Challenging end to a challenging year


US Stock Market

The modest 5.5% gain in the S&P 500 for the year disguised the slaughter in financial services (down 18.5%) and consumer discretionary (down 13.2% - primarily home builders and cars, but also retail.)  Energy stocks soared in 2007, (up 34.4%), followed by materials stocks (up 22.5%).  Utility stocks did surprisingly well (up 19.4% as yield seeking investors fled out of financials.) 

The collapse in financial stocks hit our strategy particularly hard as we generally have 25% of our assets in this relatively safe sector.  The last time financials did so poorly was in 1990-91 (combination of the Asian Currency Crisis and the collapse of the junk bond market in the United States.)  In 2007, we avoided those firms (Countrywide, American Home Mortgage) that were clearly overexposed to sub-prime - the surprise to us was that banks we regarded as far too sophisticated to be involved with sub-prime (Citigroup, Bank of American, Morgan Stanley, Merrill Lynch, for example,) were in fact hip deep in this market. 

Announced losses so far total nearly $100 billion, with probably another $100 billion to be announced in Q1 2008.  We took a look back through brokerage analyst research published through October to see if anyone had flagged sub-prime exposure as a concern for these banks - answer: no one until the banks themselves announced problems in November.  Either the banks' risk management systems failed utterly, or else senior management knew the risks but chose to ignore them. 

By comparison, the 9/11 attacks and Hurricane Katrina each cost about $100 billion.  In an economy with real and financial assets exceeding $30 trillion, losses of this magnitude are sustainable.  US GDP is 5.3% larger than in Q3 2005 (post-Katrina), 17.6% larger than Q4 2001 (aftermath of 9/11 attack), and 65.6% larger than Q2 1991 (aftermath of junk bond market failure.) 

What can't be underestimated is the psychological impact of falling home prices.  Looking at the Case Shiller National Housing Index, prices fell 7.2% between November 1989 and January 1996 and did not make new highs until January 1998.  Local markets experienced greater or lesser pain.  From January 1998 through June 2006, US house prices gained an average of 173%, but from that peak have fallen 7.3%.  We expect house prices to fall another 7-8% over the next 2 years before stabilizing.  As we pointed out in previous commentary, home purchases with borrowed money are leveraged transactions, so a net fall of 15-20% in value wipes out the home owner's equity.  The sharp increase in the foreclosure rate over the last year indicates that home owners are walking away from negative equity situations.

It is cold comfort to people owning real estate, but there are advantages to the overall economy of falling home prices.  If the rate of change in housing prices significantly exceeds growth in income or even general inflation (up 29.0% over the last 10 years,) the "affordability" of housing goes way down.  Falling prices over two years, or stable prices over the next 8-10 years, allows families currently shut out of home ownership to get in.  A sharp contraction in spending on housing keeps inflation down in general, which give the Federal Reserve more room to cut rates.