First Quarter 2008 Review and Outlook

March 31 will mark the end of a quarter that can not end soon enough. That date will put a bookend on three of the most volatile months in recent history. Save commodities and U.S. Treasury securities, few asset classes were spared the carnage. 2008 returns through March 24 are shown below for several asset classes.

Index Return Index Return
Dow Jones 30 -5.5% NASDAQ -12.2%
S & P 500 -7.5% MSCI EAFE -13.6%
S & P Mid-cap -5.4% S & P Commodity Index 9.6%
Russell Small-cap -8.0% Bonds 1.1%

In the paragraphs that follow, we provide a brief look at 1.) the causes; 2.) the anticipated resolution; and 3.) our outlook on how the balance of the year will unfold.

Causes

In our view the quarter ultimately reflects the repricing of risk in security markets. This process began in summer 2007 as problems with subprime mortgages and the securities created from them began to appear. We believe the process will end some time this year, but the aftermath will be with us for some time. At the risk of sounding clichèd, it is safe to say that some parts of the security markets, and the economy for that matter, will never be the same. The fallout will include regulations that will forever change aspects of the economy and markets. At the very least, expect more paperwork when applying for a mortgage; at the other end of the spectrum, one can expect considerable, tough oversight of the investment banks. We can only hope that the law of unintended consequences will deal kindly with us.

Resolution

Speaking of regulation, it plays a key role in resolving the current crisis. We see the resolution coming in three forms.

  • Housing fix from Congress
    This is already beginning to unfold with portfolio and policy changes enacted for the government sponsored enterprises like Fannie Mae and Freddie Mac. Those changes will not, however, fix the problem with record-high delinquencies and foreclosures, and they will not reduce the level of homes for sale. Expect more from Congress.
  • Relief for some part of the financial system
    Contrary to popular belief, the Fed-engineered buyout of Bear Stearns was not a bailout. The company was purchased after investors were nearly completely wiped out. Even the revised price of $10 per share represents only 5.9% of the company’s stock price last summer. The company was, however, too big to fail. The Fed and Treasury are hard at work to craft additional solutions, including taking unprecedented actions to provide liquidity, with the most illiquid securities as acceptable collateral.
  • Natural business cycle recovery in concert with Federal Reserve monetary policy
    Although it might shock Congress to know it, the economy can get along quite nicely without the assistance of legislators. That process of recovery is being given a high-octane boost with the Fed’s massive liquidity injections and rate cuts.

Our Outlook

We believe that these rough times may be coming to an end, although we are reluctant to issue the all-clear sign as some have recently done. In our opinion, there may be another shoe to drop, and we would not rule out an event similar to Long Term Capital Management. While this would be painful, it would lead to capitulation, an event in which investors sell risk assets at any price, washing their hands of the confounded things. There have been at least two times this quarter when such an event was narrowly averted. The first was on January 24, when the Federal Reserve cut the Fed Funds Target rate by 0.75% before U.S. markets opened with equity index futures pointing to a brutal day. The second was when the Fed orchestrated the buyout of Bear Stearns by JPMorgan Chase. Had the markets opened on March 17, Bear Stearns stock certificates would have been useful as wallpaper, and the entangled web of commitments, collateral, and calls on collateral would have driven the market to its knees.

Naturally, there are factors in favor of markets rebounding from these levels and there are indications that markets could decline further. Here is our objective categorization of the factors.

Factors pointing to higher stock prices

  • Sentiment, or investors’ attitudes toward stocks, are at very low levels. Taken as a whole, it might be said that they are at record low levels.
  • The market has successfully tested, or declined to without going below, the January 23 lows.
  • Company insiders have been aggressively buying their own company stock. This group of investors tends to be early, however.
  • Mutual fund investors have fled equity mutual funds in record numbers. January 2008 outflows were the second highest in 18 years.
  • Cash levels are quite high, providing the fuel to push stocks higher.
  • Meanwhile, the Fed is aggressively lowering interest rates, making money market funds much less rewarding.

Factors pointing to lower stock prices

  • Valuations on stocks are only reasonable, not at the low levels seen at previous bear market lows.
  • Analyst earnings estimates for 2008 are still quite rosy. We think they have failed to account for the slowing economy.
  • Quite a few pundits have called the recent activity in stocks the low based on some of the same factors we see, but especially the successful retest factor.
  • The economy is still in a precarious position.

Factors pointing to higher stock prices

  • Sentiment, or investors’ attitudes toward stocks, are at very low levels. Taken as a whole, it might be said that they are at record low levels.
  • The market has successfully tested, or declined to without going below, the January 23 lows.
  • Company insiders have been aggressively buying their own company stock. This group of investors tends to be early, however.
  • Mutual fund investors have fled equity mutual funds in record numbers. January 2008 outflows were the second highest in 18 years.
  • Cash levels are quite high, providing the fuel to push stocks higher.
  • Meanwhile, the Fed is aggressively lowering interest rates, making money market funds much less rewarding.

Factors pointing to lower stock prices

  • Valuations on stocks are only reasonable, not at the low levels seen at previous bear market lows.
  • Analyst earnings estimates for 2008 are still quite rosy. We think they have failed to account for the slowing economy.
  • Quite a few pundits have called the recent activity in stocks the low based on some of the same factors we see, but especially the successful retest factor.
  • The economy is still in a precarious position.
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