Looking at '007

January, 2007 Dr. Hans Black and Malcolm Thomas

On December 8, at the UN Correspondents Association ball, and just prior to his official swearing-in to the office of Secretary-General of the United Nations, South Korea’s former foreign minister, Ban Ki-moon, introduced himself by saying, “My name is Ban, but not James Ban. I take office in ’07. I am not shaken, but you will be stirred.” Inspired by Mr. Ban, I could not help but refer to the new year as ‘007, for it promises to be packed with action, especially as relates to the markets. What follows is what we see as the driving forces for markets in the next year or two.

2006 proved to be remarkable in that it represented the third recovery year from the stock market decline in late 2002 and early 2003. Although the broad averages in virtually all world markets have clearly failed to recoup the losses from early 2000 and the fall of 2002, the staying power of this multi-year rally has been impressive. Inevitably, after three-and-a-half solid years of gains, market participants are once again turning their backs on risk and embracing the “Goldilocks scenario”. While corporate profits certainly have been buoyant and stock prices have recovered, we cannot rid ourselves of the nagging feeling that there is still considerable unfinished business in the cleaning-up process following the speculative binge of the late 1990s. Certainly P/E ratios have gone down, which has made large-cap investing very difficult as so many companies, despite reasonable earnings, have shown almost no change in stock price. GE, Microsoft and Intel are just three good examples of extremely lackluster performance during the past three to four years.

A recent study by the BBC in the United Kingdom, which has a very unique global index consisting of the largest companies in each industry group in each of the three major regions of the world, reveals a startling truth. If one takes the top ten companies in Asia, North America and Europe in each of ten industry groups, the performance for 2006 was barely up five percent. Large-cap companies in many parts of the world simply have not done well. As returns have been so difficult for many institutions with large equity holdings, the rationale for increasing the risk profile of portfolios to capture additional performance has been overwhelming. In recent years, this has meant massive shifts of capital into hedge funds, private equity buyout groups, etc. Importantly, in the past twenty-four months, this has also manifested in the bond markets as an almost complete change of attitude toward risk. While we have commented on this before, we are astounded by what seems to be happening day after day, week after week. To illustrate, in the latter part of 2005 we found bonds of Ford Motor Company rated “BB” with two-and-a-half years to go offering a yield of over twelve percent to maturity. After long debates, we seized upon this opportunity, feeling the risks inherent in the automobile sector were deeply embedded in the bond prices. These bonds have recovered and are now trading above par with a yield of approximately seven percent to maturity. At the same time, Ford bonds have been downgraded to near default status of “CCC”. Throughout the world of corporate bonds we are finding similar examples where investors hunting for yields are seizing upon what they see as opportunities for return with little regard to risk.

We were completely unprepared, however, for the news from our esteemed colleague in the U.K of what was going on in the realm of high-yield bonds in Eastern Europe and the former Soviet Union. Little did we know that the favorite investments of 2006 by many institutional clients and hedge funds were anything from Bulgarian steel makers to Ukrainian poultry farms. Checking on this further, we discovered that none other than Merrill Lynch had arranged the sale in early 2006 of 12-percent bonds in a Bulgarian steel maker. A trip to the steel mill for investors was organized by Merrill Lynch in the hopes of bolstering

the deal, but the steel maker nevertheless collapsed later in the year. We are also amused by the sale of bonds by Ukraine’s largest poultry farm, Myronivsky Hlibo Product, which managed to raise $250 million paying only 10.25 percent for five years. These bonds in fact have done extremely well, gaining several percentage points and now yielding only 9.5 percent, as if bird flu had never existed.

Although extreme examples, we have come so far from the situation in late 2002 where junk bonds commanded yield premiums that were simply enormous, sometimes twenty or thirty percentage points above treasuries of a similar duration. We are also firmly of the view that central banks are seeing all of this very clearly and are undoubtedly as concerned as we are over what this kind of action will bring us or bring certain investments over the next one or two years. At some point in time, spreads will indeed widen and widen dramatically. Believers in Goldilocks will perhaps be shocked if the Fed does not loosen its credit policy any time soon, even if there are noticeable weaknesses in the armor of the housing market.

These weaknesses, which are real and growing, are also possibly underestimated by most observers. It should be noted that in the past five years, approximately 75 percent of North American consumption has been fuelled by wealth gains — or apparent wealth gains — in the real estate market. The so-called wealth effect in housing has been well documented but we cannot overestimate how much this really is. In the United States, approximately 70 percent of American families now live in their own homes, and the increase in value of these assets has been tremendous, particularly since 2000. During the recession of 2001 and 2002, consumers quickly took advantage of their ability to withdraw equity from their homes, using the funds for discretionary spending or other forms of consumption. By 2003, over $600 billion, or six percent of GDP, was removed from the value of homes through the process known as mortgage equity withdrawals. By 2004, $1 trillion was removed the same way. This figure represented almost ten percent of personal income. With the value of homes now falling (and we believe we are still early in the process), this game cannot continue. Higher interest rates, particularly on adjustable rate mortgages, mean consumers have to curtail their spending in order to pay higher mortgage payments; forget about discretionary spending. This has a very noticeable effect on housing construction and, of course, in many parts of the country, retail sales. It is no surprise that Wal-Mart has reported such difficult numbers during this same time. Unfortunately, the bigger the boom in any one sector, the bigger the bust. This axiom leads us to the very unhappy conclusion that the decline in real estate values and the negative effect it will have on consumer spending may have further to go. The good news, of course, is that this is overdue anyways, and will probably lead to a significant dampening of the U.S. trade deficit as a lesser thirst for cheap foreign consumer goods will help the dollar.

Beyond the immediate difficulties of a housing bubble, which seems to have burst at the same time that risk has taken a back seat in market psychology, we are unfortunately facing a number of geopolitical challenges. While it is clearly impossible to predict these things, it is hard not to be apprehensive about the possibility of a further escalation of difficulties in the Middle East. The conflict between Israel and Lebanon went very poorly in August for all sides and has exposed Israel, in our opinion, to a number of near-term risks. Should the government in Syria read the lack of success by the Israeli defense forces this past summer as a potential weakness, it may indeed be tempted to engage in a possible retake of the Golan Heights. Another scenario would be the perception by Syria that it can diplomatically take back part of the lost territory of 1967 by engaging the various parties involved in Iraq with a comprehensive and temporarily constructive peace plan. Time will tell, but the Middle East situation in general, and in Iraq in particular, is very dangerous, and can lead to unexpected developments during the new year. Similarly, the situation in Pakistan may also deteriorate quite quickly as President Musharraf’s role in the war in Afghanistan and Iraq

has clearly not been popular inside Pakistan. Any conflict of this kind or, importantly, any large terrorist activity in the Middle East, could also lead to a short-term spike in the price of oil and petroleum products, which could cause a further slump in many global economies.

Although the spotlight is clearly not on the issue of Avian (bird) flu such as it was twelve months ago, it is important to note that deaths due to H5N1 continue to mount and that the number of people who have died from this very lethal strain of bird flu in 2006 has already surpassed the total number of deaths in the previous years. The recent deaths in Egypt during the days leading up to the New Year have only further illustrated that this issue is far from over and needs very active international cooperation in order to control any potential outbreak during the sensitive winter months. International agencies such as the World Health Organization and the United Nations have been very clear on the importance of this issue even though public anxiety has clearly dropped from levels in the fall of 2005 and early 2006. Finally, any discussion of geopolitical threats cannot exclude the possibility of additional terrorist acts. Many readers will remember how close we came to witnessing acts of terrorism in August of last year as flights leaving Heathrow Airport heading for North America were targeted to explode in midair. Although now over five years since the sad events of 9/11, we cannot totally dismiss these kinds of risks as having a profound effect on financial markets in a very short period of time.

Many of our dear friends have asked me from time to time to recommend books on my ever-expanding list. In light of these requests, I would certainly be happy to share and recommend the following

“The Dirty War” by Anna Politkovskaya. Many of you will remember that Ms. Politkovskaya was murdered outside her Moscow apartment earlier in the fall of 2006 in events that may be linked to the poisoning by polonium of Alexander Litvinenko in London towards the end of the year. A keen critic of the Kremlin, Ms. Politkovskaya here writes about the war in Chechnya. Furthermore, I would like to recommend the following two books on China. The first by Seth Faison “South of the Clouds: Exploring the Hidden Realms of China”, is a very readable and eye-opening account of what is happening in China. The second, “China Shakes the World: A Titan’s Rise and Troubled Future – and the Challenge for America” by James Kynge, has been mentioned by many others and should serve as a salutary reminder to investors today.