Broker Check

Quarterly Newsletter April 2007

Quarterly  Investment Commentary | April 2007                                    Belmont Financial, LLC

Stocks rose, dropped precipitously and then recovered ending the 1st Quarter about where they started. Year to date through March, the S&P was up 0.6% & the DJIA down 0.3%. On the fixed-income side, the bond market was up 1.4% for the quarter. Small caps continued to outperform, refusing to succumb to the predictions of their demise. Tactical asset allocation allowed our managed accounts to achieve very attractive returns with only modest risk.

What Rattled the Market?  The Straw(s) That Broke the Camel’s Back

After enjoying a seven-month run of mostly climbing stock prices, investors were spooked by a 3.5% one-day loss in the USmarket. The night before the big decline, China’s Shanghai Index, reacting to rumors that the government was going to clamp down on speculation, fell 9%. This spawned fears that a slowdown in the Chinese economy will impact global growth. Furthermore, there were reports that former Fed Chairman Greenspan said that a recession was a possibility. A potential shake out in the subprime mortgage area didn’t help.

We are long-term investors, and so shorter-term market declines that are driven by fear rather than fundamentals represent opportunities to us. By way of context, a 3.5% one-day loss is by no means unprecedented and is not by itself a big source of concern. The market had gained almost 14% in the seven months prior to the recent retrenchment, and investors may have been concerned about giving back those gains. We also took comfort from our observation that big market declines have generally been preceded by stretched valuations, and this is not an issue right now. There is some uncertainty in that the extent to which hedge funds and program selling can impact the market are unknown, and their influence is a new development that could potentially cause disruptions regardless of the current valuation picture. But, if their activities caused a correction that moved prices from fairly valued to cheap, that would be a good example of where we can use our long-term time horizon to capitalize on shorter-term swings in valuation.

In terms of the fear that stock market declines in China foreshadow a global economic slowdown, I was a little surprised to see the markets react as they did. The Chinese A-share market is mostly limited to domestic Chinese investors, so any movement in that market is of questionable relevance to an outside, developed economy like the U.S. It is true that the economic expansion in both the U.S. and China has been going on for a long time, and investors know that at some point the cycle will ebb. Any evidence suggesting that this could be materializing sooner rather than later is likely to concern investors.

Subprime Loans

Subprime made a sudden leap into investors’ lexicon early this year when it became obvious than many mortgage lenders, banks, hedge funds and investors had badly underestimated the risks of loans to the least-creditworthy borrowers. Many of these buyers have stretched themselves financially to the point where they have no margin for error. With rates having climbed, and low starter rates and temporary interest-only terms winding down or expiring, defaults among subprime mortgages have climbed sharply. Consider that loans in this segment accounted for 24% of originations in 2006, defaults in this sector are in the 13% to 14% range, and some subprime lenders have either experienced steep financial losses or gone out of business.                                                                                    As of year-end 2006, more than 76% of all loans outstanding were still prime loans. This means that even if the subprime sector had a default rate of 20%—well above the prior peak in 2002—fewer than 5% of outstanding loans would be impacted. While this would be enough to cause pain, it would probably not be enough to result in a disaster for the economy.

Earnings Will Be the Key

Developments like a slowdown in China or a crunch in subprime lending would definitely impact the economy, perhaps significantly. The real question, though, is not whether they will have an impact, but rather how much of that potential risk is already reflected in stock prices. If the market has already discounted these events, then maybe we need not worry about them as much.

Even so, these are all cyclical risks, which, while more notable than average, are not enough to cause us to run for the exits. Cycles are normal, and the challenge is in evaluating how big those risks are, and in differentiating cyclical risks from events or developments that are likely to cause lasting damage. One thing we’ve learned is that the world is a scary place. In the past 20 years, we can point to many events—including the stock market crash in 1987, fears of a major banking collapse, wars in the Persian Gulf, the Asian currency crisis and near-collapse of Long-Term Capital Management (a hedge fund), panic over Y2K, 9/11/01, and the deflation scare in 2002, to name just a few—that were serious causes for concern and in some cases led investors to panic in the short term, but that didn't end up having lasting negative consequences. On the other hand, even modest earnings growth and an average P/E multiple results in returns that are better than bonds, so remaining invested in stocks still offers a likely reward. I also believe that tactical asset allocation can add value above the market over longer time frames and that would be an additional source of return for our clients.

If US stocks aren’t a compelling opportunity, is there a better place to invest? Investor sentiment always suggests there is a better place to be (though it’s rarely right). In taking a look at other asset classes that factor in to our investment strategy, we’ll start with international equities, which have been generating a lot of buzz lately.

International Equities

We’ve just finished a period where international stocks have outperformed U.S. stocks five calendar years in a row. Our detailed analysis of over 50 world-wide asset classes, has led us to overweight foreign stocks for several years. Asset classes move in cycles, usually doing well for a few years, then less well for a few. It is human nature to want to buy what’s working, but buying an asset class after a prolonged period of super-normal return is more likely to get you in at or near the end of the good run, just in time for the bad run. Right now, relative valuations for developed international equities appear to be within a fair-value range after factoring in historical valuations, local interest rates, and earnings prospects. I expect the  return potential of foreign equities over the next three to five years to be at least comparable to domestic equities.

Emerging Markets Equities

Emerging markets have performed very well over the past several years, beating their developed counterparts. Still, based on valuation measures such as price to forward earnings, emerging markets do not look expensive. However, when you look at emerging markets on more stable valuation measures, such as price to book, or compare their valuation multiples relative to that of developed markets over time, they do seem expensive. The question  is whether or not emerging markets are moving to a higher relative valuation based on a sustainable improvement in their fundamentals, i.e., are they getting re-rated and, if they are, is this re-rating deserved.                                           It seems some re-rating of emerging markets has already taken place, although not a lot. Looking at the past four-year rally in emerging markets, Morgan Stanley estimates that P/E expansion explains only about 10% of the rally and that improvement in emerging-market earnings explains the rest. So, their work suggests that the improvement in emerging-market fundamentals has been the key driver behind emerging-markets performance over the past several years.

We see other indicators that suggest emerging markets’ fundamentals have improved. According to Morgan Stanley, return on equity, a profitability measure, for emerging-market economies as a whole has risen to the mid teens—at historical highs for emerging markets and similar to the developed world. Also, emerging-market exports have risen strongly, which has improved several emerging-market countries’ balance sheets, i.e., they now run current-account surpluses and have large foreign currency reserves to meet their debt obligations. If these fundamental improvements prove sustainable, some of the re-rating we have seen so far will be deserved, and it is possible that emerging markets will be re-rated further in the next several years. Another positive note, after the recent correction, the snapback in emerging market has been even stronger than developed markets: a vote of confidence for these markets and global growth.


REITs have been exceptional performers for the past several years. REIT fundamentals still appear to be improving, on average. Most property types are seeing increasing demand, while supply remains constrained, which is enabling REITs to increase rents. Strengthening fundamentals, combined with gradual increases in rent, should correspondingly improve the security of REIT dividends. Meanwhile, demand from both retail and institutional investors continues to be very strong, with institutional investors still aggressively buying REITs. However by some measures, REITs appear overvalued and we will watch this closely.  

Final Comments

I think that the return prospects over the next several years are reasonably good and that tactical asset allocation will add value for our clients. You may have noticed a slight change in the name of my company. Belmont Financial recently became a Limited Liability Corporation (LLC). This will not have a noticeable impact on our relationship, but was done mostly for administrative reasons. New agreements will be required over the next several months; more on this later. Thank you for your continued trust and confidence and please contact me if you have comments or if your financial situation has changed.                                                                                                                                                                        Mike Durant, CFP, April 2007                                  617 489 0040