For the most part, with respect to the ranking of investment returns, the fourth quarter of 2007 was consistent with the rest of the year. In general, commodity prices moved sharply higher, as they did over the full year. Emerging-markets equities and currencies continued their advance (there is an embedded commodity play in some of these markets). Developed country foreign equities declined, a reverse after a strong advance earlier in the year—but they still outreturned the U.S. equity market, which was down across all styles in the fourth quarter. Value continued to underperform growth in the fourth quarter, this time on the downside—and was in the red on the year. Growth stocks delivered decent positive returns for the full year. Small-caps continued to lag large-caps and were also in the red for the year. REITs’ collapse intensified, as they dropped almost 13% in the fourth quarter alone. As recession fears increased, bonds performed well in the quarter and ended up with a solid 7% return for the year—ahead of the broad stock market.

2007 Retrospective

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed. The stock of the average homebuilder dropped over 50% (and over 70% going back to the pre-2007 peak) and financial stocks in general were pummeled. Household names like Fannie Mae, Freddie Mac, Washington Mutual, Countrywide Financial, Citigroup, Merrill Lynch, and Bear Stearns were among the firms caught in the mortgage market meltdown. As credit tightened and the housing market suffered, investors became more and more worried about the overall economy, triggering stock declines for many consumer goods companies. While all this was going on, U.S. exports were booming and reached an all-time high of 12.1% of GDP (as of 9/30/07). Not surprisingly, companies with significant foreign-based earnings did well including (generally) energy, technology, and materials companies. Overseas stocks also delivered great returns. Related to the overseas story was the continuation of demand for energy and raw materials commodities from China and other high-growth developing countries. This trend was also reflected in the strong performance of the energy and materials-related sectors.

Source: Francois Trahan, ISI Group (thru 11/23/07)

There was action in the bond market also. Investors first worried about inflation and then recession. At times they worried about both. The 10-year Treasury yield ranged from a high of 5.25% in June to a low of 3.85% in November. The best action was overseas as the dollar’s drop gave U.S. investors currency gains that enhanced their returns. But outside of the government bond market, perceived credit risk rose, leading to underperformance.

Remaining Focused is Key in the Age of Information Overload.

In the trenches of the money management business it is a constant struggle to avoid information overload while staying on top of the right information. The amount of analysis and data and the breadth of information available amounts to a tsunami compared to what we had access to 20 years ago. We think of ourselves as research junkies so we’d rather have more than less. But, it takes discipline to stay focused on the right information and not get distracted by the (sometimes interesting) less relevant information. Sometimes it takes creativity and persistence to find the data or research that we need to get to the right conclusions. Even with the challenges that we face with an information explosion, one thing hasn’t changed, and that is the critical importance of a common sense overlay that brings us back to what really matters and helps us resist the temptation to either overanalyze or make decisions based on knee-jerk reactions. We think this common sense is one of our strengths.

So what matters most right now? Two things:

• The underlying economic and investment fundamentals
• Understanding what is reflected in current security prices

There are other things that matter when it comes to portfolio construction, such as the scenario analysis we do, but with respect to assessing competing investment opportunities—which is what investing is all about—these two areas are where we focus our attention. In each of these the challenge is the same: to sift through a seemingly limitless supply of information and determine what is most important. An additional challenge is to stay intellectually honest about what we can confidently know or assess and what we can’t. (A variable may be very important but unpredictable or unknowable, like, say, next month’s inflation rate.) One of the common failings of amateur and professional investors alike is thinking that they are smarter than they really are, i.e., overconfidence. All it takes is a few right calls to start believing you’re Nostradamus.

Conclusion

Most equity-oriented asset classes are priced around fair value. Large-cap stocks remain attractive relative to small-cap stocks—so the former are overweighted and the latter underweighted in our portfolios. But our overall equity exposure is neutral. We continue to have tactical weights to emerging-markets currencies (through short-term bonds) and commodity futures. All three of these allocations added value in 2007.

Economic risk has risen and recession is a clear possibility, though not necessarily a high probability. However, we are taking a close look at the risk exposure in our portfolios and assessing whether we should increase our defensiveness. However, clients should understand that the possibility of a rough year lies ahead. They should also understand that this is not an outcome that can be predicted with high confidence. We’ve been surprised by positive market returns many times over the years. So we focus on doing our best to maintain adequate risk protection over a one-year time horizon based on the risk tolerance of each investor, while keeping our eye on the more important goal of long-term returns.