4^th Quarter 2007 Commentary

January 7, 2008

Taking Out Some Insurance

The month of December and the early days of January have experienced noticeable weakness in the U.S. equities markets. Normally, December and January are reasonably strong months for stocks. In December the popular indices fell 4.5% and during the first three days of the New Year, the S&P 500 and Dow Jones Industrial dropped another 3.8%. Since their respective highs in 2007, these two market indices have declined 9%.

Subsequent to the Federal Reserve beginning to lower short term interest rates during the summer, we have maintained a constructive view toward the equities markets. Now, however, we are counseling raising cash as an insurance policy because of the growing likelihood that the stock market may trend lower in the months ahead.

Up to now, our macroeconomic view has assumed no recession, no major problem with inflation, slow profits growth, and declining short term interest rates as the Fed attempts to reflate the economy. The equities market has been expected to remain volatile due to continued concern about credit issues and increased worry about the growth of corporate earnings.

The December Work Force report reflecting very little employment growth and an unemployment rate of 5% is troublesome. While this report represents only one month and is a lagging indicator, it can not be ignored. The stock market sell off on Friday can be attributed to investors beginning to shift their views about the outlook for the economy and markets in response to this report. The major implication of the employment report is that the apparent diminution of the growth of the work force, if continued, is likely to lead to a slowdown, possibly a marked one, in consumption. Stock prices of consumer discretionary companies have already been discounting this possibility. Nevertheless, the growth of the economy since 2002 has been dominated by the expansion of consumer spending, much of it leveraged. Until this labor report, the perception had been of a relatively resilient consumer because employment trends outside of housing were holding up well.

If employment trends remain as sluggish as they were in December, then the odds of a recession grow. We had been at 40% odds and now believe that the probability of a recession (two down quarters in real GDP) is at least 50% and rising. The most worrisome aspect of a marked slowdown in employment and consumption growth is the prospect of greater challenges for the credit system. Lending institutions have already tightened the availability of credit and we do not see this changing over the short term. Thus, the likelihood is growing that the broader economy may feel a greater impact than just the housing sector. Moreover the risk of a knock on effect to foreign economies may also be perceived to be rising.

The stock market has already been faced with the uncertainty of the degree of economic growth in 2008, the uncertainty of the degree of corporate profit growth and the uncertainty about the outcome and policies from the Presidential election. To some degree, the market may already be discounting these uncertainties. Nonetheless, the divergent nature of sector performance since the summer suggests most weakness has come from financial and consumer discretionary sectors reflecting already known credit worries. We suspect other sectors may begin to be hit, as technology has been recently, in the not too distant future.

Technically speaking, a divergent market does not represent a healthy market. Neither do new highs in the price of gold. While the market may rally at any time, the uptrend since 2002 may have ended in the second half of 2007. Although the market is already down 9%, we are concerned that it may drop an additional 10%. A bear market, defined as a drop of 20% or more could occur, but at this time, we prefer to highlight the potential for additional market weakness. Like a recession, we will know if a bear market has occurred after it happens. In any event, credit markets will need to normalize much more than they have so far for investors to become more aggressive buyers. As usual, any future sustainable up move in the markets will, at least initially, be led by financial consumer discretionary and small cap stocks.

It should be noted that there continue to be a number of positives. Stocks are not as excessively valued as they were in 2000, the Fed is likely to continue to increase liquidity and drive short term rates down to the 3% area, the weakened dollar is a plus for exports and foreign investment in the U.S, corporate insiders are buyers, and investor sentiment is not excessively bearish. A potential Federal government initiative to stimulate the economy may support some lift to stocks.

Our increased concern about growth and the markets cause us to recommend the following strategies: (1) increase cash in aggressive portfolios to 25% from 5%, in growth portfolios to 10% from 5%, in balanced portfolios to 15% from 10%, and in capital preservation portfolios to 30% from 15%. Sources of funds should be mainly from small-mid cap stocks and international equities (biased toward sale of developed markets). (2) Increase exposure to uncorrelated assets, such as distress and long/short hedge funds in aggressive and growth portfolios, and (3) where appropriate, we recommend purchase of high quality municipal bonds because they appear undervalued when compared to other types of bonds.

A. Marshall Acuff
Managing Director
Chair, Cary Street Partners Investment Committee