About	Our Team	Services	Investment Strategy	Portfolio Strategy	Contact	Newsroom

2008 Outlook: Uncertainty vs. Opportunity January 18, 2008 By Mat Johnson 2007 has come to a close, and in the end there was little to write home about in the context of stock market performance. The broadest measure of equity market performance, the S&P 500, ended the year with only a modest gain. Unfortunately, the rolling of the calendar didn't erase 2007 concerns over the financial sector's sub-prime fiasco, easing real estate prices, escalating energy prices and the resulting concerns these issues have inflicted upon consumer spending and economic growth prospects. Thus far attention has been focused squarely on the possibility that the factors cited above will tip the U.S. economy into a recession. Some have even estimated that the U.S. may already be in a recession. As a result, through the first two weeks of 2008, all of the major market indices have moved lower, giving back most if not all of last year's modest gains. Compounding growing fears of a recession is the estimated decline in corporate earnings for the fourth quarter of 2007. Fourth quarter earnings are currently expected to decline by -11%, largely due to financial sector earnings which are mired in losses resulting from sub-prime mortgage defaults. (Earnings are expected to increase by 12% excluding the financial sector) Given this backdrop, it is no surprise that there has been a complete dearth of news suggesting anything but a lackluster investment outlook for the year ahead. We too have taken a look at what may be on the near-term horizon, in particular on the economic front. In fact, it turns out that a reasonable case can be made that the U.S. may have already entered a recession as far back as last September. How this plays out in financial markets can vary greatly however, owing in substantial part to why a recession might occur. One of the focal points of today's recession fear is "the consumer," and how declining home values and record energy prices are poised to impact future consumer spending. However, the frequently overlooked aspect is that these two key factors have been relevant for the average consumer for over two years now, and quite unlike as portrayed in the media, are not now poised to send consumer spending over the cliff. Rather, these factors have been and simply continue to be exerting downward pressure on the willingness to spend at the same pace as previously. The fact of the matter is that in the U.S., consumers as a whole have been outspending their income for many years, owing in substantial part to the past runup in home equity and the ease of extracting this equity by borrowing against it. That this is now reversing, should now be as little of a surprise as the fact that home prices don't rise 10% a year indefinitely. Also unlike in the media version of recession, determining whether the U.S. is experiencing one, or about to, is relatively easy to assess. While the most watched measure is quarterly Gross Domestic Product or GDP (released with a significant time lag), there are four monthly measures that make ascertaining the state of the economy a bit more real-time. Perhaps more important is that these same measures highlight why the economy is weak, and how a period of recession may unfold. It shouldn't be any surprise that the primary culprit appears to be the pace of past consumer spending and sharply higher consumer inflation. Given that consumer spending represents nearly 70% of GDP; the concern surrounding slower consumer spending is understandable. The impact on the broader (non-consumer) economy however, appears more limited. First off, GDP is not the entire economy, but a little more than half of it. GDP is simply a convenient way to look at end market demand (what the government views as important), but omits a sizable piece of the economy that is primarily made up of business investment. When consumer spending is measured against the total economy, or Gross Output (GO), consumers represent a much smaller 38%, while business investment accounts for 52% of economic activity. The second aspect of assessing recession risks is that recessions are a short-term phenomenon, and typically represent necessary adjustments to prior excesses. Whether due to faster reaction time on the part of businesses due to better information, globalization, or the off-shoring of the more volatile manufacturing sector employment abroad, the U.S. economy spends a smaller fraction of time in recession than has historically been the case. Today's modern economy spends just one out of every ten years in recession, while recessions have also become shallower and less damaging to businesses and consumers. Finally, while we are already hearing of plans in Washington D.C. to provide relief to consumers in the form of tax rebates — aimed to boost consumer spending — in the long-run, economic growth benefits more from consumer saving, not spending. This is because consumer savings provides businesses with a larger pool of funds from which to invest in their businesses for future growth, and notably, new business investment has been all but nonexistent over the past several years that coincided with the real estate boom and associated spending spree of consumers. All of this taken into consideration, our outlook for 2008 is a bit more balanced than one associated with yes, there will be a recession or no, there won't. While many market forecasts have been focused on one of these outcomes for the economy, we don't view GDP, earnings or interest rates as the principle driver for the equity market this year. Our view is that economic and earnings growth will continue to be muted, while market interest rates are likely to be higher in 2008. As for the equity market, we anticipate that the uncertainty that has carried over from last year will be around during the first half of 2008. Longer term however, we see what is current being cast as a concern, slower consumer spending, as a longer term benefit (consumer savings) that will ultimately be appreciated as stronger business investment. This in turn should promote renewed job growth and a more beneficial inflationary environment. Also of note, should the U.S. experience a recession this year, one of the key differences as it relates to the stock market between now and in prior recession periods is market valuation. By our S&P 500 valuation model, the market stands roughly -10% undervalued, whereas at the onset of the 1990 and 2001 recessions the market was overvalued by an estimated +19% and +32%, respectively. Accordingly, while the talk of recession is capturing the most attention, the consequences to the investment outlook may be quite different than feared. A key element to be considered is that outside of the financial sector, Corporate America appears to be in excellent financial health, as evidenced by strong cash flows and healthy balance sheets. Ultimately, while there are notable issues to be concerned with in 2008, it has always been the case that the perceived risks get more than their fair share of the weight when assessing the future. Perhaps it is because risks are predicated upon factors that are easily identifiable, whereas positive "surprises" are by definition, a surprise. In the world of equity investing, this is widely regarded as the "wall of worry" that investment sentiment is regularly up against, and yet consistently climbs.

	Home  |  About  |  Our Team  |  Services  |  Investment Strategies  |  Portfolio Strategies  |  Contact  |  Newsroom © 2008 Quantum Capital Management. All Rights Reserved.