Q4 2007 Notes on the Quarter

Q4 2007 Notes on the Quarter

Overview of the Quarter:

The year got off to a good start but eroded as the year progressed. While the indexes did end up in positive territory, most pundits were expecting +10% returns. November was a terrible month for the indexes. The caution we expressed about housing hit the markets square in the face – and in fact, hit much harder than we had expected, and we were negative compared to most. However, this did not show up much in the indexes; let’s look closer.

Portfolio Specifics:

  1. Large Caps outperformed Small Caps; Growth outperformed Value – this usually suggests a weaker stock market and economy.
  2. The top sectors last year were 1) Energy (+36.1%); 2) Utilities (+23.6%); and 3)
    Telecom (+20.4%). The worst sectors were 1) Financials (-19.2%); 2) Consumer
    Discretionary (-13.0%); and 3) Healthcare (+8.1%).
  3. The S&P 500 was up 3.5% for 2007.

Looking Ahead:

Information is very mixed, so let’s look at the pieces.

  1. We warned about housing at the end of last year and while it took longer than we
    expected, it also turned out to be a much bigger problem than anyone (including us)

    1. There was a lot of cheap money available worldwide due to very low interest rates;
    2. Wall Street figured out (thank you Bear Stearns) a way to securitize mortgages and to slice and dice them into small pieces (SIVs and CDOs).
    3. With low interest rates (see #1) and a flat yield curve, investors jumped into anything that offered a little extra yield. With worldwide economies strong, “risk” was ignored.
    4. Banks figured they understood risk and (thanks to the end of Glass-Steagal) started selling these securities mortgages in huge amounts (the fees were massive, and they could generate these things on a WEEKLY basis). They created these things so fast that they couldn’t investigate the collateral.
    5. Buyers and sellers alike relied on rating agencies for quality assurance, but the rating agencies had no idea what was being created.
    6. As the bankers were just creating and selling these SIVs and CDOs, they didn’t have to put them on their books – so no one – and I mean NO ONE knew or knows how much is out there or what the collateral really is or who owns the stuff now.
    7. There was so much money in selling these things that Wall Street and the banks helped create businesses just to provide distribution so they could sell more. And they didn’t really care who ran those businesses or what their knowledge was, as long as they could help get the volume moved.
    8. What happens to a house of cards when a puff of wind comes along? A total collapse.
    9. Now not all the banks were involved with SIVs and CDOs. But they helped perpetuate the housing bubble which evolved by lending to almost anyone and by pushing home equity loans and commercial loans. All types of commercial loans – for buildings, condo’s and raw land.
    10. The bubble turned real estate speculation into the easy money that day-trading was in the 1990s and we all know what happened to day-traders. They weren’t brilliant; they had the wind at their back. How many real estate geniuses do you know? By the way – the really smart real estate guys have been selling all year, not buying.
    1. The end of the world is not coming
    2. We may or may not have a recession
    3. Squeezing out speculators leaves opportunities for investors.
    1. The end of the world is not coming
    2. We may or may not have a recession
    3. Squeezing out speculators leaves opportunities for investors.
  2. We have managed to piece together what happened and it is worth understanding, so here is
    our simplified, extremely brief review.

    In summary, we haven’t seen it all yet. The banks have started marking their CDOs to market, but they are still playing games. Those that didn’t have the SIVs and CDOs are just starting to raise loan loss reserves. Commercial real estate is going to get worse; there are a couple of defaults that just were announced. The problem was that the only strength in our economy has been housing related (by and large) for the past 4 years.

    By the way, that cheap money has been doing the same thing in Europe and Asia, to commodity prices, and international stock prices. So guess what else could be affected? Right, all of those international stocks that the “pundits” have been screaming should be 30% to 50% of your portfolio.

    Some of you must be wondering why I keep writing – do I enjoy making people cry??? No, it’s actually because I see reason for optimism.

    Why we should be optimistic:

An Update

Notes on the Quarter was written the first week of January and a lot has happened since then so I wanted to add an update. In the past three weeks the markets have gotten very bearish. This is the worst January in the past 70 years. The S&P is down over 8% this month and 16% from the highs reached last year. Oil and other commodities have started to weaken as have the international markets (China is off 30% from its high). Pundits are starting to say they expect a recession. Many banks are now adding loan loss reserves (as opposed to write-downs on their CDO investments). It is really ugly and everyone should sell everything – NOT!

Stocks are more attractive now than they have been in at least six years. In fact, in some cases, they are cheaper now than at any time since 1994. I am like a kid in a candy store! What kinds of things are we looking at? A little in the financial area (it isn’t over yet, but it is certainly closer), a lot in the industrials, soon we want to add commodities. We are probably early – if we are in a recession we haven’t seen big layoffs yet – but as long term investors, when things are cheap, it is time to buy. When it makes you cringe to think about buying, it is time to buy – the sicker you feel – the more likely the timing is good.

However, we are just starting to nibble. The markets rarely go straight up or straight down, and I want to get confirmation from the businesses we are investing in that they are seeing some stability in their businesses before we go all in. So, expect some more bumps, but when you look in the mirror in two to three years – I expect there will be a big grin on your face!

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