PDF version of the Market Outlook

Oil prices soared to a record $147/barrel in July on the same day the stock market recorded new lows on the year. As oil retreated nearly 17% from those highs in the days that followed, the stock market responded with an impressive recovery led by the financial sector. The Dow Jones Industrials (+.25%) and Nasdaq Composite (+1.4%) ended the month with modest gains, but the Standard & Poor’s 500 (-1.0%) finished the month with a modest loss. Financials led sector performance with a gain of 6.8%, while energy was the worst performing sector, posting a loss of 14%.

It was no coincidence that the decline in stocks converged with a new all-time high in oil. When oil prices go up, stocks go down, and when oil prices go down, stocks go up. It has been as simple as that for some time. What sent the stock market, and financial stocks in particular, plummeting well below their January and March lows was yet another chapter in the never ending saga of market manipulation.

Selling a stock short is a common tactic whereby an investor places an order to sell a stock he does not own. The investor then hopes the stock declines so that he can repurchase it at a lower price and book the profit. Regulations require that the investor borrow the stock from an existing shareholder who is willing to lend it before executing the sell transaction, and return the shares after buying them back. Naked short selling is an illegal practice whereby an investor or institution places an order to sell a stock without ever borrowing the shares. It is not difficult to understand how much damage an unlimited volume of sell orders can do to a particular stock or group of stocks. The financial sector was victimized by such an onslaught until regulators announced a temporary ban on this practice for a select 19 financial companies. The very next day, on July 16th, financial stocks soared and the stock market followed. Oil simultaneously began its steep decline.

Please do not ask us why regulators would temporarily ban an already illegal activity for just a handful of stocks. It is quite obvious that naked short selling has been a common practice among Wall Street brokerage firms, at the behest of their best institutional clients, for a very long time. It simply reached a point of anarchy similar to the episode in March that led to the demise of Bear Stearns.

We have outlined for several months the various forms of speculation and market manipulation that have infected the equity, fixed-income and commodity markets like a constantly mutating virus. The weapons of financial destruction used in this endeavor include credit-default-swaps, commodity futures contracts and now naked short selling. A lack of regulation and oversight has paved the way for this abuse. We believe these collective activities have resulted in nonsensical market prices for all asset classes (stocks, bonds and commodities), leading most market participants to the false conclusion that these distorted prices reflect a grim reality. We can’t blame investors for being disillusioned about what has become a high stakes Monopoly game, but we believe those not swayed by the emotional herd are about to receive a Get Out of Jail Free card and evict the market manipulators from their roost on Park Place at the same time.

Tops and bottoms in the stock market are typified by relatively short periods of time when perception could not be further from reality. Everything in between is a gradual revision to the mean, like a pendulum swinging back and forth. These inefficiencies in market prices are what present investment opportunities. Warren Buffet once said, “Be greedy when others are fearful, be fearful when others are greedy.” We know fear is in abundance, so it must be time to get greedy, keeping in mind that short periods of time are defined by months and not days.

The major crisis this stock market now faces is one of confidence. The television and print media, as well as the majority of market pundits, continue to fan the flames of pessimism. Where were these bearish forecasts in the summer of 2006 when home prices were peaking, or in summer 2007 when the mortgage meltdown began to unfold, or in January 2008 just before the credit crisis reached full tilt? We hate to disappoint those who continue to wallow in despair and embrace the most negative of market and economic outlooks, but the glass is half full, not half empty.

There is light at the bottom of the housing market abyss. The rate of monthly declines in home prices has slowed for three consecutive months. The volume of subprime mortgage rate resets will decline dramatically this fall. The number of unsold homes has stopped rising and new listings now match demand for the first time since 2005. The rate of new mortgage delinquencies has fallen for several months, and we have yet to see the impact of the new housing bill just signed into law by the President this week. This is improvement!

The economy grew nearly 2% in the second quarter, thanks to strength in capital spending by corporations, trade and consumer spending. This was an increase from less than 1% in the first quarter. Growth will remain sluggish, but this is not a recession. Consumer confidence actually rose this month from a 16-year low for the first time this year. We expect the November elections will result in a further boost to confidence, regardless of the outcome, based purely on the fact that the Bush administration will be gone.

Inflation is now the greatest obstacle to higher stock prices, and the price of oil is at the core of our inflation problem. The Goldman Sacs commodity index is up 70% year-over-year, matching the peak reached in 1973. The result has been a slowdown in global growth, which we expect to bring down commodity prices, led by oil. As the price of oil declines, so will the rate of inflation. This will allow the European Central Bank to lower its short-term interest rates, which will in turn strengthen the dollar and put further downward pressure on oil prices. This will ultimately lead to higher stock prices as corporate earnings continue to grow, albeit at a slow rate, but valuations increase. A lower inflation rate reduces borrowing costs, improves operating margins and increases consumers’ purchasing power. This is the key to the market recovery.

We believe the financial and technology sectors will emerge as performance leaders in the second half of the year at the expense of the energy, industrial and materials sectors. We see no change in the 2% Fed funds rate until next year, as economic growth remains sluggish and the unemployment rate continues to rise modestly. The alternative energy sector should emerge as the next great growth story over the next several years, as the global economy adapts to address both climate change and the limited resources available to meet the demand of an emerging middle class in developing countries.

Fuller Asset Management, LLC (“Fuller Asset Management”) is an SEC registered investment adviser. The Fuller Large Cap Growth Composite Portfolio (the “Composite Portfolio”) represents actual client accounts invested according to Fuller Asset Management’s proprietary investment strategy. The Composite Portfolio invests in individual large cap equity securities with a view toward capital appreciation.

The results of the Composite Portfolio are net the actual Fuller Asset Management investment advisory fees charged to the client accounts within the composite, brokerage commissions and other expenses. Fuller Asset Management’s investment advisory fees are described in the disclosure statement of Part II of the Form ADV which is available upon request.

The results of the Composite Portfolio include the reinvestment of dividends. Comparison of the Composite Portfolio to the Russell 1000 Growth Total Return and the S&P 500 Total Return is for illustrative purposes only and the volatility of the Russell 1000 Growth Total Return and S&P 500 Total Return may be materially different from the volatility of the Composite Portfolio due to varying degrees of diversification and/or other factors.

Past performance of the Composite Portfolio may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above, in part because client accounts may be allocated among several portfolios. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

PDF version of the Market Outlook

The stock market plunged in June with the Standard & Poor’s 500 (-8.4%), the Dow Jones Industrials (-10.2%) and the Nasdaq Composite (-9.1%) all suffering significant losses. Energy led sector performance with a gain of 2.2%, while financials were the worst performing sector, posting a loss of 18.7%. We would prefer to discuss the outlook for corporate earnings and the economy, or the merits of traditional asset classes like stocks, bonds and cash, but at this point in time it is all about the emergence of a new asset class — Oil!

When we fail to maintain or significantly weaken regulations designed to improve transparency, maintain market stability and prevent manipulative practices, we are more likely to see an allocation of investment capital that destroys more than it creates. This practice is known as malinvestment. Proponents of free markets are ardently opposed to regulation of any kind, but the ultimate price we pay for unregulated free markets may not be as “free” as we originally thought. We are still suffering from the ill effects of loose lending standards and the promotion of exotic mortgage products that led to the housing bubble.

The losses resulting from mortgage delinquencies and home foreclosures have been dwarfed by those incurred in the unregulated credit default swap (CDS) market. These derivative contracts were invented a decade ago with the intention of minimizing risk by allowing a bond holder the ability to insure his principal, should the credit of the issuer deteriorate, much the same way one purchases life insurance to insure his family against financial loss in the event of his death. A lack of regulatory oversight enabled speculators to purchase this insurance with the intent of betting against a company’s ability to repay its debts, rather than insuring against loss.

Compounding the risk is the practice of selling these insurance contracts to multiple speculators, none of whom owned the underlying debt, and not requiring the underwriters to maintain any capital to meet potential claims. This arrangement gives the purchaser of a credit default swap a vested interest in damaging the reputation and credit rating of the company issuing debt, in an effort to increase the possibility of default, thus realizing a claim. The destructive misuse of these financial instruments has only served to further tighten credit markets, prolonging and deepening the economic downturn.

Now we face the repercussions of malinvestment of a different sort, as our largest investment institutions continue to transition from financial assets into hard assets. The deregulation of futures markets has opened the floodgates to an investment flow that our commodities markets are too small to absorb. This has resulted in an exaggeration of the current uptrend in oil that we contend could be as much as $40/barrel. These investors claim oil’s record price increase year-to-date is based solely on supply and demand fundamentals, but we don’t see lines at the gas pump, or an outcry from oil importing nations that they are unable to obtain the oil they need. To the contrary, today’s high prices are destroying demand and the outlook continues to weaken as oil consumption in the U.S. is on pace to decline year-over-year. The rise in oil prices this year is due to speculation on concerns about future oil supply and demand. When prices realign with today’s reality, investors will look to take profits and sell with the same ferocity with which they bought futures contracts.

The stock market corrections in January and March can both be attributed to the escalation of the credit crisis, but the retest of these lows in June is a direct result of inflation fears due to rising oil prices. We see a reversal of the destructive trends in both credit and commodity markets in the second half of this year that will result in a substantial rotation out of those sectors that have been the greatest beneficiaries of global growth - energy, industrials and materials. We think the primary beneficiaries of this rotation will be the technology and financial sectors.

The incremental increase in demand for raw materials and energy over the past five years is a direct result of growth in developing countries. As prices for commodities soar, the central banks in these countries continue to raise interest rates to combat inflation, in turn slowing economic growth. We believe the fundamentals for the energy, materials and industrial sectors are gradually deteriorating as many companies become victims of their own success. A peak in the cycle is near when the price increases that material companies are obtaining no longer offset their own transportation costs, and energy stocks are no longer appreciating commensurate with the rise in the price of oil they sell.
China joined India and other developing countries in cutting fuel subsidies last month, which effectively raised fuel prices 17%.

We believe that demand destruction will ultimately reverse the investment flow into oil, leading to a decline in price closer to $100/barrel. This will remove a major obstacle to higher stock prices outside of the energy, industrial and material sectors, as inflation fears dissipate, and consumer confidence and investor sentiment improve.

It may seem as ludicrous as proposing in 2006 that home prices would suffer their first annualized decline on record, but we see improvement in the sub-prime mortgage market and in the fundamentals for the banking industry. The dollar volume of newly delinquent sub-prime loans originated in 2006 and 2007 has been steadily declining this year, as has the rate at which delinquent loans move into foreclosure. This means credit quality is improving for the banking industry at the same time deposits are increasing, profit margins are rising and costs are going down. We believe the write-offs already accounted for by the financial industry will far exceed the loan losses ultimately realized. As credit quality improves, the accounting losses on the balance sheets of financial companies will become realized gains. We believe the sector presents one of the best long-term investment opportunities since the early 1990s.

While most people admire Warren Buffet’s investment acumen, very few have the patience to share his investment time horizon, or his ability to look past the emotion that dictates short-term movements in the market. Market bottoms take time to form and usually occur when the outlook is at its worst, yet we still see reasons to be optimistic. The U.S. economy is not in recession, corporate earnings continue to grow outside the financial sector and the liquidity necessary for the stock market and economy to recover is available in the form of $4.5 trillion in cash yielding less than 3%. The Federal Reserve was the first central bank to begin raising rates in 2004 and the U.S. economy was the first to slow. Since the Federal Reserve was the first central bank to lower rates, we expect the U.S. economy to be the first to recover. We have reduced our exposure to the energy, industrial and material sectors and increased our exposure to technology with a focus on alternative energy. We believe the recent spike in oil will lead to a global boom in alternative energy-related spending with the prime beneficiaries being wind and solar. It should be a wakeup call that leading oil producing nations in the Middle East are investing more capital in renewable energy than we are in the United States.

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The stock market rose for a second month in a row with the Nasdaq Composite (+4.6%) leading the advance, while the Standard & Poor’s 500 (+1.3%) inched higher , and the Dow Jones Industrials (-1.4%) fell modestly. Technology led sector performance with a gain of 5.5%, while financials were the worst performing sector, posting a loss of 6.4%. The recent rise in stock prices would seem to contradict the consensus view that a recession is either pending or upon us, yet most investors forget that the stock market is a forward-looking economic indicator that discounts future events.

Those embracing an overly pessimistic view of the stock market and economy point to the decline in consumer spending and confidence, falling home values and mounting unemployment claims as reasons to avoid stocks and forecast recession. Many will also point to the continued fall-out from the credit crunch that crippled our financial system over the past year and led to billions in losses from sub-prime loans and credit derivatives (credit default swaps). Today, the rise in gas prices to $4/gallon, oil eclipsing $132/barrel and a global food crisis are dominating the headlines. We believe inflation continues to be the greatest concern for investors as it has stifled the potential for any sustained advance in stocks over the past 18 months. While all these factors are relevant, they are predominantly lagging indicators, telling us little about what to expect moving forward.

The last time we saw such a resounding consensus was in 2003, but the forecast then wasn’t for inflation, it was for deflation! Oil was a mere $20/barrel. Yet this marked the beginning of the greatest five-year bull run in commodities we have ever seen. Today’s debate is centered on how high food and energy prices will soar, based on limited supplies and the uninterrupted growth of developing countries like China and India. As difficult as it was to buy an energy stock, a commodity fund or a barrel of oil for $20 in 2003, it feels equally as misguided to sell them today, but reducing exposure to this sector is the prudent move.

We continue to believe the rate of inflation (CPI) in the U.S. peaked at 4.4% earlier this year after doubling from just 2% in 2007. While the food and energy components of the consumer price index (inflation) have soared, wages remain stagnant and falling home prices have limited rental inflation. Wages and rents combined represent a larger percentage of the CPI than do food and energy. Rising food and energy prices can be deflationary forces in an environment when wage growth is stagnant, because these price increases act like a tax increase, reducing the demand for other goods and services. We now believe we are nearing a pause, if not a significant correction, in the broad commodity complex, as two forces supporting the recent parabolic move in commodities change direction.

It was the explosive growth in developing countries, led by China, which accounted for the incremental demand in raw materials, food and energy, and resulted in the rise in commodity prices over that past five years. Yet it is the speculative investment flow into financial instruments that track these commodities on futures exchanges, seeking to capitalize on this incremental demand for financial gain, that has led to the parabolic rise in prices over the past year. Fortunately, we see a decline in the rate of growth in developing countries combined with increased regulation of commodity trading markets putting downward pressure on food and energy prices in the second half of this year.

China is the growth engine of the developing world, but most investors do not realize that the majority of its economic growth (60%) is derived from exports to the U.S. and Europe. Many other developing countries derive their economic growth from exports to China. With the U.S. economy at stall speed and European growth slowing rapidly, it is unlikely that China and the rest of the developing world will be able to maintain their rapid growth. Domestic consumption in the most populous countries of China and India combined is less than that of the United Kingdom and not significant enough to offset declining exports. The dramatic declines in the stock markets (leading indicator) of these developing countries over the past six months are also indicative of slower economic growth ahead.

With respect to oil, many developing countries have artificially inflated their demand for fuel by limiting price increases for consumers through subsidies to oil refiners. As a result, despite soaring oil prices, consumer demand has not declined as it has in the U.S., and the governments of these countries have absorbed the escalating costs. This tide has now turned. Indonesia recently raised fuel prices 30 percent, and Taiwan and Malaysia have announced plans to cut subsidies. We believe China will wait until after the summer Olympics to raise fuel prices. Subsidizing rising fuel costs is not likely to continue, as exports and trade surpluses decline.

We believe demand has been further artificially inflated by institutional investors whose only motivation is financial gain. While the debate about the role speculation has played in rising commodity prices continues, an independent mind need only look at the increase in dollar volume of crude oil futures contracts traded each day to find the answer. Over the past five years the dollar value has risen from under $10 billion per day to nearly $140 billion today. The dynamics of the futures markets have changed completely.

A futures contract represents the market price of a physical commodity at some point in the future. Traditionally, futures market participants were either the producers or users of the physical commodity, or speculators on futures exchanges that provided the market with liquidity by selling when prices were too high and buying when prices were too low. Traditional speculators are limited in the size of the positions they can hold to limit their influence over spot prices. Over the past five years, as stocks and real estate lost their luster, institutions have diverted billions into commodities through the futures market in an effort to capitalize on growth in the developing world. The continual and escalating flow of funds into a buy-and-hold strategy of a basket of commodities with no sensitivity to price has led to the parabolic move in prices over the past year. The regulatory body for the futures exchanges (CFTC) has compounded the problem by exempting Wall Street banks from the limits under which traditional speculators operate. As a result, anyone can use a Wall Street bank as a counter-party to speculate on commodity prices with no limitations. We believe futures contract prices are now dictating spot prices to the benefit of no one other than those seeking financial gain.

Commodity prices have clearly divorced from fundamentals in our opinion, particularly in the oil market. We believe new regulations will limit the flow of funds into commodity exchanges just as demand from developing countries deteriorates, resulting in a significant correction in commodity prices. Oil prices are likely to fall back below $100/barrel. A decline in food and energy prices would lead to a lower rate of inflation in the U.S. and eliminate what we see as the major impediment to higher stock prices. We continue to believe the stock market bottomed in March and that the rally that followed will continue through the remainder of 2008, leading to new highs for the S&P 500.

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Despite an overwhelming consensus that the U.S. is in recession, the economy grew a modest .6% in the first quarter of this year. The Dow Jones Industrials (+4.5), Nasdaq Composite (+5.9%) and Standard & Poor’s 500 (4.9%) all finished the month with impressive gains that ended five consecutive months of decline. Energy led sector performance with a gain of 10.9% as oil approached $120/barrel, while consumer staples was the worst performing sector, posting a loss of less than 1%.

We have maintained since June 2006 that the U.S. would experience a period of slower economic growth (mid-cycle slowdown) as a result of the rise in short-term interest rates from 1.0% to 5.25%. This rise in rates burst the speculative bubble in housing last summer, which then led to the current financial crisis in credit markets. The Federal Reserve responded to these events last September by aggressively lowering short-term interest rates, culminating in the most recent cut of ¼ point this week, leaving the Fed Funds rate at 2%. We believe this will have concluded the Fed’s rate cutting campaign and will mark an important turning point in the investment and economic outlook.

Most people blame the decline in home prices and the ensuing financial crisis for the stock market correction over the past few months, but the real culprit has been inflation. The stock market has been trading in a narrow range for more than a year, despite healthy corporate profits outside of the financial sector, because the nominal rate of inflation doubled due to the rise in food and energy prices. Much of this rise can be attributed to the rapid growth of developing countries like China and India, but we believe the rise in recent months has a speculative fervor similar to that which led to bubbles in tech stocks and home values.

The weakening U.S. economy, reinforced by recession forecasts from the media and most economists, combined with a mounting budget deficit caused by the war in Iraq and lower short-term interest rates, have all devastated the value of the dollar. Commodities have long been a traditional hedge to a falling U.S. dollar, but the speculative flow of institutional and individual investment funds into this asset class is unprecedented. Nearly $40 billion of the $70 billion invested in the past year was put to work in the first quarter of 2008. The registration of countless investment vehicles in recent months that package combinations of everything from crude oil to grains to metals leads us to the conclusion that the entire commodity complex is long overdue for a dramatic price decline.

Commodities are now being used to speculate on continued weakness in the dollar and the U.S. economy, as opposed to hedging other asset classes, which in turn is putting upward pressure on inflation. Despite slowing growth in Europe, concerns over rising inflation have prevented the European Central Bank (ECB) from lowering short-term interest rates, which in turn has put more downward pressure on the U.S. dollar and furthered the rise in commodity prices. We believe a reversal of this self-feeding loop began yesterday with a positive first-quarter GDP report that diminished both recession fears and expectations that the Federal Reserve has lowered interest rates for the last time. The dollar ended the month of April with its first monthly gain in nearly four years. We believe that there will be further evidence that the U.S. economy has averted recession and that the Federal Reserve has moved from an easing to a neutral interest rate policy, which will lead to a strengthening dollar and an unwinding of speculative positions in commodities.

Hastening the decline in commodity prices will be slower rates of growth for the developing world. We believe the correction over the past six months in the stock markets of developing countries like China and India are indicating slower economic growth in these countries in the months ahead. The Chinese Central Bank continues to raise short-term interest rates, limit loan growth and appreciate its currency in an attempt to contain inflation. China has been responsible for the majority of the world’s incremental oil demand over the past several years, and its need for imported goods has helped the economic growth of many other developing countries that depend on exports. If China slows, as we expect it will, so will the rest of the developing world.

The implications of a decline in commodity prices, led by slower rates of global economic growth and a strengthening of the U.S. dollar, would be a lower rate of inflation in the U.S. and a significantly higher stock market valuation. We believe the U.S. will be the best performing of the global stock markets in 2008. While the central banks of most countries around the world either continue to tighten monetary policy or have yet to begin lowering interest rates, we believe the Federal Reserve has successfully navigated a hard landing that will lead to slow yet positive economic growth for the remainder of the year.

The $100 billion in tax rebate checks from the stimulus package that are being issued this month will lift disposable income and consumer spending, resulting in positive economic growth in the second quarter. The interest rate cuts by the Federal Reserve that began last September will positively impact economic growth in the third and fourth quarters of this year. Despite the fiscal and monetary stimulus, we expect home prices to continue to decline and the unemployment rate to continue to rise, as the U.S. consumer embarks on a period of deleveraging that lasts several years.
This is far from an optimistic forecast for the U.S. economy other than the fact we do not see a recession in 2008. Our optimism for the U.S. stock market stems from historically low valuations, slowing yet positive corporate earnings growth and unprecedented amounts of liquidity around the world that needs to be invested. We believe an easing of inflation concerns in the U.S. will be the catalyst that ignites a sustained rise in stock prices.

Fuller Asset Management, LLC (“Fuller Asset Management”) is an SEC registered investment adviser. The Fuller Large Cap Growth Composite Portfolio (the “Composite Portfolio”) represents actual client accounts invested according to Fuller Asset Management’s proprietary investment strategy. The Composite Portfolio invests in individual large cap equity securities with a view toward capital appreciation.

The results of the Composite Portfolio are net the actual Fuller Asset Management investment advisory fees charged to the client accounts within the composite, brokerage commissions and other expenses. Fuller Asset Management’s investment advisory fees are described in the disclosure statement of Part II of the Form ADV which is available upon request.

The results of the Composite Portfolio include the reinvestment of dividends. Comparison of the Composite Portfolio to the Russell 1000 Growth Total Return and the S&P 500 Total Return is for illustrative purposes only and the volatility of the Russell 1000 Growth Total Return and S&P 500 Total Return may be materially different from the volatility of the Composite Portfolio due to varying degrees of diversification and/or other factors.

Past performance of the Composite Portfolio may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above, in part because client accounts may be allocated among several portfolios. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

PDF version of the Market Outlook

We believe the financial crisis that began last summer with the demise of two Bear Stearns hedge funds ended in poetic justice two weeks ago with the failure of Bear Stearns itself. The stock market retested its January lows with the Dow Jones Industrials (-.03%), Nasdaq Composite (+.30%), and Standard & Poor’s 500 (-.60%) all finishing the month relatively unchanged. Telecommunications led sector performance with a gain of 4.9%, while healthcare was the worst performing sector, posting a loss of 5.0%.

It is not money supply or the demand for credit that has plagued our financial system, but the fear our financial institutions have of losing capital, with the resulting lack of credit availability. This financial crisis may have started on Main Street, with falling home prices that triggered a steady rise in delinquencies and foreclosures resulting from loose lending standards and speculative borrowing, but the magnitude of the losses and severity of the crisis can be blamed on Wall Street.

The near bankruptcy of investment bank Bear Stearns and the rumored demise of several other major financial institutions had little to do with mortgage delinquencies and foreclosures. These problems were the result of a crisis in confidence instigated by rumor and speculation in an effort to reap gain in the unregulated credit derivatives markets. This was a classic “run on the bank” until the Federal Reserve stepped in two weeks ago and changed the rules of the game.

In just the past few years the market for an investment tool created in the mid-90’s to manage the credit risk of fixed income products grew from $900 billion in 2001 to become the largest derivatives market in the world, totaling $45 trillion today. This investment tool is called a credit default swap or CDS. A CDS is similar to an insurance policy whereby a seller or underwriter guarantees the return of principal on the value of a bond in the event of default to a purchaser for a premium. The CDS represents the value of the premium that must be paid to guarantee the bond. If the credit worthiness of a company or bond issuer is deteriorating, then the value of the credit default swap would increase, reflecting the higher cost to insure against loss. This investment tool was originally created to allow bond holders to minimize the risk of default. Over the past two years CDSs have primarily become tools to speculate on a company or bond issuer’s demise, whereby the purchaser of the CDS does not own the underlying bond and seeks to gain only in the event of default or bankruptcy.

The primary sellers of credit default swaps have been commercial banks like JP Morgan, Citigroup and Bank of America. As delinquency and foreclosure rates rose last year, speculative buying of CDSs by hedge funds on the debt of lending and investment companies soared, driving up the value of these instruments. The rising value of the swaps influenced negative outlooks by rating agencies, further increasing the value of the swap. The financial institutions selling credit default swaps were forced to mark-to-market the rising value of their outstanding obligations, leading to write-downs or losses that may never materialize. These paper losses effectively reduced the capital held by our major lending institutions necessary to create credit, despite the fact the Fed was lowering interest rates. We believe this unregulated market is the root cause of the credit crisis.

The Federal Reserve intentionally disrupted speculation in the CDS market by negotiating the bailout of Bear Stearns by JP Morgan, effectively wiping out the rising value of credit default swaps on Bear Stearns’ debt that were purchased by those betting on the firm’s demise and eliminating the obligation of the underwriters (perhaps JP Morgan). In addition, the Federal Reserve launched a new $200 billion lending facility open for the first time to investment banks in exchange for troubled mortgage-backed securities. These actions were designed to reduce credit risk, improve credit availability and send a message to speculators. A decline in credit risk will lead to a decline in the value of credit default swaps. As a credit default swap loses value it reduces the mark-to-market paper losses for the sellers and improves their capital position. The increase in capital then improves credit availability. We see little potential for actual losses in the financial system approaching anything close to current expectations, especially when the disseminators of these apocalyptic forecasts were clueless about the mortgage meltdown when it began a year ago.

The majority of economists and the public at large are convinced the U.S. is in recession. We do not agree. Unemployment claims and layoff announcements are running well below previous recessionary levels, and consumer spending is on track to post a small increase for the first quarter. The improvement in trade, due to a weak dollar and the benefit of inventory rebuilding, will lift economic growth, which we see being closer to 1% for the first quarter of this year. We believe the sudden realization that the economy continued to grow, despite the financial crisis, will be an important catalyst for the stock market recovery.

Other events we see in the months ahead underpinning a market rally are a decline in commodity prices, a firming of the U.S. dollar, rate cuts from the European Central Bank (ECB) and a decline in the rate of inflation that eases concerns of stagflation. Commodity prices have soared this year as the financial crisis intensified, despite recession forecasts in the U.S. and slowing economic growth around the world. We believe this rise was a direct result of a flight from stocks and bonds and a weakening of the U.S. dollar. We see a correction in commodity prices ahead that will firm up the value of the dollar. Any strength in the dollar will further accelerate the unwinding of speculative positions in commodities.

Inflation fears coupled with slowing economic growth (stagflation) have limited any upside in stock prices. We believe the rate of inflation peaked earlier this year, and that a correction in commodity prices will further alleviate inflation concerns in the months ahead. Lower inflation readings will allow the ECB to join the Federal Reserve in cutting interest rates in an effort to combat weak European economic growth. This will also have the effect of strengthening the U.S. dollar, which in turn will put downward pressure on commodity prices and crude oil in particular. This interrelationship between commodity prices, the dollar and inflation are critical to our bullish outlook.

We believe the stock market has bottomed, will recover its losses year-to-date, and finish 2008 with double-digit returns (20% upside from current levels) based on abundant liquidity, historically low valuations, and extremely negative investor sentiment. As the financial crisis fades and the enormous amounts of monetary and fiscal stimulus work their way through the economy, the hoards of cash on the sidelines will move back into the stock market in the months ahead.

PDF version of the Market Outlook

Despite aggressive policy action taken by the Federal Reserve and Congress in recent weeks, including passage of the stimulus package that will distribute $100 billion in rebate checks as soon as May, the stock market continued to probe for a bottom from the lows established in January. The Dow Jones Industrials (-3.0%), Nasdaq Composite (-5.0%), and Standard & Poor’s 500 (-3.5%) all finished lower for the month. Energy led sector performance with a gain of 6.7% as oil prices surged above $102/barrel, while continued write-downs of mortgage-related securities resulted in financials being the worst performing sector, posting a loss of 11.4%.

The markets are struggling for direction because investors are torn between hopes of an economic recovery later this year and fears of recession, stagflation and further losses on mortgage-related securities. Lawmakers are scrambling to rescue distraught homeowners with rate freezes, bankruptcy bills, government bailouts, and a variety of other proposals designed to stall a rise in the rate of delinquencies and foreclosures, stem the decline in home prices, and improve the availability of credit. The law of supply and demand will ultimately decide when and at what level the housing market will bottom. Achieving equilibrium will depend on future adjustments in home prices, wages and credit conditions. If home prices decline 10% in 2008, and another 10% in 2009, while wages rise 5% in both years, then median home prices will have reverted to their historical average of 2.7 times median income. Many are wondering why lending standards continue to tighten despite the decline in short-term interest rates. Wells Fargo announced last week that it is increasing the required down-payment to 25% for a jumbo loan origination. Why? Wells Fargo doesn’t want to risk a delinquent borrower with negative equity in his home should the home value fall 20%. This may be a prudent move, but it only serves to exacerbate the already strict lending environment. Ironically, the faster home prices decline so that supply and demand reach equilibrium, the sooner credit availability will improve.

We believe the stock and bond markets have more than compensated for the losses that will ultimately be realized from the decline in housing and the resulting credit crisis. As an example, Alt-A (one notch below prime) mortgage securities are now trading at approximately sixty-cents on the dollar. These valuations assume that 80% of all Alt-A borrowers default on their loans, and that the recovery rate on the underlying collateral (the home) is a mere 50%. This is unrealistic by any measure, yet markets are forward looking and reflect expectations, which are rarely consistent with reality over short to intermediate periods of time (6-12 months). The mark-to-market losses, or write-downs, on mortgage-related securities that have plagued the financial sector and resulted in tighter lending standards will eventually lead to mark-to-market gains on the same securities as the rate of delinquencies and foreclosures decline.

The credit crisis that resulted from this housing bubble has similarities to the stock market crash that resulted from the tech bubble in 2000. Back then, the supply of stock was well in excess of demand at a time when corporate earnings were declining, and the Federal Reserve was raising interest rates and removing liquidity from the financial system (limiting credit availability). Stock prices plunged, ultimately bottoming in 2003, yet eight years later the Standard & Poor’s 500 is still 6% below its 2000 level. The housing market is likely to follow a similar timeline. Home prices peaked in 2006, and will probably bottom in 2009, before they begin a gradual recovery that will take years. One major difference with respect to the stock market is that if we strip out tech sector earnings from the S&P 500 back in 2001, corporate profits were still plunging 20%, but if we strip out financial sector earnings today, profits are rising double-digits. We would argue that stocks are currently as undervalued as homes are overvalued relative to their historical average (20%).

Many of Wall Street’s most respected market strategists and economists have concluded that since the housing market is in decline and the American consumer is either ailing or on life support, the economy must be in, or near, a recession. Based on this assessment, the stock market poses too much risk for investors until there is an improvement in the outlook. We emphatically disagree. The economy grew 0.6% in the fourth quarter of 2007, and the most significant detractor from growth (-1.3%) was the biggest decline in inventories since the second quarter of 2003. Inventory rebuilding will now have a positive impact on growth in the first quarter along with exports. Consumer spending is on track to increase this quarter, and we have yet to see the boost that will result from rebate checks in the second and third quarters. The boom in demand for agricultural products from an emerging middle-class in developing economies has resulted in a 25% year-over-year increase in US farm sector output. While this sector represents a small percentage of the overall economy, it is on pace to add 0.5% to economic growth in 2008. Corporate earnings outside the financial sector grew 14% in the fourth-quarter of 2007, and we have yet to see the impact of 125 basis points of Fed easing that occurred in January. If we were going to have a recession this year, it would have already started.

Even if we assume the economy to be in a recession, this is not a good rationale for selling stocks. In January 1980, the economy entered a recession that did not officially end until July, yet the stock market (S&P 500) rose nearly 15% during that seven month contraction. The economy fell back into recession in July 1981, yet by the time the recession had ended in November 1982, the stock market was again higher than when the recession began. More applicable to today’s environment is the 1990-91 recession tied to declining home prices and a collapse in credit. The stock market reached all-time highs in July 1990, just one month before the economy entered a recession in August. Despite the fact that the stock market bottomed 20% lower just one month later in September, the recession continued until March 1991. By that time, the stock market had rallied 25% to new all-time highs from the lows established in September 1990, when the economy was in the early stages of recession.

What continues to feed our optimism about future stock market gains is the ever growing mountain of cash held by individuals and institutions that sits on the sidelines in money markets and CDs. The rates of return on these instruments has plummeted from what was 5% to what will shortly be 2-3%, as the Federal Reserve continues to lower short-term interest rates. This mountain of cash has grown 25% over the past year to approximately $4.3 trillion. We believe this money will work its way into a stock market that gradually rises up in the months ahead as recession and inflation fears dissipate and the credit markets normalize. The US economy will continue to grow a sluggish 1% in 2008. The developing economies that have served as the global growth engine will also slow, but to a lesser degree, leading to overall global growth of 2-3%. While commodity prices may remain elevated, this slower growth environment should alleviate some of the inflation concerns that have depressed stock prices.

PDF version of the Market Outlook

The crisis in credit markets that unfolded last summer quickly evolved into a crisis of confidence in the Federal Reserve, government leaders and the entire financial system. January began as one of the worst months for the stock market on record, with a decline in the Standard & Poor’s 500 of nearly 20% from the October highs, before the Federal Reserve finally responded with a 75-basis-point inter-meeting cut in short-term interest rates on January 22. The Dow Jones Industrials (-4.6%), Nasdaq Composite (-9.9%), and Standard & Poor’s 500 (-4.6%) all recorded losses for the month. Financials led sector performance with a gain of nearly 1%, while the technology sector was the worst performer, posting a loss of 12.4%.

The stock market decline began in late December with the release of inflation data that showed a 4.1% year-over-year rise in nominal inflation and a 2.7% rise in core inflation. This was the highest reading in 17 years. As the economic slowdown in the US accelerated, market pundits piled on the recession bandwagon, and the print and television media fanned the flames. Goldman Sachs forecast that the recession would begin in the second quarter of this year. Stagflation (rising inflation coupled with slowing growth) arose as a new concern for investors. The continued lack of acknowledgement and action by the current administration and the Federal Reserve Board drove stock prices lower. The absence of timely and aggressive Fed action in response to lower home prices and the slowdown in the rate of consumer-spending growth has been our key concern.

Ultimately, the decline in stock prices forced the Fed to cut short-term interest rates an astonishing 75 basis points last week, followed by an additional 50 basis points during the FOMC meeting this week, resulting in a Fed Funds rate of 3%. Washington leaders quickly outlined details of a $150 billion economic stimulus package. These actions tempered the psychological meltdown in investor confidence that rang in the New Year.

The stimulus package is designed as a bridge to increase consumer spending and corporate capital expenditure until the recent rate cuts take full effect later this year. We think these combined actions will prevent the US from falling into recession, although they are not a long-term solution to our nation’s problems. They will be instrumental in mending the negative consumer confidence and investor sentiment that led to the stock market meltdown at the beginning of the year. They will help avoid the negative-wealth effect of falling home prices and stock prices — a combination that would most certainly lead to a full-blown US recession.

Our longer term concern with the stimulus package is that the federal government is sending $100 billion that it doesn’t have in rebate checks to debt-laden consumers that need to save, in hopes that they will spend it. Isn’t this how we ended up where we are today? The budget deficit will increase and the consumer balance sheet will be no better off than before. This must be an election year! We are most likely delaying the inevitable – a consumer-led recession that will ultimately take hold, but now probably not until 2009. We see this as the lesser of two evils, for no response would surely lead to recession now. We are standing by our forecast for a continuation of the current economic expansion with economic growth of 1-1.5% in 2008.

Despite a continuation of the housing slump and lack of growth in consumer spending, we see reasons to be optimistic about the stock market this year in addition to the previously mentioned Fed actions and the economic stimulus package. Mortgage rates are near all-time lows and refinancing has soared. A proposal within the stimulus package to raise the GSE conforming loan limit from $417,000 to $729,725 will lower the interest rate on jumbo loans. LIBOR rates on which many adjustable-rate loans are based have fallen dramatically in the past month. All of these factors will reduce borrowing costs for many home owners.

We see both the core and nominal rate of inflation declining throughout the year. Declining home prices and restrained wage gains are limiting consumer purchasing power and the ability of service companies and retailers to raise prices. Globalization and advancements in technology combined with the huge increase in money supply are creating excess capacity and more competition, all of which are deflationary in our view. A decline in the rate of inflation will remove concerns about stagflation and, when combined with declining interest rates, should lead to multiple expansion and higher stock prices.

We believe current stock market valuations are reflecting a significant decline in corporate profits that has not and will not materialize. The S&P 500 is currently valued at a mere 14 times expected 2008 earnings, a level not seen since the corporate-led recession in 2002. Whether or not a recession does occur, we would argue that it has already been priced into the stock market. Bearish investor sentiment has reached a level not seen since the recession and market bottom in 1990. Both are factors which lead us to believe stock prices are set to rise in the months ahead. Declining rates of return for cash equivalents, as a result of lower short-term interest rates, also make stocks more appealing from a valuation standpoint.

We believe corporate earnings growth, while slowing, is much stronger than the headlines suggest. While fourth-quarter earnings for the S&P 500 are estimated to decline 20%, when we exclude the financial sector, earnings are on track to rise 11.4%. The majority of the 100% decline in financial-sector earnings is attributable to mark-to-market write-downs of mortgage-related securities. The value of these write-downs serves as a deduction against pre-tax income, despite the fact that no losses may have been incurred and the mortgage-related securities may recover their value over time. We believe this acceleration in write-downs into year-end (approximately $100 billion) now exceeds the ultimate loss that will be incurred by financials, presenting a great investment opportunity in the sector.

There is $1.2 trillion worth of sub-prime and Alt-A mortgage loans outstanding today, and approximately 15-20% of those mortgages are delinquent. If we were to assume the unlikely scenario that all of the delinquent mortgages went into foreclosure, and the recovery on sale was a mere 50% of the home value, the losses would amount to $90-120 billion. This is an amount that has already been collectively written down by the financial institutions holding these loans.
We remain overweight the energy, industrial and material sectors that benefit from a weak dollar and developing market growth. We are in the midst of a multi-year boom in the agricultural and commodity sectors due to an ever improving standard of living for the five billion people that live in the developing world. The steady growth in capital expenditures by corporations should lead to improving profits in the technology sector, which also remains an overweight in our portfolios. We believe financial sector out performance will be the greatest surprise in 2008, as these companies benefit from lower short-term interest rates, an improvement in net-interest margins, and easy year-over-year comparisons of profitability in the second half of 2008. We continue to avoid the domestic consumer-related sectors.

PDF copy of 4th Quarter Performance

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