks in the index usually carries a very large weight, that is, they account for a very high percentage of the total.
This style change is the result of an important fundamental shift pertaining to corporate access to capital. Clearly, the smaller the company, the lower its credit rating. Conversely, the largest companies by market capitalization tend to have the most sterling credit ratings. This distinction becomes hyperbolic with the very largest stocks, or “super caps,” which tend to uniformly have the best credit ratings and the cheapest borrowing costs. In fact, all the companies today with AAA credit ratings are super-caps. (Source: Thomson Datastream.)
In the first part of the bull market when small caps outperformed, the yield spread between risky debt and investment grade debt was shrinking. That is, it was becoming easier for small caps to borrow relative to large caps. This is a significant reason small caps outperformed in those years.
Today, the spread between investment grade and riskier debt is widening. This means it’s becoming relatively easier for large companies to borrow.
An easier financing environment for large caps, or conversely, a more difficult financing environment for small caps, points to a period of outperformance for large caps. Fisher Investments believes this trend will persist into the period ahead.
Undoubtedly, US politics will be on folks’ minds throughout 2008 and will have implications for stock markets. 2008 is the fourth year of a US presidential term—historically very positive for stocks globally. And, as politicians busy themselves with campaigning prior to November’s elections, Fisher Investments is confident Washington will again prove legislatively feckless. We think feckless is good in this department.
As always, Fisher Investments remains agnostic to political affiliation. We believe siding with one party or another creates harmful biases clouding investing judgment. Thus, Fisher Investments favors neither side in our analyses and attempts to be as objective as possible.
Presidential Fourth Year
Republican or Democrat, the fourth year of a president’s term has been good for stocks. In fact, the S&P 500 returns 14.0% on average during presidents’ fourth years. This is largely because politicians rarely pass major legislation during this period due to the reduction in power their party typically experiences in the mid-term elections. This cycle is no exception. Stock markets abhor the risk of wealth and property rights redistribution inherent in legislation, which causes heightened uncertainty and investor risk aversion. Much like last year, a gridlocked and inactive Congress means less legislative uncertainty for markets. Presidential term fourth years are consistently positive for stocks with only a few exceptions.
2008 Election Outlook
It’s still far too early to forecast November’s election outcome. 2008’s presidential election is the weirdest in our memory. For instance, most primaries this year will occur nearly six months before party conventions. But that doesn’t mean we’ll know the nominees any earlier than in the past. In fact, the nominees could be undetermined all the way up to the conventions. This is due to the closeness of the races on both sides and the extremely complex systems each party uses to compute delegates.
As an example, let’s look at the Democrats. On February 5th, about 1,700 Democratic delegates will be at stake. But candidates need at least 2,025 to secure the nomination. With two strong candidates, the delegates are likely to be divided fairly evenly because the Democrats award their delegates proportionally in each state, not winner-take-all. But even if Senator Clinton or Senator Obama won every delegate that day, it still wouldn't be enough to get the nomination.
It gets even more complex. The real wild card for the Democrats has to do with “superdelegates.” These comprise nearly 800 elected officials and members of the Democratic National Committee who are free to support any candidate they choose at the national convention, regardless of the primaries. It could come down to their support at the convention come August. Senator John Edwards has dropped out of the race but declined to endorse either candidate for now. He stands to play the role of “king-maker” by directing delegates pledged to him and will thus garner much media attention and courting from both Democratic candidates.
The Republican delegate system is just as murky. However, since most Republican states handle delegates in a winner-take-all format, a conclusive nominee is more probable with the Republicans than the Democrats.
At the very least, contrary to early prognostications, the campaign on both sides could continue well past Super Tuesday. This uncertainty carries a realistic probability of a third candidate entering the fray. It’s extremely rare to have a sitting senator ascend to the presidency (only JFK and Harding in the last 100 years), but this year it’s possible one will be nominated from both parties. Senators are often viewed as weak candidates because they have little executive experience. This opens the possibility for Michael Bloomberg, mayor of New York City, to enter the race as an Independent. Unlike Ross Perot in 1992, who faced two strong candidates including a sitting president, Mayor Bloomberg could be a winning candidate. With his billions, he has enough money to easily outspend both candidates three-to-one.
All of this contributes to further uncertainty about the ultimate outcome. It’s impossible to know right now. Either way, the degree of uncertainty tied to the elections will matter for stock returns this year.
Election years where the outcome was less certain (or, years when the ultimate winner garnered a smaller percentage of the total vote) result in middling stock market returns. Conversely, when the outcome was a landslide (or, more certain) stocks moved nicely higher.
Note also the reverse is true for the following inauguration year. That is, when the outcome was uncertain in the election year and returns were tepid, stocks tended to perform relatively better the following year. Years when the outcome was surer produced a nice return in the election year, but less so in the year following. (Source: Thomson Datastream and Standard & Poors.)
In Fisher Investments’ view, the key to this phenomenon is understanding how folks perceive the winning candidate’s party. It’s typical to believe “Democrats will be bad for business and be free spenders,” while “Republicans will restrict the budget and be friendly to business.” Neither ends up true in practice—neither donkeys nor elephants make good on campaign promises very often. Nevertheless, folks worry over Democrats ruining business in the year of the election, only to find out in the inauguration year it won’t be as bad as feared. Conversely, folks believe a Republican will be good for business (and thus stocks), only to find out in the inauguration year it won’t be as good as hoped.
But no matter what happens in November, a change in leadership isn’t historically bad for stocks. If you fear a Democrat taking the White House, you shouldn’t. From 1928 to present, White House changes from Republican to Democrat averages a 5.8% return for the S&P 500 in the election year and 20.7% in the inauguration year.
Many fear a Democratic sweep of the White House and Congress. It is possible the elections could produce the most heavily Democratic administration change since FDR was elected. But, should a Democratic sweep occur (and we certainly are not making such a prediction just yet), it’s unlikely to be lopsided as the Democratic majority was with LBJ after 1964. In that time the Democrats had 295 in the House versus 140 for the GOP, and the Senate had 68 Democrats versus 32 Republicans, a filibuster-proof and veto-proof Senate. No matter what happens in the 2008 elections, Fisher Investments believes it’s unlikely anything quite so extreme will occur. And 1964 and 1965 were perfectly fine for stock markets: 16.4% and 12.4%, respectively. (Source: Global Financial Data.)
In the months ahead Fisher Investments will provide further extensive analysis. But for now, our approach is “wait and see” as the primary election dust settles.
*Written as of February 06, 2008. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.