Outlook

One of the most significant developments of 2007 was the divergence of the financial economy from the real economy. Financials sector stocks and the financial system were under considerable stress, but the real economy proceeded fairly well. That explains a lot of the disparity of returns between financials sector stocks and other stocks. From a credit perspective, future losses for financials stocks were telescoped into one year in terms of the reported results and subsequent stock prices.

There will certainly be economic weakness in 2008. We are approaching a point of significant spillover from the financial economy to the real economy. We expect mild recession in the U.S. and significant slowdowns in Europe and China. While we may not see recessions in those economies we expect a lot of air to come out of what’s become an overheated situation.

We believe inflation pressures will decrease substantially this year, enabling the Fed to ease significantly. But let me emphasize that it’s not really about what the Fed’s going to do. It’s about what the Fed’s choices really are. The large commodity price increases of 2007 did not translate into an upward wage-price spiral. Instead, they represented one-time reductions in standards of living. That is a positive. The Fed is trying hard to avoid what happened in the 1970s, where prices and wages tried to catch one another. There’s nothing wrong with price increases, but there’s a big problem with wage increases that get out of line. There’s no evidence that’s happening in the United States, but there is evidence it’s happening in Europe. We expect the slowing economy to bring commodity prices down for almost everything but oil, which could fall by a somewhat smaller amount. Copper and other metal prices are inflated and we expect them to come down significantly.

As investors, we go for long periods with relatively tranquil markets and without any big opportunities with the potential to really drive a portfolio one way or the other. Today, we face one of those types of opportunities, the kind that may only come around every 5 to 10 years. This time, it’s primarily in financial stocks. We believe this is a time to have a huge investment in financials on a contrarian basis. We don’t see opportunities of this magnitude very often and we are taking advantage of it because we believe it has significant potential for superior returns.

Particulars

• In China, the secular growth story is intact but the economy has been through a period of massive overheating. Chinese authorities are trying to bring the economy under control and, aided by an economic slowdown in the U.S., those efforts will probably succeed in 2008 and 2009. That’s a negative for the Chinese stock market in the near term, but we would look at a significant downturn in China as a long-term buying opportunity.
• We see Europe as lagging the U.S. economic cycle by a year and expect to see slowing there as a result of recent events in the U.S. The European economy responds poorly to pressures from rising commodities prices. Trade-offs there are tougher and the Central Bank can’t come to the rescue immediately to prevent a recession.
• U.S. manufacturing weakness will be partly muted by the effects of the weak dollar, which has caused American products to become more competitive globally. However, most of the recent strength in manufacturing has been a reflection of a global economy that is stronger than the U.S. economy, not the relatively weaker dollar. That situation will fade as Europe and China weaken. We don’t think industrials stocks continue to beat expectations.
• Interest rates should continue downward more. Most of the longer-term rates are as low as they ought to be but short-term rates remain out of line. We think they will continue down as the Fed concludes it doesn’t have an inflation problem and begins to ease more aggressively.

Opportunities and Threats

• The financials sector and the homebuilders stocks are probably the most attractive areas in the market. We think investors should have large positions in these companies with significant diversification in order to mitigate high single-stock risks. Liquidity issues in some companies are significant but the group, as a whole, has the potential to double or triple and that merits substantial investment.
• We remain overweight health care, where there are solid opportunities that should remain intact through the elections. Fear of the effects of the elections has made health care stocks relatively inexpensive.
• While the outlook for the industrials sector isn’t great, there are industrial companies that look promising. For example, Boeing faces a critically weakened competitor and is a great longer term story.
• There may be some emerging strength in retailers toward the end of the year as investors begin to focus on 2009. That will be a recovery year, as opposed to 2008, which is going to be a tough year for them. We think it’s still too soon for these stocks.
• Although oil prices will likely come down, energy stocks look healthy. We are interested in global integrated energy companies and exploration and production companies. Natural gas prices are too low compared with crude oil prices and, as a result, we are even more constructive on companies with natural gas in the mix.
• We would avoid the other commodities and the emerging markets, which are over-heated and we believe are vulnerable to correction.
• While technology is perceived as a safe-haven growth area at the moment, we disagree. In the event of a significant economic slowdown, we expect technology would turn down.