Monthly Notes, Views, & The Occasional Provocation January 2007 

2007 has begun so fast, it already seems old. Before it gets any older, we reflect briefly on last year's markets. Next, we offer a few thoughts — but no predictions — about the coming year. Last, we share a few notes about the firm.

BFA is growing and — we hope — getting better. We are certainly blessed to serve our clients. Thank you for another good year and, raising our glass, here's to the next.

Warm regards,

Milo Benningfield

2006 - The Year In Review
The concept of a “year” purportedly grew out of observations, made by humans over hundreds and thousands of years, that linked such physical phenomena as the flooding of the Nile or the migrations of birds with the appearance of certain constellations just above the horizon. more

2007 - What Is Ahead?
Having just underscored the difficulty of calling the markets at any particular time, are we ready to try our own hand at foretelling 2007? Not any more than highly esteemed Barron's. more

BFA Notes
A few notes on goings-on at the firm. more

2006 - The Year In Review
The concept of a “year” purportedly grew out of observations, made by humans over hundreds and thousands of years, that linked such physical phenomena as the flooding of the Nile or the migrations of birds with the appearance of certain constellations just above the horizon. By contrast, the equity and fixed-income markets follow no such annual patterns, and calendar returns, in particular, hold little relevance for individual portfolios designed to last three, four, and sometimes five-to-six decades.

Nevertheless, it is good to be able to say: what a great year 2006 was for the equity markets! The S & P 500 Index returned 15.80%. Small-company stocks measured by the Russell 2000 Index returned 18.37%. And the returns were even better abroad. In fact, of the 50 countries whose equity returns are reported by MSCI, the U.S. market return (in dollar terms) ranked next to last among 23 developed markets and 42nd out of all 50 countries.

Common factors cited for last year’s returns include:

  • Increased company share buybacks and dividends.
  • Falling oil prices in the second half of the year caused, in part, by a mild hurricane season and a mild winter.
  • Heavy mergers & acquisitions activity (which often raises a target company’s share price and may have a spillover effect on other companies’ shares or even entire sectors).
  • Demand by hedge funds that borrowed heavily in order to buy stocks to keep up with recent market gains.

But while the happy ending of 2006 seems so clear and inevitable now, the horizon did not look so rosy to many commentators at the beginning of last year:1

When US consumer-spending weakness is felt globally, export earnings and economic activity will nosedive and murder foreign stocks. Best advice: unload your foreign equities now on all those bullish latecomers.
A. Gary Shilling, "The Coming Bernanke Bust," Forbes, December 26, 2005.

The good news about last year's flat stock market? Stocks got cheaper. The bad news? They could get cheaper still . . . the market will stay flat as earnings rise—a situation akin to what happened through much of the 1970s into the early 1980s.
Justin Lahart, "Ahead of the Tape," Wall Street Journal, January 3, 2006.

Our five-year forecasts show that most asset classes are expected to earn very little over cash."
Quotation attributed to Gordon Fowler Jr. of Glenmede Trust Co. Source: Tom Petruno, "Whether or Not to Heed the Fed," Los Angeles Times, January 8, 2006.

Of course, it’s easy to dismiss forecasts such as the ones above with “Well, you can’t get them all right.” But what was striking last year was the persistent “wall of worry” that stocks climbed despite some strong evidence that company balance sheets were in pretty good shape, inflation fairly moderate, and consumer spending still fairly robust despite the slowdown in residential real estate.

Given the persistent worries, it was no surprise in May that commentators suggested the sky was falling after the Dow Jones Industrial Average had its biggest drop in three years, and foreign markets, particularly those in emerging-market economies, nose-dived:

If either the inflation scare or the dollar scare prove correct, shares could have a long way further to fall.
Financial Times, "The Return of Fear to World Stock Markets," May 20, 2006.

Foreign stock markets suffered a wrenching sell-off Monday on deepening worries about the global economy . . . the selling wave, which slammed shares on every continent, also weighed on the US market.
Tom Petruno, "Global Cooling in the Markets," Los Angeles Times, May 23, 2006.

The economy could be facing a bout with stagflation. My feeling is we're headed for a tragedy here.
Quotation attributed to Prof. Peter Morici, University of Maryland. Source: Lisa Girion, "Stagflation Worries Are Mounting," Los Angeles Times, June 15, 2006.

By autumn, the drums were beating even more loudly in favor of a market dislocation:

It's very difficult for me to tell our clients that all is clear for them to get into the market when we have the historically tough months of September and October ahead of us.
Quotation attributed to Linda Duessel, Federated Investors. Source: E.S. Browning, "Taking Stock: What's Ahead for Investors," Wall Street Journal, September 5, 2006.

The chief executives of America's top companies have an increasingly pessimistic outlook on the US economy, according to a report published yesterday.
Daniel Pimlott, "Business Chiefs Grow Gloomier," Financial Times, October 6, 2006.

However, September and October were the best-performing months for the Dow in 2006. In fact, during the fourth quarter, the markets took off so quickly that hedge fund managers were forced to abandon their art auctions and hurry back to the office to borrow as much capital as they could in order to dive into the buying action. If you blinked, you might have missed it all. And if you were still holding cash from the beginning or middle of the year, you most certainly did.

1 Thanks to Weston Wellington at Dimensional Fund Advisors for putting together the following list of quotes.

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2007 Forecast
Having just underscored the difficulty of calling the markets at any particular time, are we ready to try our own hand at foretelling 2007? Not any more than highly esteemed Barron’s:

Let's dispense with the suspense. We already know what 2007 will mean for the stock market. [] Because it is the third year of a presidential term, the market will be up dramatically, as has been the case in such years. But because it's a year ending in "7" that is not the second year of a presidential term, 2007 will not be as good as typical third years of the election cycle. And let's not forget that because it's a "7" year that's also the fifth year of a bull market, we'll see a late-year crash, a la 1937 and '87.
“All You Need to Know About 2007,” Barron’s, January 1, 2007.

Barron’s refreshing tongue-in-cheek response to the obligatory market prognostications contains a grain of truth: the economic vital signs for 2007 are, at best, mixed. As usual, there are arguments to be made for either kind of glass, full or empty.

The case for the bulls includes the following:

  • Private-equity firms and hedge funds still hold a lot of cash that needs to earn a return or risk having to go back to its owners.
  • Corporations in the U.S. and abroad have healthy balance sheets and are benefiting from cheap debt to finance their operations.
  • Current valuations for the most part look reasonable compared to historical standards.
  • U.S. inflation is expected to remain moderate.

On the other hand, the bears (who will eventually be right, they just won’t say when) have the following points in their favor:

  • The “inverted yield curve” (longer-term bonds are yielding less than shorter-term ones, which is the opposite of the usual relationship) suggests a recession is possible, since the lower long-term yields suggest that investors expect rates to fall, and rates often fall when the economy is weakening.
  • Certain leading economic indicators likewise suggest there could be trouble ahead.
  • A U.S. housing recession could put pressure on the consumer and, in turn, reduce corporate profits.

Weighting these arguments to generate a reliable scenario for 2007 is, to put it mildly, difficult. What we can say is that in all likelihood this year’s major market determinants will not be on one of the lists above; rather, they will be the things that no one is talking about, at least not to any significant extent – in other words, news.

Given that, we will take . . . cautious optimism. “Cautious” in order to avoid reckless concentration in any particular market segment or investment style; “optimism” in order to avail ourselves of the expected long-term relationship between risk and return by staying invested, in a prudent manner, over the coming twelve months.

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BFA Notes
This past year BFA conducted a lengthy search for a capable office associate, and we are happy to announce that Mr. Gilden Chung joined the firm last fall. In the coming weeks, we will be sending out an introductory letter to our clients.

In December 2006, Wealth Manager Magazine quoted Milo in its article “Have Mutual Fund Fees Gone Up Or Down? Are They Fair or Unfair? It Depends On Who You Ask.” Milo noted “[t]here have been many studies showing that among the many variables applicable to mutual funds, expense ratios are one of the best—if not the best—predictors of future fund performance.” More important, expense ratios are far from the only cost involved in funds: “I’ve seen cases where the trading costs were…two to three times the expense ratios…To me, the failure to be more explicit about these added costs is one of the main reasons that individual investors fare so poorly in the market.”

In October 2006, Milo was quoted in Business Week’s article on alternative investments “Before You Leave the Beaten Path.” The article pointed out the dangers of listening to the latest siren songs about such asset classes as timber, rare coins, and oil. Regarding whether to include gold in a portfolio, Milo noted that while gold did act as a portfolio diversifier, an investor had to “be prepared to endure [] mediocre returns over long periods of time in order to enjoy the diversification benefits.”

Finally, in October 2006, Milo spoke on a technology “best practices” panel at the Financial Planning Association’s national conference in Nashville, and last May respected industry newsletter Inside Information profiled BFA’s use of technology to strengthen and streamline operations.

That’s all for now. We will see you again next month. Thank you for reading.

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