Letter - January 2008





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Adieu 07! ... Bienvenue 08?

We shed hardly a tear as the year 2007 passed into history. It was a rough one, disappointing on many fronts. Although the S&P 500 managed to rise a modest 5.5% with dividends, performance varied widely among different sectors. Indices of financial companies including banks, REITS and insurers fell 20%. On the other hand, many foreign stock markets, metals, oils and technology stocks scored high single-digit gains or more.

The world stock markets have started 2008 with a thud. Prices dropped sharply in the first two weeks of trading then rallied sharply on short covering as the Fed cut interest rates. Still, the S&P 500 is down 15% from its October high as we write this letter.

Heightened chances of a US recession have dampened investors’ enthusiasm for stocks. Whether we officially go into recession or not is less of an issue than the fact that economic growth is slowing sharply. While stocks do not seem overly expensive at 14 times estimated 2008 earnings, the question is now whether earnings will live up to expectations. Given the slowdown, probably not. Stock markets are telling us that.

Problems in the housing and financial markets continue to make the front page. The mortgage mess is unfolding in slow motion. It is still too early to know how risky mortgages issued in a time of excess will perform. It will take time for housing prices to stabilize. Foreclosures are costly and time consuming. In the credit markets, confidence must return so that purchases and sales of asset-backed securities can be made at realistic prices. We expect this process to continue well into 2008.

Never to be seen doing nothing during times of trouble, especially in an election year, our public servants in Washington have put partisan squabbles aside and agreed to a temporary tax cut of $150 billion. Aside from some boost to voters’ psyche, we don’t think this will have much of an effect on a $14 trillion economy. Rather better would have been making the Bush tax cuts permanent. Many investors, ourselves included, are deeply concerned that the next administration will raise taxes on dividends and capital gains, further depressing animal spirits. What Washington gives today, it takes back tomorrow.

Please see our disclosure on page 2 and our website Despite the gloom, encouraging signs are beginning to appear. Money from long-term investors is flowing into distressed situations, suggesting that prices are more reasonable. Hedge funds, vulture investors, Wall Street banks and foreign investors are buying mortgages, homes, stakes in banks and distressed mortgage insurers, all at what seem to be bargain basement prices. The market is beginning to function again.

We expect that the first part of the year will present many challenges for global markets. Even foreign markets, which have performed so outstandingly over the last number of years, seem to be poised for a breather. Nonetheless, we believe that it pays to be an optimist. Over the last twenty years, notably in 1987 and 2001, there have been a number of punishing declines. Each time, despite the warnings of the most pessimistic, the stock market rebounded to new highs. So, we counsel patience. History suggests that it is unwise to bet against the market for too long. We would say that anyone can prosper in the stock market if you take a long-term view and don’t sell when prices are down!


Our strategy for 2008 is to be patient and avoid precipitous action driven by sentiment. Current low prices reflect anxiety about an impending recession. However, the market is in the process of discounting likely outcomes. The sharp decline since January 1 is likely to abate as the year progresses, though history has shown that bear markets sometimes end with a temporary, short-lived spike to the downside. Just as enthusiasm drives stocks too high at market tops, pessimism drives them too low at bottoms.

We also observe that investors that are not invested when the market turns up miss out on the initial stages of a new bull market. This can seriously impair returns over the full investment cycle.

The financial sector which has been the worst performing sector has been so badly battered that we think that it is once again becoming attractive; we will continue to hold the stocks, which pay hefty dividends. While we do not see prices regaining pre-credit crunch levels soon, we would not be surprised to see gains in the sector of more than 20% by year-end. Looking out three to five years, we see plenty of upside from current levels.

So we say, despite the inauspicious start, “Bienvenue 08.”

All of us at P.R. Herzig & Co. wish you a Healthy, Happy and Prosperous New Year!

Tom Herzig


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