2007 Year End Market Summary

2007 will be remembered as a cyclical transition period for the stock market. This year, many long established trends have been upended. It’s the first year since 2002, the end of the last recession, that bonds out performed equities as measured by the Lehman Brother Aggregate Bond index and the S & P 500 Stock index. It also is the first year since 1999 that growth oriented mutual funds, up 15% in 2007, outperformed value oriented mutual funds, up only 0.4%. Finally, it is the first year since 1999 that large cap funds outperformed small cap funds. These trend reversals are typical cyclical changes that result near the end of a bull market and possibly the start of a recession or at least a significant slow down. This reminds us as to why it is critically important to keep a well–diversified, global portfolio and not to chase previous years’ winners.

The S&P 500 finished the year with a return of 5.5% including reinvested dividends, while the bond market, as measured by the Lehman Brothers Aggregate was up 7%. Non US markets out performed US markets again in 2007. International developed funds, buoyed by a falling dollar, had another big year up over 12% and emerging market funds posted a 36% return.

2008 Predictions: The Recession May Already Be Here

I expect 2008 to be a tough year for the equities market as the US economy navigates through the landmines left by the real estate bubble and the resulting credit crunch. I expect the US markets to perform better than the international markets this year and the large cap and growth oriented funds to exceed their small, value oriented brethren.

As for our beloved economy, I believe we already may have entered a recession. The current US housing bubble, the resulting credit crunch and the rapid increase in the price of oil to $100 per barrel may have put us into recession or at least will push us there very soon. The difficulty is that we will not know this for at least another year because that’s how long it takes for the government’s official recession counter, the National Bureau of Economic Research, to give us an answer. The most common definition of a recession is two consecutive quarters in which real gross domestic product, GDP adjusted for inflation, declines. This official definition means it is not possible to determine a recession is occurring until long after it has started. The government releases its quarterly GDP data two months after quarter end and these numbers are revised two more times. Thus, we will not know a recession has occurred until nearly a year after it has started!

Since World War II, there have been ten recessions averaging about ten months in length. Recessions are generally thought of as horrible events where unemployment rises, production falls, profits weaken and stocks crater. However, there are many positive aspects of recessions that are good for the economy and for investors. Recessions punish excessive risk taking, such as in the real estate speculation and credit risks taken in 2005 and 2006 and the tech bubble of 2000. They also reduce inflation and may even correct the balance of trade. Downturns also create tremendous buying opportunities for shrewd investors. The question we should be asking is not if we are going to be in a recession, but rather, when we will come out.