Research & Advice

|

Economic Outlook for 2008

A Review of 2007

NOBODY SAW IT COMING

On August 9th, 2007 and the days immediately following, financial markets in much of the worlds seized up…Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities.” – Former Federal Reserve Chairman Dr. Alan Greenspan, December 12, 2007.

This quotation sums up what turned out to define the financial markets for 2007. 

Just like that – literally out of nowhere and at a rapid rate – traditionally-defined relatively safe and conservative yield/coupon paying investments like the widely popular closed-end funds AVK and PFN were tragically punished.  These types of investments, used for their yield as well as for their relative safety when stock market corrections are predicted and anticipated, were whacked and have yet to recover.

Mr. Greenspan comments on what nobody in the trade, including Berkshire Money Management, saw coming.  That includes two of the brightest minds on Wall Street, the now ousted CEOs Messrs. Stan O’Neal and Chuck Prince (of Merrill Lynch and Citigroup, respectively) as well as even Goldman Sachs (whom had the presence of mind to, as a matter of common practice, short some of the types of securities in question so as to create transactional revenue as opposed to investment revenue). 

The brightest minds in the business were caught off guard.  The difference comes in reaction time to such turmoil.  For example, taken aggregately some of the largest and best organized companies on the street have acted slowly and allowed for an estimated $100 to $400 billion of losses to write off.  Similarly, famed hedge funds by Red Kite and Second Curve Capital, after posting stellar 2006 investment returns, are both sustaining losses of about 50% and 70% this year.

Even the soldiers working in the Wall Street trenches, the analysts, were blindsided as evidenced by their consensus July 2007 third-quarter earnings predictions of a 9% increase of earnings for banks and brokerage houses from a year earlier.  The actual third quarter result was a 27% drop (no, that is not a typo, – 27%).  Also in July these Wall Street soldiers expected a 10% gain in earnings for the fourth-quarter.  Now they expect a 45% drop for this quarter.

VOLATILITY

“Our favorite holding period is forever.” – Warren Buffet, Letter to Berkshire Hathaway shareholders, 1988

I cannot argue with that wisdom.  In fact Berkshire Money Management’s two largest client holdings have been held since we went into business almost seven years ago.  

However, as much as I enjoy Mr. Buffet’s quotation, most of Berkshires clients have timelines somewhat short of forever.  Additionally, our mandate, for lack of a better description, to our clients is to react to newfound risks (and opportunities) so as to minimize relative damage in portfolios from the vagrancies of the market (as opposed to, for example, ignoring  20% drops). 

Now, as I have repeatedly said and written about, my concerns are not associated with ten percent corrections; they are regular and ordinary (that does not mean that I will ignore the common-place 10% correction – I will typically shift a portion of assets to more conservative holdings.).  My greater concerns lie with crashes, not “ordinary” volatility.

To be clear, in the May 3, 2007 website article “Correction Coming” I wrote”

“I don’t like being the bearer of bad news, but there it is – sometime in the next twelve months the market should go down 10%.  And the next 5% correction should start soon – maybe within the next few months (summer doldrums?).  I certainly do not want to come across as cavalier or uncaring about your portfolio, but these ‘smaller’ corrections I largely just shake off.”

Summer came and we began the 5% correction that stretched into a 10% drop.

I also said in the October 2007 client letter that accompanied the Quarterly Report that:

 “within the next six weeks the S&P 500 will dip to its August lows (about 1,400 points)”

Six weeks later the market completed its retest.

Later in the website article as well as in the November 10, 2007 article “Conflicting Data” I explained why the strategy is not to go to all cash when a 10% correction is expected (to sum, a 10% correction is too small and ordinary and the tools to find, with precision, exact turning points are too dull). 

To be certain, the stock market is by its very definition volatile and, as exampled by the following table, 5- and 10%-drops are regular and ordinary inclusions of the stock market’s natural path (whether we like it or not).

A History of Dow Jones Industrial Average Declines (as of December 2006)

Type of Decline

Average Frequency

Average Length

Last Occurrence

Routine

(5% or more)

About 3.5 times

per year

47 Days

June 2006

Moderate

(-10% or more)

About once

per year

114 Days

October 2002

Severe

(-15% or more)

About once

every two years

216 Days

October 2002

Bear Market

(-20% or more)

About once

every 3.5 years

332 days

October 2002

Because our holding period is not forever and because what we really want to avoid are those 20% bear market crashes we get every 3.5 years, we must react when the risks rise.  As a result, there has been more trading and activity in 2007 than in the last six years combined. 

                     

We moved from equity with exposure to Financials to areas not as much as affected by subprime problems or by recession correlation (consumer staples, health care, technology, biotechnology, emerging markets).  And we moved from equity index ETFs and, where cash was available, moved toward unique and proprietary Absolute Return CD products (investors can make money whether the market goes up or down) only available to Berkshire Money Management clients with accounts at Charles Schwab Corporation (that is not hyperbole – they have only been made available to Berkshire clients through Schwab’s fixed income trade-away platform).

The end result is that we have been more active in our buying and selling (and sometimes with short holding periods) than we would normally like to be.  The silver lining to that is that Charles Schwab’s equity trading team is superb and we can typically execute broker assisted trades for large sales and utilize best execution to get the best prices.

To be sure, there is nothing inherently wrong with activity within a portfolio – quite the contrary.  In our view, investors need a manager that will act swiftly and according to the data as opposed to some other firm that would not waver from its convictions no matter how negatively it might affect a client’s portfolio.

A pet industry peeve of Berkshire’s is that so-called professional managers are too concerned that reacting to new data (which means making changes) is some sort of admission of being wrong, as if we investment professionals had some sort of capacity to never err in judgment or decision making. 

In our opinion, there is a tremendous difference between being wrong and updating a forecast/prediction.  In so doing, and in so recognizing the importance of a careful and flexible watch to your portfolio, we are sure to remain unwed to any positions or investment themes – it has been our experience that an unwavering, inflexible mantra is often times what gets investors into trouble.

 “Stay committed to your decisions, but stay flexible in your approach.” – Tom Robbins (American novelist, b. 1936)

We always thought that quotation applied to well to investing.  To think about it more anecdotally, we quote lines from one of Ivory Johnson’s articles:

“of the Fortune 500 companies in 1954, only 44 were still in business forty years later, presumably the consequence of maintaining old business strategies.  Creative destruction eliminates inefficient business models in favor of more productive means of commerce.  Long term investing has similar characteristics – the investor who refuses to acknowledge adjustments in the capital markets will shift unrealized wealth to somebody else’s pocket.”

Back to the subject of volatility, according to the Wall Street Journal, the following are the last eight time periods in which the DJIA fell more than a 10%.  The chart also reveals the magnitude of the drop as well as the days until recovery (WSJ defines the recovery as from the low point until the DJIA regains the level it held before the drop).

Downturns

Percentage Decline

Recovery (in Days)

Nov. 2002–March 2003

-16%

83

March-Oct. 2002

-31%

467

Jan. 2000–Sept. 2001

-30%

1812

Aug –Oct. 1999

-12%

68

July-Aug. 1998

-19%

83

Aug.-Oct. 1997

-13%

103

July-Oct. 1990

-21%

186

Aug.-Oct. 1987

-36%

665

Average

-22.25%

433

Average (ex. 2000-2002)

-19.5%

198

Following the averages, using October 9, 2007’s closing high of 1,565 for this cycle would put the S&P 500 at about 1,216 points on Christmas of 2008.

Excluding the (hopefully) once-in-a-generation crash of 2000-2002, the magnitude is not much better (1,244 points), but the pain does come to an end sooner (April 24th, 2008)

We will not hesitate to make changes to portfolios if the environment warrants it, but data currently suggests that there could be a major turning point for 2008 around the March – May period, where the first four months or so could look materially different that the last eight months.

Outlook for 2008

SUMMARY

The first four or five months of 2008 will be markedly different than the final seven or eight months. 

The first part of the year will see weakness in the US stock market as investors remain fixated on a weakening economy and also introduce questions as to the uncertainty of who will be the next US President.  Also during the first part of the year we expect profit growth to keep falling and to bring down capital spending.  We expect Fed easing to continue as well as a 10-year Treasury note that approaches 3.50% to reflect a continued lack of confidence in not only the economy, but also in the US financial system. 

In this environment we anticipate the best relative stock prices from Large Caps, from Heath Care, and from Consumer Staples.

By the second quarter we expect a full discount of stock prices and thus a rebound to reflect firming profit growth and an accelerating economy.  In this environment Technology and Consumer Discretionary sectors are anticipated to have better relative performance along with a shifting bias toward Small Caps. 

NOT A RECESSION, BUT STILL LOUSY

If we had to put a title on this report other than “Outlook 2008”, it would be “Not a recession, but still lousy.”  So lousy in fact that it seems as if November and month-to-date December (as of the date of our writing) will almost push Q4 2007 GDP into negative growth territory.  The final GDP number will likely be pretty close to flatline (+/- 1%), with an improvement in Q1 2008 (0% – 1%) thus averting a technical recession for 2007 and mostly likely averting a recession for 2008 (a recession is defined by two consecutive quarters of declining growth).

The risks thus rise for a recession in 2008, especially with housing shaving off an estimated percentage point-and-a-half from 2008 GDP.  But as lousy as the numbers will be we may yet avert a technical recession (for whatever that is ultimately worth).

The theme of this report, aside from sharing with you my best year-ahead predictions as well as how I have come to them, is that risks (not rewards) seem to be growing for the first half of 2008.

Still, I am left with the question, what is so disastrous about a quarter, or even two, of sub-par growth anyway?  In recent history we have seen the following US GDP growth rates:

            Q4 2005:         1.2%

            Q3 2006:         1.1%

            Q1 2007:         0.6%

As these examples suggest, a negative-to-flat quarter, or even two, do not, by themselves, necessitate anything calamitous.  Certainly I do not wish for this to sound Pollyanna-ish, especially because other factors can occur coincident to contracting GDP growth.  The more correct interpretation is that we perceive general stock market risks, as caused by the general economy,  to be “relatively” contained for 2008 (not a 2002-like capitulation). 

FUNDAMENTALS

For the US stock market, this is a quick (and fortunately rosy) snapshot of fundamentals:

  • Even if a recession were to occur it would be mild and short and thus has mostly already been priced in.
  • American’s disposable income has risen about 2.5% over last year.
  • Price-to-earnings ratio (P/E) valuations are fair, not-overvalued, at about 18 times trailing earnings (especially compared to interest rates).
  • Interest rates (as measured by federal funds, mortgage, and prime rates) are all at or near multi-year lows.
  • The S&P 500 has been flat for the last eight years, but over that same period its trailing earnings have risen by 70 percent, and the ten-year Treasury yield has dropped by forty percent (from 7% to about 4% today).
  • Dividend yields are at a seven year high and are about equal to expected inflation.
  • Despite housing problems, jobs are still being created; the unemployment rate, at 4.7%, is at a historically low range.
  • Export growth is benefiting from robust global demand.
  • The Fed is in the process of reducing interest rates (and are not expected to raise rates until 2009) and has been coordinating efforts with other central banks to make credit and cash available.
  • Tens of billions of dollars from Chinese and Middle Eastern Sovereign Wealth Funds (SWF) are finding their way to American companies, further infusing cash into, in many cases, already solid corporate balance sheets.

Fundamentally there is nothing to suggest a 2000-2002 like rout. 

To be sure, the economy has yet to get a firm grip on the ultimate amount of profit writedowns that financial companies will have to take.  The high side of most estimates is about $400 billion.  To put that in perspective, $400 billion is about 2.5% of U.S. stock market capitalization – or about one bad day on Wall Street. 

At their worst, the fundamentals suggest that we can expect the usual market volatility; an occasional (even if admittedly painful) 10-20% stock market pullback that merely temporarily interrupts the current cyclical market advance.

(Side note:  I’m still concerned that within the next decade that we will be exposed to another 2000-2002 like scenario that rhymes with, if not repeats, the 1974 follow up to 1970.)

It is important to note that in both 1990 and 2001 Fed easing failed to prevent recessions.  Due to economic concerns our risk level for the S&P 500 in 2008 is 1,300 points.  That number reflects, firstly, that with trailing 12-month profits of about $80 for S&P 500 companies, a price level of 1,300 points puts the P/E ratio at its 36-year median of 16.4.  Secondly, that number (and its corresponding P/E ratio) reflects all the goodness of current fundamentals.  In contrast, we would not expect a 1982-like washout that brought P/Es to single digits and in so doing  marked the beginning of a new secular bull market.

Our 2008 reward level is 1,760 points for the S&P 500.  At that price level the index’s P/E would be limited to one standard deviation above its median. 

If the S&P 500 drops to the risk level of 1,300 points, we would expect that the reward level would be immediately shifted down to 1,560 pints, a 20% rise from that level.

Our most likely scenario is a drop toward 1,365 points on the S&P 500 with a subsequent rally advancing toward 1,635 points.  This helps explain the recent inclusion of more conservative US sectors in portfolios as well as the use of Absolute Return CDs as offered through the Charles Schwab Corporation’s fixed income trade-away desk.

EARLY YEAR TRADES – WHAT MAY CAUSE US TO REDUCE MORE RISK

Berkshire Money Management will spend no time resting on our laurels after another successful calendar year. Actually, quite the opposite as we will be closely inspecting the first five days (FFD) of trading for the stock market.  Of the last 36 times the FFD of the year traded up, there were full year gains 31 times, an 86.7% accuracy ratio.  (Of 21 down FFD, there were 11 up years and 10 down years – not reliable).  One of those 5 down years, 1994, was just pretty much flat.  Unfortunately, the other four exceptions involved years in which the US was involved in a war.  The Iraq war thus diminishes this excellent track record.

Eyeballing the FFD is an early look of what has become known as the January Barometer, which states that as the S&P goes in January, so goes the S&P for the year.  This indicator has registered only five major errors since 1950 (an accuracy ratio of 91.2%). 

To be fair on the accuracy ratio, if you adjust for the nine flat years (+/- 5%), then there is a 75.4% accuracy ratio.  (Important for 2008, full year gains followed January’s move in ten of the last fourteen election years, or 71.4% of the time).

The January Barometer has merit not only because of historical tendencies, but because of why it works.  January, more than any other month, contains important events that help set the pace for the rest of the year.  This January we will witness several caucuses and enough polls to identify the likely winners of the Presidential primaries, the State of the Union address sets new goals and priorities, we get glimpses of new government budgets, corporate earnings are announced (which may or may not reveal massive changes to today’s forecast), a Fed meeting that could go either way, payroll numbers that will help us understand the deterioration of the housing and manufacturing sectors, the results of new Fed experiments with other central banks and whether or not larger amounts of liquidity will be auctioned off, a full month’s evidence as to whether the government-led “teaser freezer” of locking in the teaser rates of adjustable rate mortgages worked, etc.  Should these events happen in any other month there would be no January Barometer.

The accuracy of the January Barometer is impressive, but as stated, I am more concerned in 2008 with identifying risks, not rewards.  As such, I will also focus on the historical fact which concludes that down Januaries can signal the beginning (or continuation) of a bear market.  I would like to reiterate the parenthetical “or continuation” as we all know that neither bull nor bear cycles conveniently start at the beginning of the year.  In every instance except 1956, down Januaries were followed by declines averaging -12.6% to the calendar year low (ranging from -2.6% to -35.5%).  Courtesy of the Stock Trader’s Almanac the table on the following page itemizes the past troubles.

To affirm a decline in January pre-dating the start of a bear market, watch for the December 2007 low to be crossed in Q1 2008.  Of the 27 instances where the market crossed its December low in Q1 and continued (as opposed to the two instances where it closed below and then immediately regained traction), the average continuation of price decline has been 10.1% (a range of -0.3 to -25.1) past the crossed price level.

Only three significant drops happened when the December low was not breached in Q1 (1974, the oil crisis; 1981, the last full year of the bear market that launched an 18-year bull market; 1987, Black Monday).  Statistically it is bullish news if the December lows are not crossed and January ends up – those two positives have bided well for the stock market.

While we are on the topic of months and calendars, for the sake of trivia I will mention two interesting pieces of information. 

  1. Since 1964 there has been an average rally of 13.1% from the November/December low to the following quarter’s high (a range of +0.9% to 36.2%).  From the November 26, 2007 1,407 point low for the S&P 500 that puts the index at 1,591 points.
  2. Similarly, since 1964 there has been an average decline of 6.0% from the November / December high to the following quarter’s low (a range of -15.8 to +0.1).  From the December 10, 2007 1,515 point high for the S&P 500 that puts the index at 1,424 points.

From Down January S&P Closes to Low Next 11 Months

Year

January

% Change

Jan Close

to Low %

Feb to

Dec %

Year %

Change

Condition

1953

-0.7

-13.9

-6.0

-6.6

bear

1956

-3.6

0.9

6.5

2.6

flat

1957

-4.2

-12.8

-10.6

-14.3

bear

1960

-7.1

-6.0

4.5

-3.0

bear

1962

-3.8

-24.0

-8.3

-11.8

bear

1968

-4.4

-4.9

12.6

7.7

cont. bear

1969

-0.8

-13.4

-10.6

-11.4

bear

1970

-7.6

-18.6

8.4

0.1

cont. bear

1973

-1.7

-20.6

-15.9

-17.4

bear

1974

-1.0

-35.5

-29.0

-29.7

bear

1977

-5.1

-11.1

-6.8

-11.5

bear

1978

-6.2

-2.6

7.7

1.1

cont. bear

1981

-4.6

-13.0

-5.4

-9.7

bear

1982

-1.8

-14.9

16.8

14.8

cont. bear

1984

-0.9

-9.5

2.3

1.4

flat

1990

-6.9

-10.2

0.4

-6.6

bear

1992

-2.0

-3.5

6.6

4.5

flat

2000

-5.1

-9.3

-5.3

-10.1

bear

2002

-1.6

-31.3

-22.2

-23.4

bear

2003

-2.7

-6.4

29.9

26.4

cont. bear

2005

-2.5

-3.7

5.7

3.0

flat

Totals

 

-264.3%

-18.7%

-94.0%

 

Average

 

-12.6%

-0.9%

-4.5%

 

                                                                                               

Separately, on the subject of early year trade possibilities, despite the beneficial non-correlation of its profit growth and economic cycles, absent any late-December/early-Q1 2008 push in biotechnology stocks which would realign the sector’s traditional fourth quarter strength, I would look to reduce and/or eliminate any positions.

ECONOMIC CONCERNS (EMPHASIS ON HOUSING)

Despite fiscal and monetary aid, concerns about residential real estate remain (and commercial concerns are growing).  Aggregately, mortgage foreclosures could reach record levels over the next few years.  Given that residential investment is only about four percent of US Gross Domestic Product (GDP), the current oversupply of housing inventory should not have a tremendously significant direct impact on GDP growth (emphasis on “tremendously” and “direct”; the overall, indirect impact should be about a significant one-and-a-half percentage points).  There may be more serious indirect drags on economic growth, including the following:

  1. Deteriorating consumer confidence stemming from falling market values of their single largest asset, their house (and this just as they begin to receive new, higher property tax assessments);
  2. Much tighter credit availability (especially compared to the likes of 0%-interest car loans and  so-called “liar-loan” mortgages where little or no documentation as to income was required);
  3. In addition to the aforementioned two bullet points, consumer spending will also be affected by the mostly exhausted home equity withdrawals and cash out refinancing;
  4. A drag on job creation from the reduced housing-related employment (both the service side as well as the construction/manufacturing side).  As an important side note, all recessions have been pre-dated with a one-half percentage point rise in the unemployment rate; in this cycle that would mean a jump from 4.4% to 4.9%.  

Regarding that above “important side note” that all recessions have been pre-dated with a jump in the unemployment rate, even with that important tool in our bag of tricks, predicting the economy’s path at turning points is very difficult.  That is especially true today with so many existing mixed signals.

Also, if there is to be a recession, then it is the most widely predicted recession in history.  And as long as you use the economic definition of two subsequent quarters of economic contraction, then the balance of data still argues that we do not have a recession, but instead that for this and for the next quarter we have just flattish, “recession-like” growth (I’ll let you know if/when that balances shifts). 

Take as a contrasting example the 2001 recession that ended in November of that year.  Keep in mind that we never know for sure until about six months later when a recession actually started and stopped.  In November 2001, after we were pulling out of a recession, the majority of prognosticators were still arguing that we would avoid a recession.  During the early moments of the 2001 recession 95% of economists polled said that there would not be one.  Berkshire Money Management actually predicted the 2001 recession on May 11, 2001 and published that forecast in our Navigator newsletter hotline – that helped us avoid the 16.5% rout in the S&P that lasted for the next four-and-a-half months.

Today, in contrast, there is not a person out there that does not want in on the recession prediction.  That is so unusual that there is no data to support whether that mass prediction is bullish or bearish for the economy.   As usual, we will continue to look at the data, but if we had to guess (and it is just a guess), we would say that the vast number of vocal prognosticators is more of a bullish than of a bearish indicator because with so many folks moving in one direction one must consider that the story has been discounted and therefore will not happen (a side note, in such an instance as this if we only get a near-recession there is a fair amount of upside risk in stocks).

We expect the economy to brush with recession in Q4 2007 and Q4 2008, recover moderately in Q2, and then grow at an above trend rate in the second half of the year.

As a point of interest, primarily based on housing starts, the Philadelphia Fed survey (measuring factory activity), and banks’ tendency to hoard cash at the end of the year to improve their balance sheets,  I believe that flat-to-negative growth in November and December will translate to flat-to-negative growth in the Q4 2007 GDP numbers.  But remember, Q1 2007 GDP was only 0.6%; a flat number would not be unusual, especially following the last two quarters, which averaged growth of 4.4%

Beyond that guess, here are some reasons why I believe that we are not going to enter a recession:

  1. Even if profits have temporarily peaked, that does not necessarily correlate to a recession.  For example, profit margins began contracting in 1997 and there was no recession until 2001.
  2. The Federal Reserve has so far not only been aggressive in adding liquidity to the market by dropping the federal funds and discount rates as well as using open market operations (i.e. purchasing US Treasury and federal agency securities in the secondary market), but are also experimenting with new tools to encourage banks to continue lending to worthy borrowers (including coordinated efforts with other central banks).  (A side note, The Fed has dropped the federal funds rate three times.  The Dow Jones Industrial Average has gained an average of 18% in the twelve months following 14 previous times that the Fed had cut rates three meetings in a row.  The only time stocks did not increase after three subsequent rate cuts was in 1930, in the Great Depression, when the Dow fell 40%.)
  3. Interest rates are low.  The federal funds rate, the rate charged on overnight loans between banks, peaked at an inflation-adjusted three percent in the current cycle.  In comparison, the inflation adjusted federal funds rate peaked at 4% before the 2001 recession and at 5.3% before the 1990-1991 recessions.
  4. Last quarter exports expanded at an annualized rate of 18.9%, the fastest pace since 2003, and accounted for 1.4 percentage points of the GDP’s annualized growth rate of 4.9%.  Global economic growth and a cheap dollar is raising demand for US goods.  Emerging economies, which buy more than half of US exports, continue to grow.  (It is important to point out a) exports’ share of GDP is three times that of residential home construction, and b) that currency translations tend to fuel exports/imports based on long term trends – i.e. there is more export benefit to come for the US.)
  5. Jobs are still being created in the government, health, education, and leisure / accommodation sectors.  Regarding the government sector, growth has been good and in an election year administrations tend to resist making any cuts. 

Regarding job growth in general, there is no arguing that the rate of growth in non-farm payrolls has slowed, but not to the extent where it portends a recession.  Payroll growth from November 2006 through November 2007 was 1.1%; that is in contrast to annual rates closer to 1.5% when measured 12-months back from earlier months of this year.  But this is not recession territory.  For example, back in November 2001 the 12-month change in payroll employment growth was actually a negative 1.1%. 

To be sure, I am not ignoring the surveys and data suggesting a tepid hiring outlook (Manpower Inc., the National Federation of Independent Business, the Institute for Supply Management, the Commerce Department, etc.).  However, even if growth began to shrink from this point that would speak more to late 2008 and early 2009 than this and the next two quarters, which are the quarters that are currently most vulnerable to recession.  (As a mild offset to further destruction in the manufacturing sector, the good news is that the inventory-to-sales ratio has dropped to an all-time low of 1.09 so, if anything, inventory will have to be built up as opposed to workers having to be fired as inventory is worked off).

THE STOCK MARKET’S INTERPRETATION OF THE ECONOMY

As of the time of this writing, there has been no recent stock market pullback greater than ten percent.  Stocks have began prior recessions with corrections averaging 14.2% (subsequently, the average recovery rally has been 20.6%, leaving the stock market up by 3.5%).

Back-to-back pullbacks of 5% or more (like those of August and November 2007) occurred several times in 1999, but the last series happened in March 2000, and that was the start of an enormous decline.

The stock market’s prediction of a recession is mixed.

VALUATIONS

Historically the comparison of the yield on the 10-year Treasury and the earnings yield of the S&P 500 (defined as the estimated 12-month forward earnings of the S&P 500 companies divided by the price level of the same index) is very telling regarding the direction of the stock market.  This ratio is commonly referred to as “The Fed Model.”

To the earnings yield, for example, the current expected 2008 earnings are about $92.  If you divide that into an S&P 500 index of 1,400 points then you end up with an earnings yield of 6.6% ($92 / 1,400 = 6.6%).  (Using those numbers would put the forward P/E at 15).

A comparison of the S&P 500 earnings yield of 6.6% relative to the 4.25% yield paid by the 10-year Treasury would tend to push money into equities and thus acts as a “buy signal” as the interpretation is that stocks are undervalued.  With the expectation of $92 of earnings, that would make the stock market as about undervalued (using this metric) as it was at the low points of 2002 (capitulation) and 2003 (the march to war).

The problem today is that earnings are likely subject to heavy revisions, primarily from Financial companies.  Earnings for 2007 will be about $78.  Assuming no growth year-over-year (so 2008 earnings equal 2007 earnings, about $78), that would still put the earnings yield of a 1,400 point index at 5.6%. This would still translate to stocks being an attractive value relative to bonds.  (Using those numbers would put the forward and the trailing P/E at 18.)

Earnings would actually have to fall by as much as 25% (to $58.5; back to 2004 levels) to have the earnings yield equate the 10-year Treasury yield.  That would put the forward P/E at 24 and would be too high not to expect a significant stock market correction. 

Is it possible to have earnings drop by 25%?  They were cut in half from 2000 to 2001 (from $50 to $24.69).  And they were cut by 25% from 1990 to 1991 (from $21.34 to $15.97).

The year 2000 ended with an actual (as opposed to estimated) forward P/E of 53 and resulted in a peak-to-trough crash of about 50%.

The year 1990 ended with an actual forward P/E of 20.5 and resulted in a peak-to-trough crash of about 21% (in today’s terms that would put the S&P 500 at about 1,250 points).

The risks, at their worst, are closer to those of 1990-1991 than those of 2000-2002.

PRESIDENTIAL ELECTION YEARS

I have found that both the Zogby and the Rasmussen polls have proven to be consistently accurate and I will pay close attention to their findings so as to best decipher who will take the White House.  Currently, polls tilt toward the favor of Democrats; that is consistent with the historical tendency to oust a party after two terms in office, regardless of candidates.

Since 1944 stocks tend to move up earlier in election years when the White House administration is popular (based on polls, not true today, thus arguing for early year weakness).

Since 1944 stocks do very well in November and December when unpopular administrations are removed (based on polls, a Democratic win could be good for a closing year rally).

Presidential election years are traditionally up years for the stock market.  A recent exception was 2000 when stocks were punished right through December 12th when the US Supreme Court prevented the Democrats from having a manual recount in Florida.  Dividing out the year, the first four months tend to be mixed-to-flat; with the remaining eight months being generally positive (the final seven months has a slightly higher success rate – see table on following page).


S&P 500 During Presidential Election Years

Election Year

% Change

1st Four Months

% Change

Last 8 Months

% Change

Last 7 Months

1952*

-1.9

13.9

11.4

1956

 6.4

-3.5

  3.3

1960*

-9.2

 6.9

 4.1

1964

 5.9

 6.7

 5.4

1968*

 1.2

 6.4

 5.2

1972

 5.5

 9.6

 7.8

1976*

12.7

 5.7

 7.3

1980*

-1.5

27.7

22.0

1984

-3.0

 4.5

11.1

1988

 5.8

 6.3

 5.9

1992*

-0.5

 5.0

 4.9

1996

 6.2

13.2

10.7

2000*

-1.1

-9.1

-7.1

2004

-0.4

 9.4

 8.1

Totals

  26.1%

102.7%

100.1%

Average

    1.9%

    7.3%

    7.2%

*Incumbents Ousted

 

 

 

Since 1901 there have been 26 presidential elections.  In 16 of those 26 the party in power stayed in power and the Dow was up an average of 1.5% over the first four months of the year.  In the other 10 instances, when the party in power was ousted, there has been an average loss of 4.5% over the same time period.

More recently, since 1950 there have been 7 instances where the party in power stayed in power.  Of those the average gains were similar gains of 1.9% over the first four months of the year.  Since 1950 there were also 7 instances of when the party in power was ousted.  In those more recent instances there was actually a gain of 0.5% over the same time period.

When the incumbent party has lost the election, the market’s election-year performance has been worse than it has been in other election years.  The uncertainty that is inherent in a new administration typically causes selling into the first quarter, followed by a mid-year high, then renewed (but more subdued) weakness into the November election.  Presidential election years have seen an average gain of 8.4%.  However, in the 12 years in which the incumbent loses the S&P 500 gained only about 1.6% (see bold in table on the following page). 

While the polls currently favor Democrats, it is worth pointing out that 1) polls change, and 2) in the 17 election years in which the incumbent party has won, the market has gone up about 14% (and about 18% when the incumbents were Republicans).

Presidential Cycle (12/31/1888-12/31/2006)

Percentage Change from year-to-year based on S&P 500 Index

President

Elected

 

4-Year Cycle Beginning

Election Year

Post-Election Year

Mid-Term Year

Pre-Election Year

Harrison

R

1888

-2.5

3.5

-13.5

17.6

Cleveland

D

1892

1.5

-20.0

-2.5

0.5

McKinley

R

1896

-2.3

12.6

18.9

6.5

McKinley*

R

1900

14.1

15.7

1.3

-18.4

T. Roosevelt

R

1904

25.6

15.6

3.1

-33.2

Taft

R

1908

37.4

14.1

-12.1

0.7

Wilson

D

1912

3.0

-14.3

-8.6

29.0

Wilson

D

1916

3.4

-30.6

16.2

14.0

Harding*

R

1920

-24.5

7.4

20.9

-1.5

Coolidge

R

1924

18.7

21.9

5.7

30.9

Hoover

R

1928

37.9

-11.9

–28.5

-47.1

F. Roosevelt

D

1932

-15.1

46.6

-5.9

41.4

F. Roosevelt

D

1936

27.9

-38.6

25.2

-5.5

F. Roosevelt

D

1940

-15.3

-17.9

12.4

19.4

F. Roosevelt*

D

1944

13.8

30.7

-11.9

0.0

Truman

D

1948

-0.7

10.3

21.8

16.5

Eisenhower

R

1952

11.8

-6.6

45.0

26.4

Eisenhower

R

1956

2.6

-14.3

38.1

8.5

Kennedy*

D

1960

-3.0

23.1

-11.8

18.9

Johnson

D

1964

13.0

9.1

-13.1

20.1

Nixon

R

1968

7.7

-11.4

0.1

10.8

Nixon**

R

1972

15.6

-17.4

-29.7

31.5

Carter

D

1976

19.1

-11.5

1.1

12.3

Reagan

R

1980

25.8

-9.7

14.8

17.3

Reagan

R

1984

1.4

26.3

14.6

2.0

Bush

R

1988

12.4

27.3

-6.6

26.3

Clinton

D

1992

4.5

7.1

-1.5

34.1

Clinton

D

1996

20.3

31.0

26.7

19.5

Bush

R

2000

-10.1

-13.0

-23.4

26.4

Bush

R

2004

9.0

3.0

13.6

?

Up Years/Total Years

73.3%

56.7%

56.7%

79.3%

Total Percentage Gain

253.3

88.1

110.4

324.9

Main Gain Per Year

8.4

2.9

3.7

11.2

Median Gain Per Year

8.3

5.3

1.2

16.5

Mean Gains (# of cases in parentheses):

 

 

 

 

Under Republicans (17)

10.6

3.7

3.7

6.5

Under Democrats (13)

1.6

0.9

3.9

18.5

Incumbent Rep Party Wins (10)

17.5

8.0

0.0

14.3

Incumbent Dem Party Wins (7)

8.9

-0.9

11.0

12.0

Incumbent Rep Party Loses (6)

1.7

5.2

-4.9

22.7

Incumbent Rep Party Loses (6)

1.4

-3.4

12.7

14.3

*Death in Office, ** Resigned, D-Democrat, R-Republican

 

GLOBAL ALLOCATION

As with the U.S., economic concerns will weigh on the major developed markets of Europe and Japan in the first half of the year.  As in the U.S., there is global economic caution, rising risk aversion, and a growing lack of confidence in financial systems.

On the positive side, the European Central Bank (ECB) has done a great job coordinating with the US Federal Reserve Bank to get their key London InterBank Offer Rate (aka the Libor interest rate) down to targeted levels.  Helping interest rates as well as exhibiting that the ECB is going to fight hard to stimulate growth is that while the Fed has so far released a respectable $40 billion of funds through their Term Auction Facility (affectionately referred to as “Taffy” on the Street), the ECB pumped $502 billion of funds into their markets via similar efforts.

Also solidifying that the Europeans will fight hard to keep growth afloat, in August Germany bailed out subprime lender IKB.  Die-hard capitalists will argue against the morality of any bailouts, but those debates aside that action is a positive for the markets in so much that it shows that the government does not wish to allow companies to fail.

While we expect some coincident issues with the economies and the markets of the developed Western European nations and the US, we also expect coincident advances in the latter half of the year. 

However, for Emerging Markets and for the Pacific (excluding Japan), the economic outlook has yet to become a significant issue.  While we dismiss the popular topic / concept of “decoupling”, the Organization for Economic Co-Operation and Development (OECD) leading indicators, relative market momentum, and relative earnings growth continue to be positive influences for the Emerging Markets and Pacific (ex. Japan) regions.  Until the slowdown that is expected in developed nations begin to have more than merely a modest impact on these regions, we will continue to emphasize them.

We do note that while Pacific (ex. Japan) and Emerging Markets should be able to hold up better than US or Western Europe in the first half of the year (in part due to the stimulus of the Summer Olympics in China), continued slowing of the developed nations could catch up to their developing brethren later in the year.  If it does, we expect that any corrections would not break their long-term uptrend and secular staying power

US SECTOR SELECTION

In identifying sector strengths/weaknesses for the year, we have split the year into two periods, the first four-months and the last eight-months. 

In the January to April period we would emphasize market defensiveness with likely outperformance from low-beta sectors like Health Care and Consumer Staples. 

Because the May to December period will rely heavily upon what happens the first part of the year, our outlook for this part of the year is subject to heavy revisions.  Should we be correct on the first period then in the second period we would expect Information Technology and Consumer Discretionary to perform relatively well.  In coming up with the Sector Selection we considered market beta (emphasizing lower beta in the first period), credit spreads relative to historical averages, commodity prices, 10-year Treasury yields (declining in the first period, rising in the second period), sector weighting long-term mean reversion potential, sector relative forward P/E, sector expected 2008 earnings growth, etc.  Following are the results:

           

Health Care

In part due to its low beta this sector is favored in the January to April period.  Additionally, this sector is favorable due to possible mean reversion (i.e. historically speaking, it is currently under-owned relative to other S&P sectors and thus is likely to “revert to the mean” in terms of investors accumulating shares of Health Care companies), its low relative P/E (relative to the S&P 500), and high credit spreads (suggesting risk aversion by investors).  A risk to this sector is election year debate; Health Care as an investment sector tends to dislike the introduction of Democratic leadership.  With polls having been favoring Democrats much of that concern is likely priced in. 

As a sub-sector, Biotechnology offers recession-proof earnings thus allowing for predictability (if not upside surprises) in earnings.  However, this high-beta sub-sector has not performed as would be expected in Q4 2007.  Lest the sector gains positive momentum to return to seasonal expectations it will be viewed closer to a marketperform through the January to April period.

Consumer Staples

Should the economic / stock market environment offer an opportunity for this sector to perform well in the January to April period then the sector will be vulnerable to relative weakness in the May to December period.  This sector has similar tailwinds to Health Care, with the exception of having a high forward P/E.  Consumer Staples tend to perform best when the market as a whole is flat to negative, as we expect for the first part of 2008.  In the last 12 calendar year instances of the S&P 500 returning 3% or less, Consumer Staples has outperformed 11 times (92%).

Information Technology

This sector leads earnings expectation for 2008 with an 18.4% growth rate.  Much of the earnings growth will be propelled by foreign countries, especially China.  Despite low price momentum for this sector, we remain encouraged by its low relative forward P/E.

Energy

A low forward P/E and the second highest expected earnings growth rate of all sectors (16.4%) should help the sector.  It is kept from the “outperform” category due to declining commodity prices and a possible Q1 rise in the dollar.  Longer-term, we expect China and other emerging markets to make this sector a relatively good investment.

Utilities

Declining bond yields will help Utilities from January to April.  Utilities’ dividends relative to the 10-year Treasury are attractive.  While momentum is firmly on this side of this sector, it is excluded from the “outperform” category due to its relatively high forward P/E and downward mean reversion potential.

Consumer Discretionary

If the economy slows, recession or not, spending (and thus earnings potential for this sector) shrinks.  Sans an economic slowdown, we would still have concerns with the reduced access to cash by consumers given the exhaustion of cash-out home refinancing.

Financials

Long-term this sector is over-owned, but so much price destruction has occurred in the last six-months that there is near-term rally potential.  And while the Fed and the government has been helpful to this sector by aiding them in their subprime problems, we continue to have concerns regarding possible Q1 (and maybe further) profit writedowns.  Accumulation of this sector makes sense, but we are not yet confident enough to use large allocations.

Industrials

This sector has a high relative P/E and is comprised heavily of a troubled sub-sector, Building Products.  Another of its sub-sectors, Employment Services, has low expected earnings growth.

Materials

As the US economy slows in the first part of 2008, so too (to some extent) should the rest of the world.  As this occurs demand for materials should slow.  Additionally, a rally in the dollar is a likely event for Q1 2008 and the correlation is such that this should weaken Materials’ prices.

Telecommunications

This sector tends to underperform when there are high credit spreads, as is currently the case.  This sector also has the lowest earnings growth expectation of all the sectors.

CLOSING

Berkshire Money Management employs what is known as “tops-down” investing.  That is in contrast to “bottoms-up” investing which essentially means that you look at the stock of one company (as opposed to a mutual fund or an exchange traded fund) and buy it based specifically on the merits of that one company (ignoring, for example, recessions, interest rates, or price momentum). 

There is nothing wrong with that method, in fact we also use that method ourselves, but just to a more limited scaled (for example, to affirm valuations or earnings expectations).  In “tops-down” investing, macro-economic factors carry a heavier weight in assessing market directions.  Additionally, Berkshireconsiders historical tendencies.  There are many examples, but one is that sectors and asset classes have a perfect record of “reverting to the mean”.  Of course, the timing of mean reversion is difficult, to say the least.  But nonetheless, the idea behind this is that the market, while maybe never perfectly repeats, often rhymes.  That is why the phrase “this time it’s different” is such a dangerous utterance in regards to the markets.

Based on our macro-economic forecasts we are able to determine which investment selections have the highest probability of success (price gain) or failure (price loss).  Obviously, when the macro- calls are correct it becomes a lot easier to pull the trigger.  However, information and cycles often change and sometimes in nuanced fashions.  As such it is important for us to stay flexible and make changes when the situations warrant it.  In order to squeeze out profitable returns Berkshire does try to place investments according to what should be happening, but we also understand how important it is to the safety of your portfolio to react to what is happening.

 

Modified June 5, 2008