Buckle Your Seat Belts

For investors
2007 was a year of bi-poplar extremes that has left many market participants
emotionally and in some cases financially exhausted. In all the years that we have toiled on Wall Street we have never seen
such extreme market movements like those that evolved over 2007. Still, when all
the dust has settled the “average” stock will have been up for the year and
despite the “mega” economic and financial problems that are currently
impacting the U.S. economy. Indeed
given the current environment we believe the stock market has behaved rather
well. Does this suggest that 2008
will be the year that reality finally sinks in on investors?

Indeed,
economic reality is not very good right now. A lot of greedy and supposedly
smart bankers lent money to folks who were very high risk. Now the folks who wanted in on the housing boom and saying that they
didn’t understand the risk and therefore the government should protect them
from foreclosure. Of course the
government is more than happy to oblige thereby putting one more nail in the
coffin of free markets, while not solving the underlying credit problems. If we were to see a major blowup – say, several financial institutions
simultaneously taking large and unexpected losses in sub-prime or other risky
debt – already-anxious lenders could drastically cut back on new loans and cause
a real credit crunch. That could prompt both consumers and corporations to
dramatically lower their spending, which could be the catalyst that sends the
economy spiraling downward and into recession. At the same time the US dollar has been in free fall reflecting the
global view that U.S. economy is a mess. Oil
spiked to the $100 per barrel level in 2007 once again punctuating the rising
cost of energy and the failure of anyone in power to really address the
longer-term energy outlook. All of this negativity has spooked the American
consumer and spending is beginning to slow down, making the risk of a recession
very real. And the potential icing on the cake is a bunch Democrats
running for president who cannot wait to raise taxes. If one acknowledges that all of the points raised above are not good news
for the stock market, we wonder how any reasonable investor can be bullish for
2008?

To
be sure, the bullish among us will point to the moderate valuation of stocks as
reason to be optimistic. And we
admit that valuations are attractive, but traditional analytic measures may not
apply when such mega-problems loom in the immediate future. If the economy
were just on the verge of recession we could handle that since that is just part
of the normal business cycle. However,
when the possibility of economic slowdown is combined with tighter credit and
high energy costs we begin to really worry. Our view is that it would be prudent to reduce the exposure to stocks. So
buckle your seat belts, it’s going to be a bumpy 2008.

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