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Saturday, 15 September 2007 00:00 Written by James Van de Voorde

Despite a continued surge in volatility, the markets were able to turn in mostly higher returns in August.  The Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite were up 1.10%, 1.29% and 1.97% respectively for the month and are now positive by 7.18%, 3.93% and 7.5% for the year.  Masked by the strength in these widely used, large-cap market barometers, the Value Line Composite was actually negative by .34% in August and is now up only 1.97% for the year.  Since the Value Line Composite consists of 1,700 equally weighted stocks, it is considered a good yardstick for how the average stock is faring and now clearly indicates that stock market leadership is firmly in the grasp of large-cap stocks, especially large-cap growth stocks.
    Bearing out this large-cap growth leadership, Osher equities are decidedly ahead of their respective benchmarks with the average of all Osher equities up 9.28% through August.  There are at least two critical, well-defined trends in place that should allow for continued Osher outperformance for the foreseeable future, especially during this period of economic uncertainty:
    Flight to quality: The recent liquidity crisis in the financial markets has led to a reevaluation of risk across all asset classes.  In the bond market, money has flowed away from riskier emerging market and high-yield corporate bonds (which only a few short months ago enjoyed record low spreads against Treasuries) to the safety of U.S Treasury bonds and bills.  Reflecting this flight to safety, since early June, the yield on the 10-year Treasury bond has declined from 5.3% to as low as 4.3%.
    In the stock market, money has flowed away from riskier small-cap stocks to the relative safety of large-cap stocks.  In addition to the aforementioned evidence of the demise of the “average stock” as witnessed by the performance of the Value Line Composite (which includes large-cap stocks), the bellwether benchmark for small-cap stocks, the Russell 2000, is barely positive for the year with a scant .66% advance through August. 
    What is behind this flight to quality?  Spreading contagion in July through mid August from failing subprime mortgages has impacted virtually every corner of global financial markets; hedge funds, private equity, global investment banks and regional banks alike, mortgage originators and lenders and commercial paper markets have all been affected, and in some cases lending activity has outright frozen.  On August 17th, between regularly scheduled FOMC meetings, recognizing the need for immediate intervention in order to avert a deepening crisis, the Federal Reserve cut the rate it uses to lend to other banks, known as the discount rate, by fifty basis points from 6.25% to 5.75% and extended discount window payback terms from its typical one-day period to thirty days.  Moreover, the Fed broke from its inflation fighting bias (affirmed just 10 days earlier on August 7th) by stating that “the downside risks to growth have increased appreciably”.    Clearly, the Fed’s actions and accompanying statement illustrate real concern that the subprime financial event, previously thought to be contained, had mushroomed into an economic event.    
    Then, on September 7th, the flight to quality “trade” gathered even more steam, when the Labor Department reported that nonfarm payrolls fell by 4,000 in August, well below the consensus expectations for an increase of 112,000 jobs.  This was the first time in four years that the number of jobs actually contracted, potentially signaling a weakening U.S. economy.  In addition, previous reports for June and July were revised sharply downward – the monthly average 44,000 new jobs created for the past three months is significantly lower than the 147,000 monthly average seen between January and May. 
    While it is true that a negative monthly employment report does not a trend make and further true that negative monthly payroll reports have accurately predicted recession only one-third of the time, the combination of potentially rising unemployment with a housing market that seems destined to deteriorate further has given the markets pause.  Mortgage delinquencies, foreclosures and unsold housing inventory are all on the rise, even as housing prices continue to adjust lower.  Downside risk to the U.S. economy has increased and the possibility for recession now seems to be at least an outlying possibility.  The latest Wall Street Journal economic survey pegs the risk of recession at 36%, up from just 28% one month ago.   
    The silver lining is that a cut in the Fed Funds rate by the Federal Reserve is now a foregone conclusion.  The futures market is now priced for an almost 80% chance for a fifty basis point cut when the Fed next meets on September 18th.  Given the recent convulsions in the credit markets, continued weakness in housing and unexpected decline in employment, there should be more than enough cover for the Fed to cut by 50 basis points without the “moral hazard” stigma that tarred the Federal Reserve during the Greenspan era.  If the Fed decides to cut rates more incrementally by 25 basis points next Tuesday, the market may fear that the Fed is already behind the curve.         
    To be sure, not all economic news has been gloomy.  Productivity gains have accelerated, retail sales for August surprised on the upside and even the employment report showed a continued rise in personal income.  Further, GDP growth in the second quarter accelerated to 4% from the disappointing .6% rate of the first quarter, so the economy was very strong and building momentum before the subprime fiasco began to unfold.  Furthermore, corporate balance sheets have never been stronger as evidenced by the approximate $2 trillion hoard of cash held by S&P 500 companies.        
    During recessionary periods, companies that can consistently and predictably deliver earnings growth despite the economic environment rise to the top and exhibit strong relative performance.  It is no coincidence that Osher portfolios are well stocked with traditionally consistent growers such as consumer staples and health care companies that will deliver steady growth even if the U.S. economy temporarily stumbles.  Consistent, predictable growth and high quality balance sheets are Osher philosophy hallmarks that will serve clients well during this rocky period. 
    Global growth: While the U.S. economy slows, growth overseas remains brisk, especially in emerging economies such as China, India, Eastern Europe and Latin America.  The International Monetary Fund recently increased its forecast for global growth from 4.9% to 5.2%, even as it simultaneously reduced its GDP forecast for the U.S. economy from 2.2% to 2% for the year.  For perspective, the U.S. represented only 12% of 2006 global GDP growth and will undoubtedly count for less of that growth this year.  While the forecast for U.S. growth may come down further still, the strong international trends in place should allow leading multinational companies to deliver solid earnings growth, even if the U.S. should slip into recession.  As a whole, S&P 500 companies generate 44% of sales overseas, compared to just 32% in 2001.  As S&P 500 sales become increasingly diversified internationally, U.S. companies in general and Osher companies in particular are better able to capitalize on overseas strength, while minimizing the negative impact of the housing crisis.
    Weakness in the U.S. dollar has accelerated the importance of foreign sales.  U.S. based companies with strong multinational operations are the greatest beneficiary of this trend because the weak greenback makes their goods cheaper to foreign buyers.  In turn, profits generated in those foreign markets are amplified when translated back into dollars.  For U.S. companies with 40% or more of their sales abroad, the weak dollar can add as much as 3% to annual earnings growth.   
    We have already seen this phenomenon play out in the first two quarters of the year when actual earnings trounced consensus estimates on the heels of stronger than expected growth from large-cap multinationals.  As a prime example of what we expect, 1st quarter GDP was barely positive at .6% and yet S&P 500 earnings growth came in a shade under 10%, more than double the consensus.  A primary criteria we use in selecting stocks is a company’s operations overseas – we have a strong preference for companies that are able to demonstrate success not only here in the U.S. but also in foreign markets.  This secular trend in international growth has become an increasingly important catalyst for earnings growth and is especially apparent in key sectors such as technology, industrials and consumer staples, all sectors that Osher has overweighted in client portfolios.
    While we recognize that the odds have increased for recession, we remain confident that Osher portfolios are optimally positioned to weather the potential storm.  Our focus on high quality, large-cap, multinational growth stocks will serve as an anchor for client portfolios and should continue to deliver strong relative performance with less risk.

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