Third Quarter 2008
The financial market events of the past several months have been breathtaking, culminating in unprecedented government intervention in the markets and financial institutions and a major sell-off in stock markets around the world. The month of September marked the worst month for the S&P 500 Index since September 2002. Leaving out a rally on the last day of the month, September would have been the worst month since August 1998, when Russia devalued its currency and set into motion a series of events that culminated in the collapse of the hedge fund Long Term Capital Management later in the year. There are many similarities between the 1998 financial panic and today’s environment, including the use of excessive leverage by certain financial institutions, overly complex investment strategies, and ultimately government intervention in the markets. The 1998 panic was followed by strong stock market performance over the following year. We are not expecting or even hoping for an exact replay of the late-1990s stock market, but we do believe that valuations today, as in late 1998, suggest that stocks are attractively priced for long-term investors.
Virtually all markets around the world declined sharply in the third quarter, with the U.S. stock market actually falling less than most. The performance results for the Renaissance Small Mid Cap Growth Portfolio were disappointing for the quarter, trailing the Russell 2500® Growth Index. Our underweight position to health care stocks hurt results, as did stock selection in consumer staples and industrials stocks. Considered “defensive,” health care was one of only two sectors to post positive returns for the quarter (financials was the other). However, our better-performing stocks during this period were generally those related to sectors that are not always associated with defensive areas of the economy, such as the consumer discretionary and information technology sectors.
Materials stocks were among the strongest performers in our Portfolio over the first half of the year, but were underperformers during the third quarter. Weakness in commodity prices and fears of slower growth in emerging economies overseas were the key factors leading to the underperformance of this sector, whose fortunes tend to be tied more closely to the general level of activity in the global economies. The energy sector of the Russell 2500 Growth Index was the worst-performing sector, down 41% for the quarter. Seven of the ten worst-performing stocks in the Portfolio came from the energy and industrials sectors and detracted over 500 basis points (5.00%) from performance in absolute terms.
We believe that the recent meltdown in the financial markets is a product of years of risky behavior as well as structural issues within various financial institutions, but that the catalyst for the meltdown remains the upward move in interest rates from 2004-2006. In our first-quarter 2007 commentary, we noted that past increases in interest rates have corresponded with periods of stress in the financial markets. Subprime mortgages were the original “problem” in the markets, but the problem has ultimately resulted in bankruptcies (Lehman), government takeover of major financial institutions (Fannie Mae, Freddie Mac, AIG), and proposals for further significant government intervention in the economy. Today, the Fed Funds rate stands at 1.5%, and, we believe, its steep reduction since the start of the crisis is a necessary step toward better market performance in the future.
In our opinion, another step toward better market performance is better valuations for stocks as a whole; and here again, we have seen improvements recently. The S&P 500 fell 29% from its high last year to its September 29 low this year. The resulting contraction in P/E ratios combined with dramatically lower bond yields has resulted in the most attractive valuation picture for stocks relative to bonds that we have seen in almost three decades. However, even assuming a 20% reduction in estimated earnings stocks still appear very attractive relative to bonds.
In terms of specific stock performance in the third quarter, we have been disappointed and somewhat frustrated not to be able to add more value relative to our benchmarks across our various strategies. Although many elements of our stock-selection process have generally added value over the past few months, the relative ineffectiveness of various earnings estimate revision (EER) measures, which is one of the quantitative factors we employ to identify companies that are experiencing improvement in their fundamentals, has detracted from performance. What is striking is that stocks ranked the worst on the basis of EER have been the strongest performers, while highly ranked stocks have performed the worst. We believe that liquidations from hedge funds, which frequently employ EER-based strategies to both purchase top-ranked stocks and sell (short) bottom-ranked stocks, may have resulted in forced sales of fundamentally strong stocks and forced repurchases of stocks with weaker fundamentals. We believe that once the markets stabilize, companies that are enjoying positive changes to earnings estimates in this difficult economic period will be amply rewarded, and we have positioned the Portfolio based on these expectations.
Finally, valuations on individual stocks have improved to very attractive levels as a result of recent price declines. A simple reversion in valuation ratios back to five-year averages suggests significant price appreciation potential for the Portfolio, even without growth in underlying earnings.
In summary, the market events of the past several months have been dramatic and challenging for all investors. However, we are generally supportive of government intervention as being necessary and appropriate in light of extremely unusual circumstances. We are encouraged by relatively attractive valuations for stocks, and believe that long-term, investors will be well-rewarded.
The views expressed represent the opinions of Renaisance Investment Management as of September 30, 2008 and are not intended as a forecast or guarantee of future results.
Disclosure
Any sectors, industries, or securities discussed should not be perceived as investment recommendations. Any securities discussed may no longer be held in an account’s portfolio. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable.
The S&P 500 Index is proprietary data of Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.
The Russell 2500® Index, Russell 1000® Index, Russell 2500® Growth Index, and Russell 2500® Value Index are trademarks of Russell Investments. Russell®, is a trademark of Russell Investments. An investment cannot be made directly into an Index.
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