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 January 2007 Risk and Reward
It's also why there can occasionally be a year like 2006. Going into it, most expected both a slowing economy and equity market. The expansion was over 3 years old and the Federal Reserve was tightening monetary policy. Geopolitical tensions and the Iraq conflict continued to simmer if not heat up. Against this backdrop even the optimists only expected modest stock and bond gains. But the exact opposite happened. It didn't matter if you were a stock or bond investor, you experienced gains. Whether you invested domestically or abroad, you were pleasantly surprised. Capitalization or style didn't matter, they both rose. Commodities and currencies were more of a mixed bag, but there were big gains there, too. There were a lot of explanations for this good fortune, ranging from an amazingly resilient domestic economy, rapidly developing foreign markets, and an increasing array of sophisticated investment vehicles providing access to new areas of the global market. Some or all of these may have been correct, yet last year's stellar performance was still a pleasant surprise. One thing was clear, however: In 2006, risk was amply rewarded.
Bring it On What a difference five years makes. In 2006 investors were once again chasing risk. Small cap stocks, emerging market stocks, and commodities provided remarkable gains in the first four and a half months of the year. The higher they climbed, the more investors sought them out. With the emergence of focused mutual funds and exchange traded funds (ETFs), investors had more access to these markets than ever before -- and they took advantage of it. Gold and emerging market stocks hit a wall on May 9, falling almost daily for the next month. Their weakness permeated global markets sending them in a tailspin, too. Pundits opined on all sorts of "bubbles bursting" from gold to real estate to foreign stocks. Concerns about recessions -- both here and abroad -- began getting some press. As early year gains disappeared, speculation rose that equity markets had hit their high for the year in mid-May and might even finish in the red. But the Fed stopped raising interest rates, oil prices peaked out in early August, and the U.S. economy showed signs of ongoing strength. Stocks rallied even through the traditionally weak September-October period. Foreign equities -- particularly emerging markets again -- resumed their climb. Bonds and commodities leveled off and held their own. Once again the riskier asset classes were the place to be. At the close of 2006, foreign stocks were market leaders, particularly China, Latin America and select European countries such as Spain and Sweden. Contrary to almost daily pronouncements from pundits that the U.S. real estate market was entering the investing equivalent of nuclear winter, real estate -- as measured by Lipper's mutual fund category -- finished the year up over 30%.
Riskier bonds also led fixed income. Foreign bonds were at the top and high yield junk bonds were next in line. Other, safer, high-grade corporate and Treasuries succumbed to rising interest rates, returning slightly less than their coupons. Ironically, as more and more investors pursued risk, they were driven to riskier assets. As money poured into emerging market stocks, share prices rose to even higher levels, making inherently risky assets riskier still. Spreads between junk bonds and Treasuries narrowed as investors snapped up higher yielding issues. The risk was still there, but the reward was diminished. As the year drew to a close, those seeking yield were forced into riskier vehicles such as packaged unsecured loans or sub-prime mortgage bonds. Clearly these strategies worked in 2006, but what about 2007? Will risky assets continue to provide stellar results or will their downside risk become more evident?
New Year, New Strategy When the investing environment is perfect as it was in 2006, there's only one way to go. On the other hand, while it's difficult to believe that 2007 will match 2006, there's equally little reason to think the bottom has to fall out. Markets rarely move in tandem -- as they did last year -- so a slowing in one need not be reflected in all others. Indeed, this is the more likely scenario than a repeat of 2006. The trick for the successful investor is to determine which markets will hold up and which will falter. It's not likely that simply seeking risk will again be a successful strategy. Risk may have been the key factor in 2006, but the cooling U.S. economy will be the theme in 2007.
Evidence is mounting that the four year old expansion is beginning to slow. The housing market, which had led the upturn is now beginning to fade. New home sales and starts are falling off while sale prices are beginning to decline. Rising interest rates have made mortgage refinancing less attractive. Slower growth also weakens the dollar in the global currency markets. As the U.S. economy is leveling off, Asian and European economies are warming up. Latin America and other emerging markets still have a way to go -- even if their stocks are already somewhat overvalued. Bond investors may be heartened by the prospect of slower growth since it lessens the threat of inflation, yet there's a downside for them, too. Fixed income investments tend to do well when the economy weakens because their prices move inversely with falling interest rates. Indeed, much of the market's rally this summer occurred after the Fed stopped pushing rates higher and investors turned their attention to the potential for future rate cuts. But with the 10-year Treasury Bond now around 4.70%, it's well off its June high of 5.25%. While higher than 4.40% where it began 2006, it's conceivable that one, two, or possibly even three rate cuts are already reflected in the current price. If the Fed only moves modestly (or worse yet, not at all), rates could quickly move back toward 5.00% sending prices in the opposite direction. In fact, it's highly likely that any move by the Fed to lower interest rates will lead to the end of the so-called "inverted" yield curve. When the Fed cuts rates, it acts at the short end of the curve. A cut -- or even anticipation of a cut -- will send short-term yields lower. The long end of the curve is more sensitive to fixed income investors' perception of potential inflation. When the Fed was tightening, they were thought to be keeping inflation at bay, allowing yields on longer maturity bonds to fall as a reflection of this diminished threat. But when the Fed finally reverses course and starts easing, that safety net will be gone and fixed-income investors will again require additional compensation by way of increased yields. As a result, by the end of 2007, the yield curve will return to its normally upward-sloping shape as short-term yields decline and longer term rates rise. Bond investors may enjoy a brief rally early in the year, but will be lucky to receive their coupon as a total return when higher yields lead to capital losses.
Quality vs. History Earnings quality is also an issue. Early in the expansion, companies were able to slash costs to increase profits. This was a quick way to boost the bottom line even before the top line started to expand. Now that these savings have been realized, firms are turning to a new way to increase profits: Share buybacks. Rather than reinvesting back into the business through plant and equipment, companies are buying back their stock thereby increasing earnings per share by reducing the amount of shares outstanding rather than growing the top line. But just as there's a limit to the expense that can be cut, there's also one for how many shares can be repurchased. Ultimately the top line has to grow to provide the cash flow necessary for buybacks. In addition, the whole process becomes more and more expensive if stock prices remain elevated or even rise. At some point, repurchases will run their course -- perhaps as soon as 2007. Foreign investment is less likely now than in the recent past, to prop up share prices. As overseas economies remain buoyant, investment dollars are flowing there rather than to the U.S. While foreign markets may continue to flourish in 2007, prospects for stocks are a little rougher domestically.
Fundamentals aside, history does hold out some hope for 2007. Although the democrats, typically not friends of the market, made substantial gains in last year's mid-term election, stocks may still stand to gain. Going back to 1946, the S&P 500 has climbed an average of 23.1% in the year following mid-term elections. This is considerably greater than its average for other years in the cycle. Analysts speculate that this is because the post mid-term year coincides with the third year of the presidential term, typically one of the best for the market. As newly elected Congressmen try to make their mark on government, the President does whatever is in his power to position the economy in his party's favor for the coming election in the following year. Both can be fiscally stimulating for the economy and the market. Of course the big risk here is that these historical patterns have simply been a fortuitous coincidence, not unlike the Super Bowl indicator (If the NFC representative wins the Super Bowl, the market will be up, if the AFC representative wins, it declines). Although interesting, market patterns without fundamental underpinnings are really nothing more than a documented hunch. It's our sense that U.S. stocks are poised for a mid to upper single-digit gain, slightly less than the historical average annual return. It wouldn't be surprising to see volatility increase from the current low levels. It's also possible that there will be another mid-year selloff, possibly the slightly overdue 10% correction. The second quarter is the likeliest timeframe. About the only thing that seems fairly clear is that last year's risk-seeking strategy is likely to fail this year. As the economy slows and profits become harder to come by, safe, old-line growth stocks will be the place to be. Last year was a great year for investors, but a repeat performance isn't likely. Indeed, that's what makes years like 2006 so special: They don't occur very frequently. In that regard, 2007 won't disappoint. Search this site! Just enter you key word or words:
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ART OF WHAT MAKES INVESTING SO challenging is that the markets are so unpredictable. That's true for the economy as well, although economists would have you believe they've reduced it to a science. It's this unpredictability that makes investing successes so rewarding.
