GDP Growth
The current positive US business cycle which started in October 2002 is now 46 months  old. The median bull market has lasted 27 months since 1900. The current bull market started in March 2003.  US GDP growth in Q3 2007 was 4.9%, compared to 3.8% in Q2  and 1.6% in Q1 2007.  The Blue Chip Economic Indicators newsletter, a survey of economists, predicted GDP growth in 2008 to be 2.4%.

Corporate Profits
US Corporate profits decreased in Q3 2007 by $19.3 billion, versus an increase of $94 billion in Q2 2007. Foreign corporate profits increased by 21.9 billion in Q3 2007 versus an increase of $16.7 billion in Q2 2007.  ConsensusEconomics forecasts that US corporate profits will grow by 3.2% in 2007 and 6.0% in 2008. That compares with US profit growth of 16.4% in 2003, 12.6% in 2005, 16.4% in 2005 and 12.5% in 2006.

Job Growth
The US economy added 388,000 jobs during Q3 2007. Nonfarm payrolls increased 94,000 in November, 170,000 in October, and 44,000 in September 2007.

Unemployment
The Q3 2007 unemployment rate increased to 4.7%, up from 4.5% in Q2 2007, but even with 2006 and down from 5.1% for 2005, 5.5% for 2004, and 6.0% for 2003. It got as low as 4.0% in 2000. The economy is pretty much at full employment, as of the date of this report.

Housing
Building permits in October 2007 were 1,178,000 seasonally adjusted, a 6.6% decline from September. Privately-owned housing starts in October were 1,229,000 seasonally adjusted, a 3% increase above September but 16.4% below the 1,470,000 October 2006 number. Housing completions in October 2007 were 1,436,000, 25.2% below the 1,919,000 October 2006 number.

According to a Standard & Poor’s article in The Outlook newsletter, every recession since 1960 has been accompanied by a decline in residential construction, but not all construction declines have resulted in recessions. The article cited 1967 and 1995 as the exceptions. However, from February to October 1966 the S&P lost 22% in value anticipating a recession, which did occur two-and-a-half years later. From February 1994 to February 1995 the S&P lost 8.9% but there was no recession.

Housing Values
We did not report declines in home prices because it has been well reported that housing prices have declined. The degree of decline varies with location and there is no clear end in sight. One way to get a sense of how deep the decline is would be to register on www.ziprealty.com. Look at the homes for sale, click on a sample and scroll to the section showing price adjustments and time on the market.

Consumer Sentiment
The Michigan Consumer Sentiment survey showed November 2007 index at 76.1 versus 92.1 in November 2006, 106.5 in July 2006, and 96.9 in January 2007. This was the reading in two years. Reasons given for the decline were rising prices of food, fuel, and manufactured goods plus falling home prices. Most economists think the consumer will spend less in 2008 due to the same reasons.

Personal Income Growth
Personal income increased $21.2 billion or .2% in October 2007 to a total of $11,814 billion versus $11,055 as of October 2006. That’s an annual rate of 6.86%. Personal income growth is a key element of US economic expansion, as is job growth.

Personal Consumer Expenditures
Personal consumption spending increased $23.8 billion or .2% in October 2007 to a total of $9,836 billion versus $9,373 as of October 2006. That’s an annual rate of 4.94%. Consumer spending is a number all economists are watching closely, as they are concerned that with 70% of the US economy dependent on consumer spending, a significant decline (in PCE) could spell trouble.

Inflation
The Consumer Price Index for All Urban Consumers increased .6% in November 2007, before seasonal adjustment. That’s 4.3% higher than November 2006.   The index for energy increased 5.7% and accounted for 70% of the CPI Index increase.  Some economists think the CPI understates inflation because it includes only a rent factor rather than mortgages, which would reflect the rising home buying costs.

The Fed’s favorite inflation gauge, the CPI-U less food and energy, the “core” rate,  rose 0.3% in November 2007, after six straight months of 0.2% increases. The unadjusted twelve month increase ended November 2007 was 2.3%. That is higher than the 1% to 2% comfort range that the Federal Reserve prefers. Wall Street fears a situation where the inflation rate is higher than the GDP rate,  a condition known as “stagflation”.

Productivity
For Q3 2007, the Bureau of Labor Statistics reported that productivity in the business sector 5.7% grew faster than Q2 2007,  (seasonally adjusted annual rates). In the manufacturing sector, the Q3 2007 increase was 4.5% over Q2 2007. These are good numbers. Productivity is one of the keys to neutralizing the effects of wage inflation.

Interest Rates
The Federal Reserve is set to lower the Fed Funds rate  another 25 basis points in January 2008.  The Fed Funds Rate is now 4.25% which is slightly higher than the 10 Year Note Rate of 4.20% which low yield is reflecting more concern about a recession than about resurgent inflation. The European Libor rate remains stubbornly above 5.00% and that rate is used to set a lot of US business loan rates. Historically, the separation between the two rates has hovered around .11%. Wall Street thinks there are at least three more rate cuts coming. I have heard that historical evidence shows that after three or more rate cuts, one year from that point, the market will be higher.

Money Supply
There is an old saying: “Just as the party gets going, the Fed takes away the punch bowl.” From what I read and hear, money supply is actually increasing now that the Federal Reserve is concerned about the credit crises. The Fed buys Treasury notes and bills to increase the money supply and sells notes and bills to take money out of the supply. According to money supply figures reported by Barron’s for the week ended December 3rd, the total of M1 and M2 was $8,814.2 billion versus $8,395.9 a year ago. That’s a growth rate of 4.98%. History shows that, over time, when money growth decreases, the economy and the stock market decrease, and vice versa, when money growth increases, the economy and the stock market increase. Is the money supply growth fast enough? I don’t know if we could find any two economists that would agree, but one fact we all know, if the banks do not use the money supply growth to increase loans to small businesses, rather than “taking away the punch bowl”, we are in trouble.

Earnings
Standard & Poor’s Investment Services forecasts earnings for the S&P 500 for 2008 to be $102.32 or 16% higher than 2007 earnings. That’s just hard to believe.   That’s one reason why we are underweight US securities. We don’t see that much to gain at the moment by investing in the S&P 500 ETF.

Foreign company earnings growth may also slow (Europe and Canada are slowing as we write this), but China, India, Russia, East Europe,  Brazil, and Latin America may continue to outpace the rest of the world. We hope so, as we are overweight foreign securities in those countries.

Energy
Oil closed at $90.93 per barrel on Monday December 17, 2007. This compares with a high of $74.61 per barrel on May 2, 2006. T. Boone Pickens, manager of a commodity hedge fund and former CEO of Mesa Petroleum, thought in 2005 that the trading range would be between $40 to $60.  The price reached $60.23 on  January 3, 2006.  It was then that Pickens recently appeared on CNBC again and said he wouldn’t be surprised if oil reached $80 per barrel before yearend and predicted $100 per barrel prices within twelve months. He was right again. Oil reached $98.00 a barrel this fall and may have hit the $100 mark intraday.

Refining capacity is at 84 million barrels a day and demand is something north of 86 million barrels per day. Approximately 22% of production is light sweet crude, which everyone wants for clean gasoline. The rest is heavy, sulfur rich crude, more expensive to process, and is typically used for other purposes. Coal tar sands in Canada hold roughly the equivalent of the Saudi oil fields, but production has not been ramped up, since it has been only recently that it has been profitable to produce it. Depending on which expert is opining, oil reserves are adequate or declining. I believe the Saudi’s are lying when they say they can increase production because there is evidence that their wells are being pumped with water assistance, indicating the wells are ageing.

The research contained in the book “The Oil Factor” by Stephen Leeb published in 2005 makes a convincing and scary case that the supply of oil is declining and prices will top $100 per barrel at some point in the future. His predictions don’t look as impossible now. The energy problem is not going away anytime soon.

US Current Account Deficit
The US bought more from the world than it sold to the world by about $208.1 billion, down from $223.1 billion (revised) in Q4 2005.  The US current account deficit, including other outflows and inflows, totaled $791.5 billion (revised) in 2005 versus $668.1 billion in 2004, or 6.4% of gross domestic product. Economists do not think this high rate is sustainable. Is this a problem? The current situation works fine as long as the world buys US Treasury notes and bills, or the dollar depreciates against the world’s currencies, or their currencies appreciate.However, if foreign countries decide not to recycle the dollars back into US debt instruments, that would cause US interest rates to rise in order to entice foreigners into buying our debt and, if rates continued to rise, a recession in the housing market and other sectors of the economy would occur. During Q1 2006 foreigners bought $157.6 billion of our debt securities versus $242.7 billion in Q4 2005. That’s not a good trend.

In March 2005 Korea said it was thinking about cutting back on US debt purchases because it didn’t like the depreciation of the value of those notes and bills due to the declining dollar. The 10-yr Treasury note yield went from 4.20% to 4.6% in a couple of days, which tells us what might happen or worse if the world suddenly stops buying our debt. In addition, the stock market dipped as well.  Eventually, these debts have to be repaid somehow.

The Federal Reserve is currently cutting rates to combat the credit crises and a potential recession. The value of the dollar has been declining, and we are betting it will continue to decline as long as US interest rates are lower than rates of other countries.  Investors tend to want to hold gold as protection against a depreciating currency.  We are maintaining positions in the Tocqueville Gold fund and the ETF StreetTrackers Gold.

US Current Account(Budget) Debt
In 2005 the government debt totaled 4.7 trillion versus 3.3 trillion in 2001. Is this why the Treasury is issuing the 30 year bond again, starting in February 2006? Frankly, there is a real question as to when will be the right time for investors to be long on bonds. If the Treasury does go ahead with their plan, will long-term bond rates go up and short-maturities go down? Or will the opposite happen, as holders of short maturities sell those notes to invest in the 30-yr bond?  Will the 3, 5 and 10 year note yields go up? What will the effect be on mortgage rates? Stay tuned.

Stock Market, Long-Term
We think the market will track the economy and S&P earnings growth somewhat, but there will be periods of irrational exuberance followed by irrational despair. A recession and corresponding market decline is given a 50% by Dr. Alan Greenspan, former Federal Reserve Bank Chairman. The recession will probably be caused by a combination of factors. The housing and credit crises, high energy prices, business cycle slow-down, and personal consumption slowdown will be the likely causes.

We think the 18 year US bull market from 1982 to 2000 could be followed by an 18 year US secular bear market, with intervening rallies...lower highs and lower lows. Buy-and-hold will be replaced by buy-and-watch. Active portfolio management will be essential to success during the coming years.

Stock Market, Short-Term
As mentioned above, we think a recession could start sometime in the next twelve months. As this is written Monday December 17, 2007, the DOW, NASDAQ, S&P, Russell 2000, etc. are all down, as they were on Friday, December 14, 2007. The market also had a bad day on Monday. On Tuesday, the DOW recovered from a drop in the morning to finish up 65. The S&P 500 did a similar thing. Wednesday will tell us if there is to be a Santa Claus rally. If a so-called “Santa Claus” rally is to be, there is not much time left for it to start. The idea that foreign stocks can survive a significant fall in US stock prices is shaky at best because the markets have shown themselves to be closely correlated. Our premier timing service is telling us that cycles are down into February for most markets. I believe it is time to lighten up on all equity positions in order to reduce volatility.

Stock Market, Technical Indicators
On July 31 the S&P 500 Index closed at 1276 which was over the 200 day average of 1260 and just over the 1266 38.2% Fibonacci. However, the 38.2% level was penetrated intraday. The 61.8% retracement is only a 7.38% correction. The 1121.26 monthly 38.2% retracement would be a 15.48% correction, and that is within a “normal” 10 to 15% correction range.  Since the index has taken out the daily Fibonacci retracements and has retraced over 100% of the last run, we will focus on the weekly and monthly Fibonacci timeframes.  Those levels are shown in the following table. On the weekly timeframes the S&P 500  made it down to 1266 intraday last week. It will go lower. Fibonacci retracements have proven quite reliable historically, and they work for most markets.
 

Fibonacci levels for the Russell 2000 Index, representative of the small cap market, are shown below. The index has fallen more than 100% of its daily Fibonacci retracement (which is not shown below). On the weekly timeframe, the index will have to fall to 719.73 in order to complete a 38.2% retracement on the weekly from October 15, 2005 low. The index hit 700 on Monday July 31, 2006. It has fallen to the 50.0 % Fibonacci retracement on a weekly basis. It is more likely to fall to the 61.8% point of 679, which is near the 400 day EMA of 673. The index has not fallen to its 38.2% retracement on a monthly basis, but in a bear market pullback, that is very possible. We have had a bare minimum allocation to small cap mutual funds for some time now.

Other technical indicators forecast further weakness. July 31, 2006,  the indicators say we have an overbought US market. The McClellan Summation Index, a good advance indicator, started the year at 369; rose as high as 772 on February 1st, and has been declining ever since. It got as low as –518 on June 27th and stands at +22 at July 31, 2006.

I don’t have a good answer as to why we don’t track the foreign markets. We should.
 
The chart below shows the other technical indicators we watch on a daily basis.

These indicators are telling us the market is due for a short-term decline.

Stock Market, Sentiment Indicators
As of July 31, 2006  the AAII Index percentage of bulls was 34.9%, the percentage of bears was 43.0%, and the percentage of neutrals was 22.1%. A high percentage of bears to bulls is a contrary indicator, but given current conditions and technicals, it may not be high enough to signal a near-term rally. 

The Chicago Board of Exchange’s VIX or volatility index was 14.95 at the close of trading July 31, 2006.  The VIX ranged from 11.10% on February 15, 2005 (the height of the market indices) to 19.34% on August 6, 2004 (the low of the market indices).  A VIX over 25 indicates fear, investors paying premiums for puts, a contrary indicator, and a possible buying point. A VIX at 10.00 indicates complacency, investors paying less than normal prices for puts, and possible selling point.  (The VIX is derived from two month of prices of all quoted at-the-money and out-of-the-money S&P 500 Index puts and calls.) 

The correction will probably continue on into October.  The market is overbought at the moment. However, the market could be higher when the year ends on December 31.

Foreign Stock Markets (unchanged)
At a seminar on May 6, 2005,  a representative from Julius Baer Global mutual fund showed correlation between US stocks and foreign stocks to be approximately 90%, meaning that the 90%  of the performance of foreign stocks can be attributed to performance of US stocks. If US stocks fall $1.00, foreign stocks should fall by $ .90 cents. However, he gave other reasons to invest in foreign markets at that time.  Valuations were generally more reasonable. Opportunities for growth were greater than the US then and we believe still are. Foreign consumers do not have as much debt; therefore they have more sustainable consumption patterns. We tend to agree. On the other hand, there are risks.

Last quarter we reduced the Fidelity Latin America Fund to a 1% holding because of concerns over the socialist leanings of the governments of Venezuala and Bolivia. Apparently other investors have similar feelings because the Latin American stock market sold off, mostly after we sold. During this last period we increased the allocation to India to 2%.

Housing Market Bubble
Lately, there has been much debate about whether there is a housing bubble. Since 1929 the average annual increase in real estate has been 5.3%. Since 1968 the average annual increase has been 6.2%.  In 2004 the increase was above 10.0% in many areas versus around 5.0% in the 2000 to 2002 timeframe. Properties in coastal areas have risen at a greater rate than 10.0% recently. Prices in certain areas of the country have risen at higher rates. Prices are being driven by low interest rates, low down payments, loss of objectivity on the part of realtors, appraisers, and mortgage brokers, shortages of desirable land, high immigration rates, speculative activity, and lack of supply (of good homes and land). Household or personal incomes are not keeping pace, pushing affordability down.

In our view, anytime prices are rising faster than the historical average, there is the potential for a bubble. The present rates are not sustainable, irrespective of whether there is a bubble in a particular area of the US. A study of historic median house prices to median incomes will show the multiple is much higher than historic multiples. A study of rent to house prices will also show higher ratios.

Yale professor Robert Shiller believes there is a housing bubble, but he is not sure how to measure it or when it will end. He believes that excessive talk about and attention to the problem will be the catalyst. He believes it will end badly, whatever that means to individual sectors and areas of the country. Not everyone agrees with the bad ending.

Why should you care? Because a severe break in housing prices can cause a recession in the US and in turn possibly in foreign countries. Stock markets will follow downward.

For those of you thinking about a real estate purchase now, let us add this little postscript. Martha Stewart has sold her East Hampton NY place for $9 million in 2005 and has her Turkey Hill farmhouse in Westport CN listed for sale at $9 million. Her cost in 1972 was $80,750. As we know, she had pretty good timing in selling Imclone stock, didn’t she? Only kidding.

Commodities Bubble
During the year our Phelps Dodge holding was acquired by Freeport-McMoran at a nice premium. However, if the world economy slows, there will be a question of whether the Asian economies can keep the commodities bubble bloated. We added to gold positions, bringing the allocation of gold and metals together up to around 7% but the reason had more to do with the declining dollar. We still hold the ETF GLD and the Tocqueville Fund because the world economy is still strong, inflation is still a threat, the US government is still selling bonds to cover the budget deficit, the dollar may continue its decline,  China may increase gold reserves significantly, sucking up most of the world’s gold production temporarily, and last but not least, there are tensions in the middle east which could widen.

Valuations
At any one time, the market is either overvalued or undervalued. We believe it is never precisely fairly valued as so many commentators will say from time to time. When Robert J. Shiller published Irrational Exuberance in 2000, he thought the market was clearly overvalued. He still thinks so today. High prices, relative to average, have been followed by lower prices, regardless of fundamental factors. In every market, reversion to the mean takes place.

According to Jeremy J. Seigel in Stocks for the Long Run 3rd edition,  the real return on stocks from 1802 to 2001 was 6.9%. Add inflation of 3 to 4% and you get a total return of somewhere north of 10%. Seigel argues that the price of an investment should equal the present value of the future stream of dividends, including buyback of shares from retained earnings. Whether you get a 10% return depends in part on the the price you pay for the investment and the dividends it pays. This bring us consideration of the price-earnings ratio or PE ratio.

According to Seigel, the historical PE ratio of “the market” from 1871 to 2001 has been 14.45. Divide that into the average value of “the market” and you get a figure called the earnings yield, 6.8%, which nearly matches the 6.9% real return, cited above. Seigel says that “the market” represents the entire market value of all stocks of all companies, both large, medium, and small in size. That makes comparisons difficult with individual indices such as the DOW, the S&P 500, the DJ Utilities, the NASDAQ, and the Russell 2000.

As of December 14, 2007,  according to Barron’s,  the PE ratios for certain of these indices are all higher than 14.45, (DOW 47.03, S&P 18.60, DOW utilities 18.41). Seigel argues that a stable economy, low trading costs, low inflation, and lower taxes justifies PE ratios in the low 20’s, for an earnings yield of between 4 and 5%. However, inflation is not low, the economy is not stable, and the 2 yr Treasury note yields 2.97%. Using the historical 14.45 ratio together with the current environment suggests present market overvaluation to us.

For 200 years, the equity premium in the earnings yield of stocks over the rate of “safe” long-term government bonds has been about 3.5%. Since 1926, the equity premium has been about 5.0%. Seigel argues that the future equity premium should be between 2.0% and 3.0%. The earnings yields on the DOW (2.13%), the DJ Utility average (5.43%), the S&P 500 Index (5.36%), and the S&P Industrial Index (4.54%) are all lower than either the 10-yr Treasury note yield of 4.20%% plus 2.0% and the 30-yr Treasury bond yield of 4.59% plus 2.0%. Again, this suggests present market overvaluation.

Historical dividend yields have been in the area of 3.0%. Prior to 2004, dividends received by individual taxpayers were taxed at their marginal tax rate. Today, qualified dividends are taxed at a maximum rate of 15.0%. Dividend yields could conceivably be in the area of 2.4% and still be at the historical level. The dividend yield for the S&P 500 Index is presently at 1.90% as of December 14, 2007. Companies aware of the desirability of paying dividends are increasing them, narrowing the gap between historical and present yields. Again, this suggests present market overvaluation.

Historically, the ratio between earnings growth and price to earnings (PEG ratio) has been 1.00. Put another way, over time, the percentage of earnings growth of a company should be the same as the percentage of the price-earnings of the stock. The S&P 500 forecasted earnings for 2007 is $88.49 versus the historical $87.72 for 2006, an implied growth rate of 1.01%. With a PE at 18.60, the PEG ratio of the S&P 500 is presently 18.6 which indicates overvaluation. A better indicator would be the 2008 projected earnings of $102.43, an implied growth rate of 15.75% and a PEG ratio of 1.18. A range of 1.00 to 1.50 is reasonable.

Bonds
Since our last investment outlook letter we made major additions to foreign bond mutual fund positions, playing the decline of interest rates. That game may be about over sometime in the next twelve months, as the US and world economies start to grow and inflation picks up.

REITS
REITS have outperformed all other asset classes over the last five years, but that trend has come to an end.  Yields have come down from substantially, the sector may be overvalued, and the economy is slowing. We will be patient with investments in this asset class. We have made money in this sector and perhaps the opportunity will come again.

The Iraq War
Like it or not, the costs of the Iraq war are affecting the economy, the budget deficit, and politics. The troop surge together with Sunni cooperation appears to have defeated Al-Quida. Peace and security finally may be at hand. Many problems remain. Iraq has 112 billion barrels of oil reserves and 110 tillion cubic feet of natural gas. It produces somewhere over 2 million barrels a day. Through January 2006, oil production has averaged about 1.9 million barrels a day,  somewhere south of 2.03 million barrels a day in 2002. Iraq exports about 1.0 million barrels a day and consumes the difference. The US hopes to get production up to 3.0 million barrels a day. If it happens about 1.0 million more barrels will be exported, it is hoped. Clearly, if the war was about oil at the beginning, it isn’t about oil at this point unless production becomes a lot more efficient a lot more quickly. 

Bear Market Funds
We do not hold any bear market mutual funds or ETFs at the moment. But that could change, and change quickly.

Our overall focus is long-term, but we have short-term worries

We will raise cash, hedge to a degree, and buy the best-in-class mutual funds and great, financially strong businesses on the dips. About one out of every four years, there is a 20% correction. We have already had two 10% corrections in 2007/  If a 20% correction develops in 2008, we believe it will be an opportunity because we are long-term bullish on the American economy. 

Cash (Unchanged)

We expect to vary cash positions depending on opportunities to invest and hedge.
We believe that healthy cash positions, hedge positions, foreign equities, energy, and defensive-type equities will serve us well in sustaining our outperformance of the indices during 2006.

We appreciate the trust and confidence you place in us to manage your wealth.

Source of index information was the online website finance.yahoo.com.