Q3 Commentary (2007)
"We don't know what we don't know.”
Donald H. Rumsfeld
The above quote, originally uttered in 2002 as clarification of U.S. policy on the “war on terror,” has recently been exhumed to describe the reaction of many market participants during the third quarter of 2007 to the potential impacts of the subprime mortgage contagion. A vacationing index fund investor in the S&P 500 might open a quarterly statement to show a respectable return of 2% and have no indication as to the roller coaster events of the period. However, we know of no vacation destination remote enough to have been able to ignore the headline of virtually every major news publication, Internet site, or YouTube video exclaiming the credit market meltdown that effectively froze the markets during July and August.
Readers of our quarterly commentaries can recall how long and how strongly we have concerned ourselves with the topic of a pending housing crisis which first graced these pages in 2005 warning of the potential for the worst housing collapse since the demise of the Wicked Witch of the East. While early concerns focused on the consumer and related spending impacts, our more recent discussions morphed towards the potential for a financial market event. The unwinding of the credit excess created by the combustible ingredients of high levels of liquidity, leverage, and lax lending standards created just that in the mortgage derivative markets.
Commencing with the mid-July announcement from Bear Stearns that two hedge funds investing in subprime mortgages were virtually worthless, the commercial paper market (the lifeblood of lending) virtually dried up as fear of the unknown gripped lenders. We have recently seen some stabilization in these critical markets. The aggressive actions of the global central banks and the FOMC through decisive cuts of 75 and 50 basis points in the Discount and Fed Funds rates respectively helped spur the confidence of the markets that the worst of the crisis was behind us. A resumption of the strong buying seen in the 2nd quarter resumed over the final six weeks, erasing all of the prior declines in the major equity averages which had fallen close to 10% at the worst levels. Despite the markets confidence, we have now witnessed asset writedowns of major global financial institutions in excess of $21 billion in this area as we enter the 4th quarter.
Though slowing on a trend basis, Q2 GDP did bounce back as anticipated from the 0.6% gain in Q1 to post a revised 3.8% gain placing year-over-year growth at a still below trend 2% level. As consumer spending moderated and residential construction remained a drag on growth, a weak dollar and strong global demand created a positive contribution from exports. Early reads on Q3 indicate an above 2% growth level before slowing further into the end of 2007 and early 2008 as the key to continued economic growth will rest on the confidence of the U.S consumer to continue a record string of 62 consecutive quarters of positive real spending growth. While the decline in the value of the U.S. dollar has assisted GDP growth and corporate earnings (as almost 40% of revenue from S&P 500 companies are foreign), it continues to add additional potential inflation pressure via increased import prices to a consumer already facing strong increases over the last year in the headline inflation components of food and energy. This confidence will be tested in the quarters ahead as headwinds of household debt service levels and declining home values contrast with strong gains in household net worth. The key barometer may be the jobs market.
After averaging non-farm payroll job growth of over 180K per month in 2006, growth this year has slowed to just over 120K per month with the unemployment rate ticking up to 4.7% from a low of 4.4%. While clearly in a slowing trend, the job market has held up and along with strong earnings gains continue to indicate slowing real consumer spending of 3.4% year-over-year. This bears continued monitoring. More housing and financial-related layoffs are sure to materialize over the next quarter as fallout continues from housing and credit market turmoil.
Following up on a record 14 consecutive quarters of double-digit earnings growth, the S&P 500 continued to surprise on the upside in the first 2 quarters of 2007. Strong corporate balance sheets encouraged large share buybacks which combined with strong global demand and foreign operations, allowed earnings growth to still achieve a strong increase of around 8% despite slowing domestic demand. The supportive earnings and valuation backdrop and the expected stimulus from easing Monetary policy helped fuel a rebound in the major averages enabling the S&P 500 to post a quarterly gain of over 2% bringing the 2007 total return in excess of 9%. The more domestically focused Russell 2000 Small Cap index printed a negative return of –3% reducing the gain for the year to 3%. Developed economies are also starting to show signs of slowing and this was a cause of a quarterly decline of -2.5% in the EAFE index for a total return of over 6% for the year. The big winners continue to be the emerging markets that shrugged off a 20% decline during the credit crunch of mid-summer to ring up 12% and 29% gains in the MSCI Emerging Markets index for the quarter and year.
The key to third quarter earnings season may rest on the financial sector that represents about 25% of total earnings and the guidance as we move forward. Expectations for profit gains in this area have moved from a gain of 8% in mid-August to a decline of over 6% as write-downs, increased reserves and slowing loan demand are all manifestations of the credit turmoil. Consensus expectations for the full year 2007 are for the S&P 500 to post earnings of about $95 or a gain of 8% with further gains in 2008 of over 6%. While we would not be surprised to see a modestly better quarter than expected, challenges remain for the balance of the year and into next year.
While the markets appear confident that the worst of the credit crisis is behind us, we are less certain regarding both this assumption as it applies to the capital markets and additional impacts especially in the housing and consumer sectors. The credit markets have all but decimated the Alt-A and subprime markets which had accounted for more than one-third of the demand for housing over the last two years. While this may represent only a small portion of the market (less than 10%), this is the marginal buyer that has helped fuel excess demand and has now been eliminated from the equation. Add on to this that mortgage credit standards have tightened considerably (not to mention confidence) and we can expect slackening demand for quite a while.
Even more importantly, despite strong talk of a political response via expansion of the FHA loan limits to address the challenges of the mortgage refinancing, we feel that most of these concerns are still in front of us. The largest bulk of these resets will occur over the next 4 quarters. We are troubled that the majority of the subprime delinquencies have yet to reset. The pending defaults are not even due to the higher rates but rather that the mortgage payments are almost 50% of the stated income levels of these borrowers. As most of these are no documentation loans and qualified at the teaser rates, one may only imagine the actual debt-to-income levels. These increasing defaults will only serve to increase the supply side of homes that is already approaching record levels. While we are confident that this will start to moderate towards equilibrium, it will require large price declines and time both of which will be concerns to the U.S. consumer.
We are truly in a global economy and the long economic expansions worldwide and operating profits of the S&P 500 that have more than doubled over the last 5 years are testament to this. While historically high profit margins may soften during a period of slowing domestic demand, the real test of global de-coupling may be in the impact on the developed and especially developing economies as the U.S. consumer slows. While we do not anticipate a recession as our base case, a moderate one certainly has increased in probability as the housing correction unfolds. The economic slowdown along with the heightened market volatility we have recently witnessed suggest the continued emphasis on higher quality assets. In the equity markets especially, this focus continues to be on the high quality companies that comprise the Coho portfolio. While we maintain an extreme underweight to the financial sector, our holdings continue to have a strong global presence and exhibit the qualities of steady growth of earnings and dividends that have consistently produced the long-term pattern of results that we seek.
