The Markets	12/31/07      Close	9/30/07    Close	4th Qtr.  Change	12/31/06 Close	12 Mo. Change	YTD       Change
Dow	13,299	13,896	-4.30%	12,463	+6.71%	+6.71%
NASDAQ	2,656	2,701	-1.67%	2,415	+9.98%	+9.98%
S&P 500	1,473	1,527	-3.54%	1,415	+4.10%	+4.10%
10-yr Treas. yield	4.04%	4.58%	-0.54%	4.71%	-0.67%	-0.67%
Fed funds rate	4.25%	4.75%	-0.50%	5.25%	-1.00%	-1.00%

(stock indices are before dividends; yield and rate changes are absolute changes)

The Dow hit a 10% correction on November 26 for the first time since early 2004. Despite a rebound in December, the fourth quarter was very difficult for investors. The stock market continued to feel the weight of mortgage write-offs and losses at financial firms, while fixed income investors were lucky if they avoided losses form mortgage and derivative securities. Indeed, one of the biggest challenges for any investor is determining exactly what risks exist with an investment, and the mortgage crisis highlights the fact that those risks are sometimes hidden until it is too late.

The Federal Reserve cut short term rates in both of its meetings this quarter in response to the credit crisis. However, the problem is not the supply of money but tighter standards, lack of confidence and banks’ need to shore up their capital, which has required them to sell high-quality assets and keep available cash rather than lend it. Other central banks have joined the Fed in injecting money into the system, and the Bank of England cut its short-term rate ¼% for the first cut since summer 2005, but the European Central Bank held rates steady even in the face of surging inflation and the strong Euro.

The CEO’s of both Merrill Lynch and Citigroup were canned, and Countrywide, the largest mortgage lender, instituted a program of voluntarily refinancing adjustable rate mortgages with interest rates that are “resetting” to a higher level. Like the broader plan encouraged by the Treasury and announced by other lenders, this relief will actually help only a small number of borrowers who have been able to stay current with their loans. Likewise, changes in lending standards by the Fed will affect new loans but not existing loans. Ultimately, these troubles were seen as opportunities by several sovereign investment funds, which made multi-billion investments in several large banks and investment firms.

Oil finally hit the magical $100 a barrel level, but it turned out to be a manipulation of the market by a publicity-hungry trader and the price never closed above $100; oil had settled into the mid-$90’s by the end of the quarter on fears of slowing demand. Housing sales and prices continued their slide, with sales down nearly 20% from a year earlier and prices down more than 6%. Some cities such as Miami saw price drops in excess of 10%. With housing inventories approaching 10 months, it remains difficult to see the end of the slump as foreclosures still loom large.

Unemployment inched up over the quarter, and officially hit 5% for December. Durable goods and manufacturing eked out positive but slowing growth, while third quarter productivity was a surprisingly strong 6.3% and unit labor costs were down slightly. Core consumer inflation was 3.2% for the 12 months ending in November, above the Fed’s target range and further cause for concern. The Fed is trying to maintain the balance between stimulating the economy through rate cuts and not fueling inflation, especially with higher rates in other countries.

Looking Forward

It is looking more and more likely that the consumer won’t be able to fully prop up the slowing economy, so the question now becomes how long the slowdown will last. Whether the slowdown becomes a recession in technical terms (two consecutive quarters of “negative growth”, a classic oxymoron) may be less important than the impact on market psychology and the spending habits of both consumers and businesses. Indeed, some analysts claim that a recession has already begun and simply won’t be recognized until several months later.

Housing and mortgage woes will be felt at many levels for quite a while. At the personal level, increased mortgage costs and the possibility of foreclosure will put pressure on consumer spending. Lenders and investment firms have still not fully absorbed all their losses and write-downs, while tightened credit is affecting borrowers from the consumer to private equity buyout firms. (There may be some poetic justice that some buyouts have been cancelled for lack of financing, while other buyouts completed at the height of easy money are struggling mightily.)

Even the primary elections and the upcoming presidential election will cast uncertainty over the markets and economy as various candidates show strength, make proposals and then possibly fade as other candidates take the lead. The old saw that interest rates don’t go up and the economy is not allowed to slow during an election year simply does not hold true, particularly now as global economic forces make it nearly impossible to precisely manage the economy over the short and intermediate terms.

The other looming unknown is whether the dollar will weaken further or finally stage a comeback. Lower short-term interest rates and the continuing trade deficit argue for the dollar continuing to weaken. On the other hand, compared to a basket of developed currencies the dollar is testing levels not seen since the early 80’s, and if other economies begin to slow, as is already happening in Europe, the dollar will look much more attractive to global investors. As with all market cycles, the dollar will eventually reach a point where it is seen as a bargain and then begin to recover. The implications for investors are that the generous gains from international investments may be coming to an end.

Our Portfolios

We continued to gradually trim exposure to both US and international stocks, and are now slightly below “neutral” on our stock allocation. The overall stock allocation is still tilted toward international, but as noted above, we are keeping a close eye on the dollar, the growth in other developed economies and actions by central banks.

This does not mean, of course, that we are inclined to dramatically flee stocks. It is times like these that fear must be resisted and perspective must be maintained. Those who succumb to fear and take a very defensive posture are ultimately faced with the more difficult question of when to reenter the market to pursue growth. The notorious difficulty of getting all those market-timing decisions right argues for taking the long-term view, riding out volatility and maintaining a constant stock position. The stock market is forward-looking and an indicator of future sentiment. While the woes of the financial sector and the weakening economy have obviously led to the recent market declines, it is telling that the market has not dropped even further.

Wither the Consumer?

Consumer spending has been the engine of the US economy for the last 15 years, and it continues to grow as a percentage of gross domestic product. Despite the reversal in home prices and the contraction of “cash out” refinancing, despite much higher energy prices, despite a softening job market and despite a weaker dollar that makes foreign goods potentially more expensive, consumers have just kept spending. If consumer spending dries up, the economy will surely head into recession.

This is another example of the clash between the macroeconomic “big picture” and the microeconomic “little picture”. Everyone agrees that individual households would be better off by curbing their spending and saving more, but the aggregate effect of such a shift could be devastating to the economy as a whole.

That is not to say that conditions do not exist for accommodating this shift, at least over the long run. With the weak dollar, US exports have been rising much faster than imports, reducing the trade deficit (especially if oil is excluded). At the same time, imports are more expensive, so consumers should naturally reduce their purchase volume of imports even if they are spending the same dollar amount. Business investment, which has been relatively weak since the build-up to Y2K, has long been expected to increase along with exports and pick up the slack of the consumer.

The problem with this theory is that consumers are resistant to change, making a smooth, gradual transition less likely. Mortgage problems, increasing foreclosures and tight credit could create the shock that causes consumers to hole up, well before business investment has the chance to kick in.

Consumers have three sources to support their continued spending – taking on more debt, tapping or selling assets or current income. Already high debt levels and tighter credit have already taken their toll on consumers. Likewise, with the savings rate nearly non-existent, house prices falling and most other savings in retirement accounts, selling assets will not provide much support. Let’s hope job and wage growth can carry the load of the consumer may fall off a cliff.