“It’s tough to make predictions, especially about the future.”Investment managers of all stripes are familiar with Yogi Berra’s quote, and yet every one, including us, persists in making predictions, or, as we prefer to call them, forecasts. Here is our review of what we expected in 2007 and a preview of what we think 2008 will look like.
2007 in Review
In our December 26, 2006 review/preview, we couched our 2007 forecast in terms of “Hopes and Fears.” We list them below, unedited, in the order they were presented, with check marks indicating our accuracy.
- Third-longest cyclical bull market without a 10% correction
- Possibility of higher federal taxes
- Geopolitical Risks
- Popularity of foreign investments leads to their underperformance
- Soft landing in the economy
- A cut in the Federal Funds Target Rate
- Lower interest rates
Another decent year for stocks
Naturally, caveats attend our correct calls, chief among them that we are writing this recap with about five business days remaining in the year, so the decent year for stocks continues to play out. At times, it hasn’t felt like a good year for stocks, but the broad U.S. indexes should return about 7%, with most equity portfolios we manage showing higher returns. At the beginning of the year, our forecast for full-year equity returns was 6.5%, which is about 0.5% away from spot on. Also, the soft landing call continues to play out, with the distinct possibility of a recession in 2008 remaining. We did not foresee the sub-prime mortgage issue, but we had been, and remain, leery of housing in general for some time.
2008 in Prospect
For the next year, we again expect a soggy first half (+0.95%) and a better full year (+4.29%). We arrive at these figures by taking a simple average of six probability-weighted forecasts submitted by the six voting members of our investment team. As is often the case, the average values mask widely disparate individual views. The standard deviation for our six-months forecast is 2.34%; for 12 months, 3.04%, which means that the ranges of our estimates are wide. This has been the case for the past several years, but our consensus results have been good.
We have four major areas of concern going in to the new year. Those areas are discussed in greater detail below. We then conclude this piece with some reasons to be optimistic.
1. The U.S. Economy
We see a number of key areas in the economy, areas that have to hold up for the economy to stay out of recession territory. Key among those areas is employment. It must hold up so that consumers can feel confident about spending. Unfortunately, we are seeing some weakness in Weekly Claims for Unemployment Insurance (aka Initial Jobless Claims). That economic series is volatile, but the trend is moving upward.
2. Subprime and Housing Issues
The consumer is also being squeezed by falling home prices, which reduce household wealth. Where consumers have taken adjustable rate mortgages based on marginal credit worthiness, falling home prices and, in some cases prepayment penalties, make refinancing virtually impossible. Couple that with reduced lending appetites by banks and a certain segment of consumers looks to be in trouble. Finally, Delinquent Mortgage Loans (90-days+ past due) are at all-time highs since the early 1980s, as are Mortgage Loan Foreclosure rates. As a group, we feel that the majority of subprime issues are not yet behind us, and we fear that there could be further problems with credit derivatives, such as credit default swaps, an idea that has been raised by others before us.
3. The Federal Reserve
The Federal Reserve board of governors is very inexperienced. According to BCA Research, only one, Donald Kohn, has any experience with navigating financial crises. Recent action suggests that the Fed is out of touch with markets or oblivious to the message implied in markets. We are hopeful that the Fed will mount an aggressive easing campaign that will boost stocks and keep the economy out of recession territory. We do not think the Fed will hold the economy hostage, risking recession, just to send a message to certain market participants. It is helpful to note that almost any time the economy gets in trouble, and monetary policy is called upon for a bailout, there is the inevitable chorus of comments that the Fed has lost its ability to influence monetary policy. That part is déjà vu all over again, with another nod to Yogi Berra. This time will not be different.
4. Election Year
Lastly, we turn to our concern about stock markets in election years. Typically, and on average, election years are good for markets, returning a median gain of 8.3% since 1888. That makes them second best to pre-election years. When one looks further into election year results, however, one sees that the stock market does poorly when the incumbent party loses the White House. Markets abhor the increased uncertainty that attends the change. Presently, all signs are that there will be a different political party in the White House in 2009.
Reasons to be Optimistic
All is not grim, however. One can view the equity markets as a stool with three legs, and a three-legged stool depends upon all three legs. In our view, the three legs are employment, fed rate cuts, and valuations. The first two legs are a little wobbly right now, while the third is in good shape. Regarding valuation, while stocks aren’t cheap by historic measures, they are reasonable. Finally, another leg is taking shape under the stool, which adds to our confidence, and that leg is insider buying, which is well above average and at a level that, in the past, has signaled further gains for stocks. In conclusion, the hopes we had for 2007 carry on into 2008, albeit it in modified form, as in “several rate cuts.” We expect, too, in 2008, to be able to see across the valley of despair that is the housing market.
We appreciate the confidence you continue to place in us. We value your business and our relationship with you. As always, call, write, or e-mail us with further questions and/or concerns you may have or that we failed to address here. In the meantime, we wish you the most prosperous of years in 2008.
Tower Private Advisors Investment Management