As we entered the third quarter of 2007 the economy appeared poised to regain its growth after a slowdown in the first quarter. Most economists and market strategists were positive regarding the outlook for the economy and the equity markets for the remainder of the year.  Both the Dow Jones Industrial Average and the S&P 500 Index registered new highs after having peaked seven years earlier in 2000.

However, investors became cautious after the announcement that several hedge funds had financial difficulty as a result of investments in mortgage backed securities. This led to a more detailed evaluation of the deterioration of the housing market and particularly sub prime lending.

The repricing of risk and the commensurate decline in stocks and high yield bonds in the summer of 2007 began several years ago. Traditional investments for investors are portfolios comprised of stocks and bonds. These securities are at the very heart of a capitalistic economy as they offer ownership with liquidity.  As the inflation rate declined over the last several years the rate of return on bonds also declined.  With declining interest rates investors lengthened the maturities in bonds to capture a higher rate of return.  As this process continued, interest rates on longer maturities declined.  Eventually a flat yield curve developed with lower interest rates across all maturities. 

In a response to these lower interest rate yields, investors were encouraged to take higher risk either by borrowing to leverage their investments or by lowering the quality of their investments to achieve higher returns.  A variety of investments were created to achieve these objectives.  It began with sub prime mortgages and expanded to high risk corporate borrowing.  These issues were then packaged into mortgage backed securities and collateralized debt obligations.  The pyramid continued with credit derivative issues and other forms of lesser quality securitized investments.  The rating agencies such as Standard & Poors and Moodys were encouraged to provide high quality ratings to these packaged securities in order to attract investors.

A “repricing of risk” for a variety of investments was the logical next step. In this process there became a realization that several excesses had developed in the economy besides the obvious ones in housing. Many financial service firms had over expanded and are now in the process of scaling back. Of course those industries that support housing are also experiencing slowdowns. 

We expect a return of the positively sloped yield curve where higher yields are provided for longer term maturities giving recognition to their higher risk.  In the equity markets, we expect a continuation of the movement to large capitalization stocks. This is all part of the process of repricing risk and adjusting values more realistically. In this process, investors with long term horizons will continue to be rewarded.  

Abner, Herrman & Brock Asset Management

Founded in 1981, Abner, Herrman & Brock Asset Management manages portfolios individually structured to assist each client in achieving their investment objectives.  Stock portfolios are managed utilizing a Core Equity philosophy, investing in both large capitalization value and growth disciplines with an objective of long-term, after-tax appreciation and below market volatility. Portfolios are diversified across economic sectors, industries and companies.  Bond portfolios are managed to provide a high rate of current income.  Portfolios are invested in staggered maturities of U.S. Treasury, government agency and investment-grade corporate bonds and where appropriate, investment-grade municipal bonds. Portfolio managers are available to meet with clients upon request.

Please visit our web site at www.ahbi.com for a more detailed description of our investment Philosophy, Process and People.