Adieu 07! ... Bienvenue
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
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
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
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
So we say, despite the inauspicious start, “Bienvenue
All of us at P.R. Herzig & Co. wish you a Healthy,
Happy and Prosperous New Year!
Please read our important notice
about these letters and the securities they mention.