The stock market suffered its worst day of trading since September 11th, 2001, when on February 27th the Dow Jones Industrials declined 416 points over concerns that the U.S. and Chinese economies were slowing more than investors anticipated. The Dow Jones Industrials (-2.8%), Nasdaq Composite (-1.9%), and Standard & Poor’s 500 (-1.9%) all finished the month with losses. All of the market averages have moved into negative territory for the year. Utilities led sector performance with a gain of 4.7%. Financials were the worst performing sector with a loss of 3.2%.

Ben Bernanke, the Federal Reserve Chairman, testified before Congress just two weeks ago on the state of the economy. His rosy outlook for economic growth and employment, combined with indications that the housing market was finding a bottom, drove the Dow Jones to record highs. Just one month ago, market strategists were concerned about accelerating economic growth, strong consumer spending trends, and the possibility of rising inflation and interest rates. What happened?

We believe the recent acceleration in economic growth is now behind us. Fourth-quarter GDP growth was revised down to 2.2% from a previously reported 3.5%. First-quarter growth appears to be running at a sub-3% rate. The market was clearly caught off guard by a record 9% one-day decline in China’s stock market but, let’s consider the fact that China’s market was up 100% last year! We believe the recent correction in both U.S. and Chinese markets was simply that – a correction. The two primary concerns that market participants should have regarding the current stock market are inflation and interest rates. At this stage, both are declining, which is very positive for stocks.

We do not share Bernanke’s rosy outlook for the housing market, employment, and consumer spending. For the following reasons, we feel that economic growth will slow to 1-2% in the second half of 2007 prompting the Federal Reserve to begin cutting short-term interest rates. The Federal Reserve Board has tightened monetary policy for an extended period of time since June 2005. Energy prices have risen substantially over the last two years. Real growth of the U.S. economy has started to moderate with the declining growth of consumer spending on automobiles and housing. Consumer price inflation has been moderating. This is a positive backdrop for the stock market with overall profits continuing to rise. However, if the Federal Reserve does not respond quickly to signs of further significant weakening in real growth, we may take further defensive action in our equity portfolios.

The housing market is far from a bottom. Mortgage delinquency rates are on the rise and several sub-prime lenders have gone bankrupt. Foreclosure filings are up 25% and housing vacancy rates are up 35% — both records. As more loans go bad, regulators will increase pressure on lenders to tighten standards, and credit availability will decline. This will reduce demand for homes and put further pressure on prices, which we see suffering their first ever annual decline. Moreover, we believe the problems in housing are not restricted to sub-prime loans. Many prime borrowers that used Alt-A loans (adjustable-rate and interest-only) will suffer from having bought homes they couldn’t afford with traditional loans. As loan rates adjust upward, they will not qualify for lower-rate traditional loan refinancing due to stricter lending standards. Previously, when these homeowners found that payments were unaffordable, they were able to sell their homes for a profit as prices rose. Should the recent cycle of Fed tightening result in a financial crisis, we believe it will be in the sub-prime and Alt-A lending business. This is not an insignificant figure. Approximately $2.4 trillion of the $10.2 trillion in residential mortgage loans outstanding at the end of last year were sub-prime or Alt-A loans.

The unemployment rate has started to rise and companies continue to cut wages and benefits. Weekly unemployment claims are running well above their fourth-quarter level. As the housing market continues to deteriorate, and companies outsource abroad or cut salaries and benefits to protect profit margins, the unemployment rate will approach 5%. We believe employment growth could slow to zero.

Consumer spending must slow. The savings rate was negative for all of 2005 and 2006. The only other time this occurred was during the Great Depression in 1932 and 1933. Neither Congress or President Bush have proposed a fix for the AMT tax which will impact more than 20 million middle-class Americans with annual incomes ranging from $70,000-150,000 per year. The AMT tax will eliminate nearly 60% of all the tax reductions implemented by President Bush and will drain consumers of an additional $50 billion. Under the Bush budget, seniors will be paying a larger share of their Medicare expenses as a result of no longer indexing income thresholds to inflation. Mortgage equity withdrawal (MEW), which has powered consumer spending over the past three years, peaked last year at $870 billion. It has now declined nearly $500 billion. All of these factors will be a tremendous headwind for consumer spending in 2007.

A timely response by the Federal Reserve to the deterioration in housing and consumer spending is critical to our bullish market outlook. Corporate earnings growth is forecast to slow to 4.1% in the first quarter, but we believe future market gains will be realized as stock price market multiples expand in response to lower interest rates as a result of lower inflation.

We believe U.S. government bond prices will rise as long-term interest rates decline to 4% due to the slowing economy, but we see problems for low quality, high-yielding debt. Spreads should widen from record low levels, leading to lower returns for high risk bonds. By the same token, we believe large global company stocks will outperform their smaller, more speculative brethren in the months ahead.

We reduced our exposure to the stock market in January (review last month’s Market Outlook) in our model equity asset allocation and our large cap growth portfolio by 5% and 10% respectively. We repositioned the cash in our equity asset allocation into U.S. Government bonds in anticipation of slower economic growth and declining long-term interest rates. We continue to look for opportunities to reposition the cash in our large cap growth portfolio in anticipation of a recovery from the recent market decline that will move the market averages to new highs in 2007.

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