Total returns for most indices in 2007 fell below historical averages.  The table below summarizes results for various time periods.

While 2007 will go down in history as a mediocre investment year with the major indices generating modest gains or small losses, this performance actually reflects a combination of bull and bear markets for various market sectors.  The following table highlights this variation in performance in 2007.

In looking at the best performing sectors, the common denominator appears to be the strength in emerging market economies.  Even with respect to energy (where prices are heavily influenced by geopolitical issues), strong growth in emerging markets has kept demand for oil at high levels despite soaring prices and slowing economies in the U.S. and Western Europe.

The common factor with respect to the weak sectors is a slowing U.S. economy due to problems in the housing industry.   These problems have spilled over into other consumer sectors and have caused substantial losses for financial service companies.

Interestingly, the strong and weak sectors have become linked as financial service companies have attempted to repair the damage to their balance sheets by raising new capital.  Their bailout is coming primarily from foreign investors - and principally from emerging market countries. Merrill Lynch sold a $5 billion stake to a Singapore investment fund, Citigroup raised $7.5 billion from the Abu Dhabi Investment Authority and Morgan Stanley received a $5 billion investment from China Investment Corporation.   

With the housing sector showing continued weakness and lenders reporting additional losses, the Federal Reserve lowered interest rates in the fourth quarter in an effort to stimulate the economy and ease pressure on both consumers and financial service companies.  During the quarter the Federal Reserve lowered its target interest rate twice to 4.25%, putting it 1.0% below where it started the year.   Long-term rates on all categories of bonds (Treasury, corporate and municipal) declined during the quarter.  The LB Aggregate Bond Index produced total returns of 7.0% and 3.0% for the year and quarter, respectively.

Entering 2008, the market is clearly worried about the possibility of a recession, which could lead to a prolonged slump for stocks. While stock market corrections are difficult to endure, they typically produce good investment opportunities and have always been followed by bull markets.  However, to take advantage of a recovery from a market correction, it is necessary to be invested when the news is still negative.  By the time that it is obvious to everyone that the problems have been resolved, stocks will be higher and the opportunity will have passed. 

While most of the current headlines are negative, there are a number of positive factors as well.  First, interest rates are declining (with the help of the Federal Reserve), and stocks historically do well in a declining interest rate environment.  Second, the emerging markets have become new engines for world economic growth.  Their strength should continue to provide support to the U.S. economy.  Third, stock valuations are very reasonable by historical standards, especially with the recent weakness in prices.  Deep-pocketed foreign investors have recognized this by making large investments in the battered stocks of leading companies. 

When will stocks start moving higher again?  That’s hard to say.  The investment process utilized by Vista to manage portfolios is not highly dependent on predicting the future – since this is regarded as an almost impossible task.  Instead, it is felt that good long-term performance can be obtained by maintaining an asset mix that is appropriate for an investor’s objectives and risk tolerance, utilizing diversification to control risk, and owning investments that are reasonably valued and offer attractive return potential.

John D. Frankola, CFA, CPA

The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.

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