January 2008

The overall performance of the markets in 2007 was somewhat disappointing. We thought we would share with you our research about the prospects for 2008.

There has been a large movement with the media and the public that says a recession is near, but we have not been able to uncover sufficient data to support that claim. We have not found a correlation between real estate prices and consumer spending, nor have we been able to find a correlation between lower consumer confidence and recessionary pressures. We are in the midst of a re-pricing event involving two of the three main classes of US assets, the credit markets and real estate which has partially spilled over into the stock market, especially the financial sector. The core fundamentals of the US stock market are very strong, however, and the consensus estimate for earnings growth on the S&P 500 for 2008 is approximately 15 percent, according to Reuters.

Many of you will recall that at the height of the Internet bubble, the media and financial services industry were touting a “new economy” and “new paradigm” while we were selling overvalued assets. Today, you will hear the same people talk about a recession and the collapse of domestic stock earnings, when we do not see much evidence to support those claims either. Stock prices look very attractive, and we are eager to take advantage of the deals even though transition periods in the market are always difficult to stomach. We would be selling if we believed there were significant fundamental risks in the domestic equity markets, however, another regression event in the domestic stock market such as the one that occurred between 2000 and 2002 is very unlikely in the near term.

The S&P 500 has nearly doubled in value since its bottom in 2002, but in spite of that, the underlying valuations of stocks have improved by 40 percent, dividend yields have increased by 35 percent, and gold has nearly tripled. 30 Year US Treasury bond yields have declined during that same time period, and our research indicates there is a grave imbalance in the credit markets, including Treasuries, that must correct. Long term interest rates will rise as the credit markets re-price themselves to reflect current economic conditions, regardless of the Fed’s attempts to lower them.

During recent months, bank stocks have taken a beating due to concerns in the sub-prime credit market. There are, however, financial institutions and small banks that have been unfairly beaten up due to their association with the larger, more debt-ridden banks. Often, when you are most tempted to abandon a sector it can be a great buying opportunity. Unlike many mania assets that have formed in the past, such as dot com stocks, banks and savings and loans are fundamental to our economic system, they will survive, and the Federal Reserve was created specifically to ensure that will happen. Unfortunately last year, Fed secretary Ben Bernanke was more concerned about price stability than adding liquidity to the banking system and credit markets. We believe he will have to change that position this year, regardless of whether or not prices rise.

We anticipate the US dollar will continue to decline, which is good for the US economy since 47 percent of the revenues generated by the S&P 500 are currently derived from abroad. Despite what you hear in the media, the contraction of the dollar has been good for our economy, and we will come through it as a much stronger, healthier nation. A weak dollar is a healthy consequence of overpriced US assets. We do believe the European markets are overpriced and may experience a pullback.

We do not believe the worst is over in the housing market, and we could see a 20 percent correction in housing prices from their 2005 peak before it is over. Many regions of the country are approaching that level, but several areas still have a way to go. We also expect more foreclosures, and are significantly decreasing our positions in large financials and central bank stocks that have exposure in this area. The commercial real estate sector may experience a slowdown due to overbuilding, but the lending practices in that sector are more stringent, so we do not expect to see the same degree of credit problems we have witnessed on the residential side.

Our research shows unemployment may continue to rise due to displacement of construction industry workers, but the inability of these people to transfer skills to other sectors will continue to create a tight labor market in the majority of the economy.

We remain diligent about our concern for inflation, but we also believe that the Federal Reserve has no choice but to generate more liquidity to deal with the continuing credit crisis that many financial institutions are experiencing.

Periods of market volatility often present great buying opportunities. We will continue to keep a watchful eye on further market and economic developments, and we will continue to make changes to your portfolio as needed.

John L. Brotherton, CFP™
Donna K. Brotherton, CFA