January 2008

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

2008 Forecast

Portfolio Comments

A number of my forecasts for 2007 were accurate. I predicted a 5-10% return for US stocks (5%). Real estate finally turned out to be the bad investment (-15%) that I’ve been predicting for several years now. You were better off if you stuck to the short end of the bond market and avoided junk bonds. And, indeed, the debt markets caused the crisis du jour, with the sub-prime mess.

I got foreign developed markets right (7-8%), but missed on emerging markets again. They produced 30% returns; I thought they’d be more in the 10% range. (You may have noticed that I tend to be early in predicting the end of a trend.)

Within the US market, I greatly underestimated what would happen to the prices of oil and precious metals. Oil is just below $100 per barrel, which is about the peak it reached in 1979, adjusted for inflation. Energy stocks rose 30% as a result. Since most of you have relatively low exposure to energy stocks (they comprise about 15% of the S&P500), performance suffered as a result.

As a reminder, the asset management fee drops from 1% per year to 0.8% per year starting January 1. Because I bill in arrears, you’ll notice the lower fee with the March 31 billing.

Source: Vanguard

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 Market View

For all of the hand-wringing about the sub-prime market, at least everyone seems to have been reminded, at least temporarily, that investing involves risks. The big banks will undoubtedly devise new and interesting ways to lose money in the future, when the sub-prime crisis is forgotten. But for the next year or so, their profits will be snipped by the defaults on asset-backed and mortgage-backed securities, a risk they thought they’d passed on to some other poor sod.

Interest rates have dropped on safe (US Treasury) bonds, and have risen on junk bonds. The interest premium on junk bonds (the spread) is now around 5-6%, more in line with historical norms. The spread could go higher if the US economy goes into reverse and default rates rise.

The Treasury yield curve is now upward sloping, also more normal. The difference in interest rates between short-term and long-term debt is now about 1.5%. If China, Japan, and oil-producing countries weren’t propping up the dollar and keeping a lid on long-term rates, the yield curve would be steeper still.

The Price-to-Earnings (PE) ratio on the US market is about 16, also, you guessed it, more normal. Sixteen is the long-term average for the US market. The ratio could drop, due to a drop in the stock market, if some unexpected piece of bad news comes our way. But most of the bad news on housing and mortgages is already priced into the market.

The PE ratio on emerging markets is now higher than that for the US market. That is not normal. What people are saying is that the US will be stuck in slow growth for a while, and these emerging markets are where the growth is, and, ipso facto, that’s where you need to invest. I find it hard to believe that every other country will toot along just fine while the US struggles – that’s rarely happened before. And people seem to be forgetting that investors haven’t always been treated nicely. So I think the argument we’re hearing about emerging markets is a variation of the ‘it’s different this time’ argument. Be wary of this. The future may not be an identical twin to the past, but it’s certainly a close family member.

The dollar has continued to fall, as many of us thought it would, based on a big trade deficit, a slowing US economy, and lower interest rates. But it is now probably 20-30% undervalued versus the Euro, based on what those currencies can buy. Markets have a tendency to overshoot, and currencies can stay over or undervalued for extended periods, but I think the dollar won’t fall much more, and might even strengthen a bit from here.

Within the US market, so-called growth stocks have found new life. If you owned Apple or Google in 2007, you feel pretty smart. But those stocks are very expensive; when investors sour on those companies, the stocks’ prices will sink. Oil has been another winner. Strangely, while most of the US market is predicting slow growth or recession, the oil market is priced as though growth will persist without a hiccup. Somebody’s wrong, and my guess is it’s the oil investors.
 
Private equity funds have been stymied by the frozen debt markets – their main source of funds. In their place, I expect European companies and Asian and Middle Eastern government funds to make bids for US companies. The Euro is strong and oil profits are big; that money needs to go somewhere, and US stock prices look pretty reasonable.

Sources: The Economist, Wall Street Journal, Value Line

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The Library: articles by Steve TeSelle:

• College Savings Options
• Retirement: What's the Target?
• Fun Facts About Taxes
• Understanding Your Finances
• Risk, Anyone?
• A Primer on Asset Allocation
• Debt, Friend or Foe?
• Life Insurance Basics
• Calculating a Return

  To read them online, simply click on the title. To obtain a printed copy, please call us at 303-733-4999, or e-mail me at steselle@doratocapital.com.

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  2008 Forecast

  An Insight Into Dorato’s Investment Style

  The 2008 forecast:

  Based on a Price to Earnings (PE) ratio of 16, US stocks seem to be priced more reasonably than they have been for a few years. We could still get a negative return from stocks if the US economy falters more badly than most of us expect. But assuming 1-2% US growth in 2008, I expect perhaps 8-12% from US stocks. The best opportunities are in some of the sectors that performed poorly in 2007, including financial and consumer-based stocks. I don’t expect the oil profit boom to continue, and expect low to negative returns in that sector.

  Developed foreign stock markets have similar return potential to the US market. Unlike the past several years, I don’t expect foreign returns to get a boost from a weaker dollar. I expect a 5-10% return from European stock markets and 10-15% from Japan.

  Emerging markets had another wonderful year in 2007 -- five years in a row of above-average returns. As I’ve cautioned in other sections of this newsletter, emerging markets are not immune to slowing growth in the US. It’s fine to have a portion of your portfolio in these markets, but tread carefully. Now is not the time to go overboard.

  Bonds have generated single-digit returns for the last several years. I expect more of the same for 2008. With an upward sloping yield curve, at least you get some extra compensation for owning longer-term debt. But not much. And if inflation kicks up, bonds would suffer. That risk of inflation makes bonds a less than compelling investment for 2008. The reason to own them, however, is to diversify your portfolio and so reduce its volatility.

  Tax-exempt state and local debt returns should be about the same as in 2007, around 3-4% for intermediate-term debt. There is some risk that the companies that insure municipal bonds could face ratings downgrades, due to losses in other types of debt. That would roil the municipal markets, raising the possibility of losses for municipal investors. However, I think other finance companies would step in, either to buy the insurers or to issue new insurance. There’s slow, steady money to be made in insuring municipal debt. Somebody would fill the void.

  Real estate will probably suffer again in 2008, especially residential. As the cost of debt rises, the value of real estate falls. At some point, the real estate markets will right themselves, but I think it’s still too early to wade in here. My expected return for real estate is in the -5% to 5% range.

  As for asset allocation, stocks continue to hold the key to long-term growth. To keep up with inflation, investors should maintain at least 40-50% of their portfolios in stocks. To provide income and diversification benefits, investors can add investments such as bonds, real estate, and commodities. For 2008, I prefer bonds over REITs and commodities. As always, I suggest investors maintain a balanced asset allocation and try to keep costs down.

   

  Sources: Economist, Value Line, Vanguard.

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