Year End Letter To Clients.
I have reprinted above the last paragraph of my 2006 year end report. Indeed, stocks did spend much of 2005 doing nothing. That pattern also continued throughout the first half of this year. Then the Federal Reserve indicated that they were done raising interest rates last summer and stocks were off to the races. All of the market’s returns in 2006 came during a five month period corresponding from July 17th to December 14th. For the record the S&P 500 advanced with dividends around 15%, the NASDAQ Composite advanced close to 10% and the average stock gained around 10.5% this year. According to CNBC and Market Watch the average hedge fund returned between 9-13% in 2006 and 70% of all mutual funds underperformed their benchmarks.*
At the beginning of a new year the investment clock inevitably gets rolled back to zero and the world is inundated with pundits giving predictions as to what the markets will do in 2007. Like most years, I have seen compelling argument for both bullish and bearish markets. Some of these predictions come from investors I respect for their opinions. Others come from people who for all of their years in our business have what seems to me very little real appreciation for what makes markets move. However, I don’t like predictions per se because they often have little or no basis in fact. A prediction or forecast is a statement or claim that a particular event will occur in the future. It’s etymology comes from Latin (præ- "before" plus dicere "to say"). They have some use if you are trying to develop a variant investment view away from the market crowd. However analysis simply based on the forcast of future events replaces fact with the hope that your scenario pans out in your favor.
For example, I can predict that at some future point we will have a recession likely resulting in a bear market for stocks. I cannot tell you when that event may occur or what might at this point lead us into this kind of environment. Those arguing this bearish case and perhaps a recession in 2007 point to the following: Our foreign situation remains tense and uncertain throughout large parts of the world. Housing has slowed in many major US metropolitan regions. The American consumer is too stretched financially and rising interest rates will finally put a pinch on their wallets. The problem with this analysis is that currently (and I stress currently) data points don’t support this thesis. That could of course change and then we would have to factor this into our own investment work. But the majority of economic data: from corporate earnings growth, to the large decline in the price of gasoline, to data on wage growth and consumer spending simply does not point to an economic contraction at this time. Such a prediction made without supporting facts renders that line of thought unlikely in our view based on what we currently know.
In contrast, probability is the extent to which something is likely to happen. It can be used to draw conclusions about the likelihood of potential events and outcomes. As such it can be factored into investment analysis. Last year I stated that the markets had the possibility of delivering above average returns. Probability suggested this was possible because stocks spent close to 3 years delivering below average returns. In the meantime corporate earnings had experienced healthy increases while economic growth had been above trendline. There was no law that said this had to happen but it was wise to at least factor this into our investment equation.
Probability currently tells me that stocks have the potential to appreciate 7-10% in 2007. I say this because current economic growth of 2-3% would have the potential to sustain that type of market advance. I think healthcare, certain areas of technology and certain types of industrial commodities have the greatest potential to outperform this year. Therefore these are areas of current investment focus. As per last year I believe that for most investors the most efficient manner to invest in these sectors is through the use of Exchange Traded Funds.
Probability also tells us that 2007 will bring a number of surprises and unexpected events that no one could possibly anticipate. Probability also makes it likely that somewhere in 2007 the stock market will experience a decline between 6-10%. I say this because we have researched the historic volatility of the S&P 500 since 1982 and in almost every year stocks have experienced this type of correction. There have been four such corrections since the beginning of 2004. Stocks experienced double digit increases off of their lows in July without seeing anything close to a 2% correction in price during that time. It is reasonable to infer that in the short run stocks could pause in their advance or even experience such a correction. Again we base this probability on what stocks have traditionally done after large gains. We can also use probability to infer that we will also see some impressive rallies. The market has had at least one 10% rally from its lows in every year since 2003. Again there is no law that says any of this has to occur. However, the fact that such events have occurred in the past means that we must incorporate them into our investment analysis.
What is most important about the year ahead is how we navigate your investments along the way. Success in the stock market is all about the long term journey. If you catch the majority of market rallies and take some prudent steps during the declines we can realize strong investment results over time.
So let the pessimists wallow in their gloom and let the optimists be perpetually positive. They will both be right at times. However I believe that the winning market strategy is to keep an open mind, pay attention to what we see and adjust portfolios per a client’s risk parameters.
*Source: CNBC: Street-Smarts citing Market Watch on 1/12/07.
posted by CR English at 1:01 PM
