When I was a kid I had a morning paper route. It was fun during the summer, but toward the end of the year it was quite a challenge. Six days a week I struggled through the ice and snow of a Herkimer, NY winter dragging a sack full of newspapers weighted down by the dreaded holiday advertisements. The end of my route took me to the crest of a hill from which I could see my house in the distance and my father cooking breakfast through the kitchen window. That comforting sight meant mission accomplished, and a hot plate of French toast awaiting my arrival. It also meant I’d soon be able to feel my toes again, at least until the following morning.
The end of the year is always a good time to look back and remember what has been accomplished and to prepare for the challenges ahead. For our firm, 2007 has been a very rewarding year. We’ve grown our client base by about 50%, and our flagship large-cap quality growth equity portfolio has outpaced all of our benchmarks by a considerable margin. We have a lot to be thankful for.
But the following morning will soon be upon us… During the last few weeks we have been thinking long and hard about 2008 and what might transpire in the markets. On this note, there were some interesting tidbits from Barron’s recent semi-annual survey of 112 Big Money managers. According to the survey, the sectors predicted to lead the market in 2008 are the same ones that led in 2007, namely technology, energy, health care, and basic materials. Moreover, the sectors expected to lag in 2008 are the same ones that lagged in 2007, namely consumer discretionary and financials. I find these predictions particularly interesting from an historical perspective. Statistically, sectors that out perform in one year are more likely to under perform in the next year and vice versa. Yet, the majority of investors as well as Big Money managers tend to ignore this reversion to the mean effect, which if nothing else, proves once again that “Big” does not necessarily mean “Good.”
So let me try to address three critical questions for 2008...
- Will the problems in the credit market spill over and pull the U.S. economy into a recession in 2008?
- Will there be a reversion to the mean from a sector perspective?
- How will election year politics affect the markets?
First of all, I think the U.S. economy will slow next year but it will avoid a recession. Strength in employment and productivity, continued global growth, a resilient consumer, and timely help from the Fed should allow the economy to weather the mortgage meltdown and subsequent tightening in the credit markets. At the same time, a slowing economy will make it more challenging for companies to achieve earnings forecasts. Point being, even without a recession earnings disappointments may be on the rise.
Second, I do think there will be a reversion to the mean from a sector perspective. The real keys are the timing, magnitude, and duration of these sector rotations. I suspect the financials will have a rally in 2008, but we are not in any rush to over weight the sector just yet. I don’t think we’ve seen the last of the write-downs related to the mortgage meltdown. As a result, there is likely to be false rallies that prove short lived.
Consumer discretionary stocks should also perform better as valuations look increasingly compelling. Any break in oil prices, or an interest rate cut by the Fed, could spark a sharp rally in this sector. If there is a rotation into financials and consumer discretionary stocks in 2008, my sense is that money is likely to flow out of energy and basic materials. While stock selection will remain a significant driver of portfolio performance, sector strategy will become increasingly important as 2008 unfolds. Patience and disciplined valuation are the critical components when determining sectors to focus on and which to avoid. Within this environment, it would not be out of the realm of possibility to have a rotational market with little overall net gain for the market as a whole during the year.
Dreaded political advertisements weighing us down…
Third, there is potential risk to the market from political developments as the balance of power in Washington is up for grabs. With the media focused on the credit crisis, this potential risk has faded from view, but it will definitely take center stage as the election approaches. The best scenario for the markets would be gridlock in Washington, with the presidency and congressional control split between the two political parties. That outcome appears unlikely at this point, as the Democrats seem to have more momentum.
In conclusion, we have an economy that is slowing, but should avoid a recession. Earnings growth will be harder to achieve, meaning the market might make little overall progress but exhibit sector rotations through out the year. Meanwhile, election year politics will likely increase overall volatility. We should also remember that the five year bull market is a bit old in the tooth. Hence our cautious stance.
Yet, like that vigilant paper boy battling the elements, we will trudge along eyes focused on the crest of the hill, hoping we can say again next year, “mission accomplished,” while we are ever thankful for the warmth and support of family and friends.
Happy Holidays and God Bless!
