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

The stock market took a drubbing in November, with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite falling 4.01%, 4.4% and 6.93% respectively.  While each of these important market barometers remain positive for the year, the recent stock market slide took all three indices into official “correction” territory, implying a 10% decline from their recent highs.  This marks the third such (approximate) decline of 2007.  Despite this incessant volatility, the Dow Jones Industrials, S&P 500 and NASDAQ were still in the black by 7.29%, 4.43% and 10.17% respectively through November. 

Large cap leadership is back and masking broader damage to the overall stock market.  The S&P Midcap, S&P Smallcap and Russell 2000 indices are down 5.17%, 7.48% and 7.28% respectively through November.  The S&P Financial Index is down a whopping 16.04% year-to-date.  And the equally weighted Value Line Composite is down 6.87%.  In the current environment of sluggish U.S. growth, strong overseas demand and heightened credit risk, high-quality, large-cap multinational growth stocks are viewed as a safe haven.  Reflecting this emerging trend, the composite of all Osher equities gained 11.54% through November.

Speaking of safe havens, the yield on 10-year Treasuries has sunk over 140 basis points in the last six months from 5.29% to 3.85% as investors have traded in stocks for the safety of bonds.  According to Jason Goepfert of the well-regarded research site www.sentimentrader.com, relative value indicators that measure investor preference for bonds over stocks reached the highest level in 40 years.  And cash in retail and institutional money market funds recently swelled above $3 trillion.  The growing popularity of bonds and cash reflects an enormous amount of pessimism already baked in the cake.  Indeed, the American Association of Individual Investors most recent survey on investor sentiment shows 56% of respondents as bearish on the stock market, the largest percentage of bearishness since 2000.   

While the contrarian in us leads us to believe that the extreme pessimism may be creating a significant buying opportunity, the stocks having already suffered the full extent of a bear market decline, especially banks and retailers, are down for good reason.  With the housing market unlikely to turn around before 2009 and the subprime mortgage mess likely to get messier, credit has tightened markedly.  Banks and brokers alike have taken significant asset impairment charges tied to bad mortgages, placing their capital ratios at risk and freezing their willingness to lend.  The recent correction points to the market’s fear that the combination of tight credit and declining housing prices will ultimately hit consumer spending and throw the economy into recession. 

Offsetting the bearish case, the Fed has recently signaled that another interest rate cut is in the cards, an about face from the October 31 Fed statement that indicated an end to the rate-cut cycle.  The futures market is now priced 100% for the probability of a 25 basis point cut of the Federal Funds rate on December 11 and a 50% chance for a 50 basis point cut.  If the Fed reduces rates by “only” 25 basis points, they are likely to signal that additional cuts are possible and they may further reduce the discount rate.  Recent commentary by Fed Chief Bernanke and Governors Kohn, Mishkin and Yellen all seem to indicate that the Fed will do what is necessary to ward off recession. 

And while we have reservations about the long-term impact of any government sponsored rate freeze on subprime adjustable mortgages and the so-called Super SIV fund currently being crafted by our nation’s largest financial institutions, the short-term impact should be to bring back a sense of order to the mortgage market. 

Meanwhile, other economic indicators look favorable.  Third-quarter business productivity surged to its highest showing in four years, preliminary data on November payrolls showed a surprising increase in hiring by private companies and the ISM service sector index showed continued expansion in November.  Led by exports and capital spending by corporations and government, GDP should be able to maintain close to 2% growth in 2008, good enough to deliver mid-single digit earnings growth for S&P 500 companies.  And lest we forget, the S&P 500 now trades at between 15 and 16 times forward earnings expectations, a considerable discount in such a low inflation, low interest rate environment. 

The shaky credit environment has placed a premium on quality and the economic slowdown has placed a premium on growth.  With quality and growth as our investment hallmarks, today is a great day to be an Osher client.  Please contact us with any questions and remember to notify us of any changes that might influence your portfolio or financial pan.

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