Although there no doubt will be some bright spots in the markets this year, the hangover from the subprime mess will likely get worse before it gets better and will continue to put a damper on overall performance.
Standard & Poor's was expecting 2008 earnings of nonfinancial companies to grow about 12%, but other analysts were less optimistic.
"One of the main risks for equity markets remains earnings," says Rob Kapito, president of BlackRock, New York. "Whether earnings are down, or up slightly, we expect a plethora of earnings downgrades and disappointments, focused heavily on the financial and consumer discretionary sectors."
On the fixed-income side, he says he sees value in municipal bonds. Despite the ongoing pressures on state and local governments, weak fundamentals and problems with bond insurers, yields were attractive. Tax-free municipal bonds yielded as much as taxable bonds.
Kapito also favors shorter-term, high-quality corporate bonds with neutral durations. And the selloff in the high-yield bond market also created investment opportunities in the high quality sector.
Despite the subprime loan meltdown, an international credit crunch and fears of a recession, the average mutual fund managed to eke out a 6.85% return in 2007.
According to Morningstar Inc., large-company stocks returned 5.5% last year, compared with 15.8% in 2006. Small-company stocks, down 5.2%, compared with 16.2% returns in 2006. Other 2007 vs. 2006 returns: bonds returned 9.9% vs. 1.2% and cash returned 4.7% vs. 4.8%. Inflation was 4.6% in 2007, up from 2.5% in 2006.
Growth stocks, however, widely outperformed value stocks. International stocks, precious metals and natural resource funds also performed well. Bringing up the bottom were financial, real estate and smaller company stocks.
Robert Turner, manager of the Turner Core Growth Fund, up 22.24% in 2007, said that nonfinancial company earnings, particularly in the health care and technology sectors, are solid. "We have had seven years where value has outperformed growth," he says. "But it is late in the economic cycle when companies with sustainable earnings perform well. The economy is slowing. Companies with robust earnings will perform well."
It was a tumultuous year. The Dow Jones Industrial Average was stuck in a trading range of 12,500 to 14,000 for the last eight months of 2007. Rising oil prices, inflation fears and credit fears increased market volatility. The Dow Jones average underperformed the total return on long-term Treasury bonds.
There were a record number of mortgage defaults as a result of subprime adjustable-rate loans. And in October, new home sales were down 20% from the same month in 2006.Meanwhile, the dollar continued its decline.
Some mutual fund portfolio managers confessed that all this financial turmoil wreaked havoc with their funds' performance.
Steven Rogé, manager of the Rogé Partners Fund, a multicap fund of funds that also invests in individual stocks, says that his value holdings were a drag on performance. The fund, up 2.82% in 2007, underperformed the S&P 500, which returned 5.49% in 2007.
His largest mutual fund holdings include Legg Mason Opportunity Fund, Wintergreen Fund, Third Avenue Value International and Longleaf Partners. The fund's individual stocks were holding companies such as Berkshire Hathaway and Leucadia National Corp., which acquire companies selling below intrinsic value.
"We really were affected by the problems in the subprime market," Rogé says. "The managers of the mutual funds we own tend to own financial stocks in their portfolios."
In the longer term, however, Rogé is optimistic that his mutual fund will benefit from undervalued stocks once they rebound.
"Our fund managers are buying stocks like Cisco, GE, Intel and Microsoft. Profits of these companies have doubled over the past six years, but the stocks got cut in half. They were selling at 30 to 40 times earnings. Now they are selling at 13 to 15 times earnings."
The big stock fund winners in 2007 could do well this year, Rogé says. Natural resource and commodity-related funds gained 37.15% in 2007. Technology stock funds also delivered double-digit returns of 15.95%, while large-cap growth funds grew 13.45%.
Paul Sutherland, co-manager of a stable of four Utopia Funds, with assets of more than $700 million, is happy 2007 is over. He's investing worldwide in any size company. His typical holding has strong free cash flow, is a good franchise and is cheap in relation to earnings growth rates. He's been buying foreign stocks overlooked by Wall Street analysts.
"We had one rough year--the worst in my 25-year career," he says. "It was like 1,000 little cuts. We had a great first half of the year. But financial and real estate stocks got toasted. Late in the year, the dollar strengthened and our foreign holdings declined."
Sutherland says the Utopia Growth Fund gained just 5% last year. But he was optimistic about 2008. "This year will be the year of the stock picker," he says. "We've been buying companies with strong free-cash flows and balance sheets, as well as good product strategies in the alternative energy, health care and financial services sectors."
Among his largest holdings: Sify Ltd., Motorola, Barclays Bank, iSoft Group, Finetick Corp. and J. Front Retailing.
Not all fund managers had a poor year. Bob Turner, manager of the Turner Core Growth Fund, says he was on target. Nine of his 10 sector positions beat their corresponding indexes. Contributing most to the fund's performance were consumer Internet companies, gaming, health care and technology stocks. Financial services, real estate and utility stocks, however, registered subpar performance.
He also found some winners in the financial sector. Turner has a large stake in the Chicago Mercantile Exchange and MasterCard, which both gained more than 30% in 2007.
Going forward, he says that continued global economic growth should help bolster U.S. corporate earnings. "Our focus is to own stocks that we think have superior earnings prospects," he says.
Turner favors shares in Internet companies, luxury retailing, consulting, mining, energy, natural gas utilities, specialty pharmaceuticals, biotechnology, semi-conductor, data networking and wireless industries.
The fund's largest holdings include Google, Cisco Systems, Microsoft, Intel and Apple Inc.
International stock funds also performed extremely well because of the decline in the dollar and because of global economic growth. The average foreign fund outperformed the MSCI-EAFE index in 2007, according to Morningstar Inc., Chicago. Pacific/Asia and Latin American funds registered strong returns of 48.23% and 45.77%, respectively.
Growth-oriented funds were the best foreign stock fund performers because they had less exposure to financial companies than value funds. Foreign growth stock funds also profited from red hot returns in emerging markets.
Although this year is expected to be a good one, particularly for growth companies, it's not a sure thing. The International Monetary Fund's latest world economic outlook report cut growth projections from 5.2% to 4.8% because of turbulent conditions such as volatile oil markets, strong flows of currencies into emerging markets, continued problems in the subprime lending market and slower U.S. economic growth.
Nevertheless, money managers believe that foreign growth stocks will outperform value stocks because of fast-growing foreign companies engaged in exporting.
George Greig, manager of the William Blair International Equity Fund, says global market volatility increased because of tight credit conditions and concerns about a slowing U.S. economy. The global markets, for example, lost almost 12% in August 2007. But he believes that foreign large-cap and midcap growth stocks, led by emerging markets, telecommunications, energy and industrial stocks, will continue to do well.
His fund gained 17.97% last year.
"The subprime/structured credit shock has stirred up considerable controversy about where the economy and financial markets go from here," he says. "Confidence has been boosted by timely and decisive Fed strategy, flexibility on the part of the European Central Bank and the Bank of England."
Going forward, he says emerging markets "have a much more dynamic growth picture, but increasingly challenging valuations compared to the developing markets."
As a result, there are still risks in the emerging markets.
Greig invests in large- and mid-cap growth stocks. His holdings were growing earnings at high double-digit rates. The bulk of the fund's assets were invested in Asia and Europe.
Late last year, he raised his holdings in British Sky Broadcasting, which provides pay television broadcasting services to retail and wholesale customers in the United Kingdom and Ireland.
He also bought shares in Mitsui & Co. Ltd., a Japanese trading company that arranges financing for customers and suppliers in connection with trading activities. The fund's largest holdings include ABB Ltd, Vale Overseas Limited, Nintendo, Tesco and BG Group.
Precious metals funds gained an average of 24% amid fears of inflation, rising oil prices and the falling dollar. "The subprime mortgage crisis was the catalyst that pushed gold to a 28-year high," says Donald Doyle, chairman and CEO of Blanchard Co., New Orleans. "The trend will continue due to strong global growth, abundant global liquidity and reduced supply from central bank sales and mine production."
Although gold's fundamentals appear appealing, some are concerned. The reason: Speculators and hedge funds made big bets in the gold futures market when the Fed cut rates in the last quarter of 2007. But once the Fed stops cutting interest rates and the dollar strengthens, gold should give back some of its recent gains.
The hardest hit funds were financial and real estate stock funds, down 11.7% and 14.63% respectively in 2007, as a result of the real estate and lending crisis. The worst may not be over for these sectors. Health-care REITs, on the other hand, may be a single bright spot in the real estate sector in 2008.
Congress temporarily extended a health insurance program for children. The State Children's Health Insurance Program gave doctors a one-half of a 1% rate increase for treating the elderly and disabled in Medicare. Congress gave physicians a 0.5% rate for treating the elderly and disabled for Medicare rather than the expected 10% cut.
On the financial services side, Mark Schmeer, senior vice president of equities at MFC Global Investment Management, Boston, is optimistic. He favors life and health insurance companies because they were not seriously affected by the subprime loan debacle.
"Some investors have expressed concerns that if the losses at major banks are severe enough, banks will have inadequate capital to finance new lending," he says. "We believe that tighter credit and lack of liquidity is specific to individual companies and not a global phenomenon. Those companies that are in difficult circumstances are finding sources of capital."