Our Market Commentary

Portfolio Review
 

The fourth quarter was unusually weak for equities. The housing sector’s woes, signs the economy was slowing and cascading problems in the credit sector all worked to keep stocks under pressure in the period, even with aggressive rate cutting by the Federal Reserve.

Despite these headwinds your account topped the benchmark S&P 500 in the quarter by several percentage points. We likewise outdistanced the blue chip benchmark by a double digit margin for the full year.

Credit for this outperformance is due in large part to our overweighting in energy and alternative energy plays. Other stocks in the portfolio that are leveraged to both growth and inflation—namely materials and industrials—also benefited from this market and economic environment.

By being significantly underweighted financials and consumer discretionary shares we were largely spared from the weakness in those sectors in the quarter. As opportunities cropped up, though, we added positions in marked down, high quality companies, including several financials.

Outlook

Not to put too fine a point on it, but 2008 could prove to be an extremely difficult year for investors. The one-two punch of a weak economy coupled with mounting inflationary pressures has led to the worst start for the stock market since the Depression. And this situation won’t be resolved overnight.

The important question is not whether we’re in a recession or merely a period of very slow growth, though. Instead, the real concern is whether the current weakness in the economy will start to feed on itself, leading to a deep economic contraction. From an investment standpoint the difference between a slow-growing economy and a mild contraction is very minor. Assuming the recession is mild, stocks will likely find a bottom near its current level. However, a deeper recession, which really takes a bite out of corporate profits, would mean that stocks have even further to fall before all is said and done.

We believe where we head from here will depend largely on the actions of the Federal Reserve. The central bank has been behind the curve throughout the current crisis. Its concern with fighting inflation caused it to underestimate the severity of conditions in the housing sector which, in turn, has caused other parts of the economy to slow. But as the situation has continued to deteriorate, Bernanke and Company now have to cut short-term interest rates more than they would otherwise care to in order to jump start the economy—even if it means higher inflation down the road.

In the meantime, cash as an asset class doesn’t offer much in the way of safety. Today, T-bills yields are roughly 100 basis points lower than inflation. So the absolute security of T-bills comes at a stiff price: holders will loose money in real terms. It has been a long time since the difference between the inflation rate and T-bill yields was this great, and the reappearance of this phenomenon today tells us that inflation has gained the upper hand. As long as this situation persists, you’ll be rewarded for keeping your money out of “safe” investments and instead choose investments that will gain value as inflation rises.

Although we’ve become more cautious with our holdings, we see good values in many high-quality growth stocks. Overall, stock market valuations are currently in line with historic norms. And our portfolio selections are, on balance, trading at PEG ratios well below those on the major stock market averages. Our energy positions are likewise trading at historically low P/Es, making them great bargains at the moment.

We’ve long held equity positions known for their “defensive” characteristics. By this we mean stocks that are relatively immune to an economic slowdown in the U.S. These are companies that are leveraged to a weaker dollar and growth in foreign economies, along with a handful of health care companies that also fall into this category.

By this time next year, we think the U.S. economy will be growing well again, although inflation could easily top 5 percent by then. Most likely the Fed will still have its hands tied for fear of upsetting the expansion. As a result, shares of companies focused on hard assets such as gold and other commodities, along with companies expanding into emerging markets, will prove to be the best investments.

In spite of the poor start to 2008, we are optimistic that our diversified portfolio of reasonably valued, high-quality growth stocks will continue to provide the best potential for outperforming the market over the next year. Of course our approach remains to be aware of possible dangers and to be prepared to act accordingly. While past performance is no guarantee of future results, this strategy has served us well over the years under various market conditions.  

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Disclaimer: The specific securities identified and described herein do not represent all of the securities purchased, sold, or recommended for advisory clients, and that the reader should not assume that investments in the securities identified and discussed were or will be profitable. The mention of securities in this letter should not be deemed as a recommendation to buy or sell the securities. Leeb closely monitors the companies held in client portfolios. If a company’s underlying fundamentals or valuation measures change, Leeb will reevaluate its position and may sell part or all of its holdings.