Sunday, January 20, 2008

2008-- - What's in Store?

With each day, we hear that the US is either in a recession or about to descend into one. The funny thing about recessions is that by the time we've officially entered one (a recession is generally considered to be two back-to-back quarters of negative GDP growth), the stock market starts discounting the eventual recovery and climbs higher.
If we do end up going into a recession, it will be the first time that I have ever seen an economy experience negative growth while also experiencing full employment! The last US recession I remember was back in 1991.
The Way it was: At that time very much like it is now, the big banks and brokers were reeling from massive losses due to the commercial real estate market blowing up. That had a knock-on effect, and collapsed the junk bond market, which then killed the entire Savings & Loan industry to the tune of one trillion dollars and that’s in 1991 dollars.
There were also defaulting LDC (less developed country) loans which rocked the big banks like Citibank, Chemical, and Chase. (not many remember the old Chemical bank. In adition to the banking turmoil, we were experiencing massive layoffs across many different industry groups that took unemployment levels to more than 7%. So when I think "recession," these are the kind of thoughts that come to my mind.
Today: Let's examine where we are today. Once again the banks are getting bombed due to bad real estate loans, but this time it's residential not commercial. But unlike a commercial property, a home is something that most people will give their last breath to fight for.
Granted, there were many sub-prime loans made to speculators, and they are probably less inclined to do "whatever it takes" to not lose their properties. The vast majority of these loans were to regular home owners. The year 2006 was the biggest year for sub-prime loan issuance: estimated range is between $380 - $500 billion in sub-prime loans.
Currently just 2% of those loans are in foreclosure, while the industry average sub-prime foreclosure rate is 20%. All of that debt was set to reset at much higher rates next year, but the President's plan to freeze the teaser interest rates will essentially stop any Foreclosure Armageddon we might have faced in 2008 dead in its tracks.
So there will still be housing pain in 2008, to be sure ... but it will be severely muted by the rate reset freeze.Companies like Morgan Stanley (MS) just announced almost $10 billion in write downs for the quarter and are writing their sub-prime portfolios down by 75% of face value.
In my opinion that's far too aggressive, and if 2008 is not as bad as the Street is pricing for, we may see a wholesale revaluation of the Street's sub-prime assets sometime in 2008. From a publicity and confidence standpoint, Morgan Stanley did the right thing. They essentially sucked in the quarter and took all of their medicine at once and adopted a worst case scenario for their sub-prime debt. They bolstered their balance sheet with $5 billion from a Chinese Government Sovereign Wealth Fund, and cleared the path for them to enter 2008 with a clean slate.
That's another difference I'm seeing this time around. The banks are moving a lot faster and are being a lot more proactive about dressing down their bad loans, writing them down and moving on. The banking situation was so bad in 1991 due in part to the banks trying to mask losses throughout the late 1980's by not marking their loans to current market prices.
The Opportunity: We've come a long way since then. The other potential boon for 2008 is the little talked about one-year repeal of the alternative minimum tax. This tax was originally conceived to target the ultra wealthy, to make sure they paid their share. But over the last few years, more and more upper middle income families have been snared in the AMT net. The temporary repeal of the tax is going to put about $54 billion extra dollars into consumers' pockets for 2008, or about an extra $2,000 per family.
I understand that many lost a bundle in the 1999 - 2000 bear market, and that those scars still run deep. As someone who couldn't look at a screen for a year after losing everything in 1998, I completely get that.
The thing to remember about this market, though, is that we do not have an equity valuation bubble. The main fear gripping the market is one of economic growth rates and that's what the market is fretting over.
But outside of the United States, the rest of the world is experiencing massive growth. China, India, Brazil, etc. These guys are partying like it's 1999.
There are three clear ways we can participate:
1. Start looking at companies that get the majority of their profits from overseas markets.As the US dollar weakens, companies that get most of their profits from stronger currency nations can convert back into even more dollars. Companies that fit this profile include Coke (KO), McDonalds (MCD), and John Deere (DE).
2. Don't be afraid of directly owning foreign stocks. They have been and will continue to be some of the best performers out there.Do you remember learning about developing nations in geography class back in the 1970's? Well guess what? They developed!
We are in the midst of a global growth wave that we haven't seen since the industrial emergence of the United States. China, India, Singapore, Brazil, South Korea and many more are developing into major global players. This is a trend that will last for years. Companies that fit this profile include the Chinese Oil giant CNOOC (CEO), the Brazilian mining power house Companhia Vale do Rio Doce (RIO,) and China Mobile (CHL).
3. Use ETFs to lower risk, especially if you are unsure of which foreign stocks to own.Exchange Traded Funds are truly the greatest investment innovation over the last 20 years. They are a great way to get highly targeted coverage in very niche-specific sectors. Some great international country funds worth looking at are INP (which will give you exposure to Indian stocks) and FXI (which gives exposure to Chinese stocks).
Sectors for 2008: The sectors that you want to pay special attention to next year include Technology, Oil and Agricultural Commodities.As corporate margins get squeezed by advancing energy prices, companies will be scrambling for ways to reduce costs. One of the fastest ways for them to do so is through technology efficiencies. That can include better accounting software, database management software (Oracle : ORCL), and technology consulting services (Accenture : ACN).
With Oil Stocks, you want to focus on those companies that are growing their reserves at a rapid rate (minimum of double digits). These companies will be the takeover targets of 2008 as the oil majors look to acquire their way out of their dwindling reserves.
With Agricultural Commodities, you're going to want to get exposure to milk, corn, sugar, soy, etc. As the rest of the world's wealth grows, so does its appetite for the things we take for granted. The Chinese are eating more meat, and that means they need more grain to feed their livestock.
Guess who owns the grain markets? The good old US of A, of course. The US dominates the global agriculture markets, and this will be a HUGE theme for 2008.In closing, I want to remind you that there will always be clouds on the horizon no matter what, but there will always be places where you can make money.
So ignore the doom prophets. I've never met a rich pessimist, so embrace the incredible opportunities that are ahead of us. Good Luck!