Issue 41 - January 2, 2008

2007 - Year in Review

“As advocates of long-term investing, our goal is to construct portfolios that can prosper in good markets and provide hardy resilience to downward pressure during market corrections. Perhaps no year in recent memory has provided such a testament to the importance of this discipline.” - The opening comments of our 2006 year-end newsletter seemed hard to improve upon.

2007 saw a year of tremendous volatility. Markets moved ahead only to pull back several times through a series of events culminating in the recognition of mounting mortgage-backed security losses. Asset allocation once again played a dominant roll. After lagging for several years, growth outperformed value and the largest companies narrowly outperformed mid and small caps. International investing both in developed and emerging markets provided generous returns over the course of the year predominantly propelled by growth in global earnings. The weakening US Dollar added incrementally to these returns as well.

As the markets came to address the repercussions that years of easy credit had fostered, investors around the world found that they had sorely underestimated risks across a broad array of instruments. We have argued for some time that not caring about risk is not the same thing as not having it. As defaults accelerated in the summer, credit ratings plummeted, margin calls ensued and a number of mortgage related markets seized up. The trading models which had worked with remarkable precision suddenly proved untrustworthy. All manner of high grade securities had to be sold to meet margin calls when bids either dried up or were deemed prohibitively low for these suddenly lesser rated bonds. These fire sales have created significant dislocations in both high yield and high grade markets and have provided excellent buying opportunities as we saw in the municipal bond market in the fourth quarter.

The current investing climate could best be described as uncertain. Financial institutions which lie at the heart of any economy, are suffering punishing losses brought on by years of shoddy underwriting practices. Many transactions where risks were taken for granted have been exposed as bad combinations of greed and naiveté, and in some cases, old fashioned fraud. The costs are extraordinary. The Bank Credit Analyst sites $100 billion in write-offs in the second half of 2007 with another $100-200 billion yet to come as accounting standards continue to force the day of reckoning.

The Federal Reserve which has been navigating the roiling markets since the summer with a combination of interest rate cuts and procedural modifications has been criticized from all sides for acting too slowly. In fairness to the current chairman, Ben Bernanke, this was not a problem of his creation. Unlike Wall Street’s financial engineers who managed to make silk from sow’s ears until the summer of ’07, there is little that the Fed can do even with immediate interest rate cuts to make bad loans into good. As in any recuperation, time is likely to be the most important and helpful factor. Global liquidity remains abundant and current rates are far from prohibitive. However other necessary ingredients such as trust and transparency remain in short supply. Short-term funding rates for banks known as Libor, remain elevated and are acting at odds with the Federal Reserve’s efforts. An eventual return to a positively sloped yield curve will create a favorable backdrop for traditional lending practices and will allow the banks to earn their way back into good health just as we saw in 1993-4.

2008 - Outlook

While the constant, negative drone of pundits does not make for an inspiring investment backdrop, there are many reasons to maintain a long-term investing perspective.

In terms of basic fundamentals, interest rates remain low and equity and bond valuations are far from frothy. While financials do make up roughly a third of the S&P, they do not represent the entire world wide market, nor are all financial enterprises created equal. The continuing evolution of the Global growth story provides meaningful opportunities for companies around the world. Fear and risk premiums have returned to the markets and investing discipline has always been a critical factor in maintaining long-term success. As the cleaning up of balance sheets proceeds, investors should have their faith restored in structures and ratings and quality should once again be rewarded.

The dollar may come under further pressure over the course of the year, particularly if the Federal Reserve lowers the benchmark rate substantially further. While that is always possible, it is increasingly looking like the least likely outcome. Instead, we were witness to a different direction from the largest international reserve institutions with the first steps in a coordinated global reserve bank action plan in December. These institutions provided unprecedented liquidity and terms to assist banks through the always tricky year- end funding period. In addition, those countries whose currencies have strengthened the most over the past few years are finding that there is an exporting price to be paid by the native corporations. Those companies impacted the most will not be silent in their lobbying efforts to encourage currency stability.

Housing will continue to seek equilibrium however that will likely take more time. Supply still exceeds demand in certain markets and there remain a daunting number of sub prime mortgages facing rate resets in 2008. One nationwide refinancing plan has already been put forth which may provide some relief and there are certain to be more. But there are no easy or quick solutions, and the best the markets can hope for is an orderly unwinding.

There is much ongoing debate as to whether the US will slow down into a recession or worse. Recessions, which feature a negative growth rate, have historically been accompanied by a significant increase in unemployment and that is something that we have not yet begun to see. That doesn’t mean a recession won’t happen, but the combination of an accommodative Federal Reserve and solid employment should provide sufficient underlying strength to keep the US economy moving forward. Practically speaking this is a matter more in the purview of the academics. A slow down in the real world never feels as good as an expansion regardless of the scorekeeping.

The US economy has proven itself to be far sturdier than many would have imagined. The perfect storm of rising commodity prices, falling housing values in conjunction with mounting defaults, and a weakening dollar have been offset by strong global demand and export growth along with continued strength in employment. While there are many uncertainties, 2008 will be a year of transition and one which will afford opportunities which may be explosive in some cases. We will continue to look for ways to add resiliency to our portfolios while seeking good exposure to growth opportunities.

• 2007 - Year in Review
• 2008 - Outlook