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As economic reports on 2007 become finalized we are now seeing the confirmation of the very shaky condition of our economy. 2007 began with wide corporate profit margins, low unemployment, a quiet “hands off” Federal Reserve and expanding manufacturing – the opposite of today’s circumstances. Wildly volatile equity and fixed income markets reflect subprime mortgage stress on the credit markets and enormous losses (both realized and in confidence levels) in our financial system – banks, mortgage originators, credit rating, and insurance companies. Rising food and energy prices, when added in, could lead to the end of a seven year business cycle expansion. We now believe the economy (GDP) needs to grow around 2.5 – 3.0% to provide jobs for new entrants, and for a time this will not happen - at least in the first half of 2008. The combination of the above factors and a deep real estate recession will be too much for the economy to shrug off quickly despite the heavy dosings of liquidity being administered by the Federal Reserve. There are, however, normal positive reactions beginning to be seen, which seem to indicate that the situation could be somewhat better as the second half of ’08 begins.

They include;

As 2007 progressed, tight job markets (unemployment at 4.4%), at a time when profit growth was slowing, threatened to push labor costs upward faster than productivity could accommodate – inflation began to rise. This now appears to be self correcting.

Commodity costs (oil, fertilizer, metals, etc.) are demand sensitive to a large degree – slowing retail sales, manufacturing, and inventory accumulation will lessen pressure here. Foreign economies are beginning to suffer along with the US – all lessening pressure for a time.

To sum up our outlook, we feel that it is not possible at this moment (late January ’08) to predict whether we are presently in or will experience a mild recession – it’s that close. The bursting of the credit bubble we are experiencing will take a long time to play out, at least several quarters. The slowdown, however, should not be deep or long lasting as an accommodative Federal Reserve, resilient consumers and a slowly progressing economy pull us through.

Equities

It is probably beyond our (and yours) descriptive powers to characterize the fears and apprehension brought on by the extreme market volatility experienced in 2007 and which continues into 2008. Exacerbated by a market driven by computer trading by hedge funds, ETFs (Exchange Traded Funds) and Mutual Funds, we see the markets as wild and inexplicable when on the downside and euphoric, equally inexplicable when rallying. We’ll have to get used to it – it will not go away, and over time, the outcome is the same. Good companies will prevail, sectors will dominate, asset allocation is paramount, and trends will manifest themselves.

2007 will, along with volatility, be remembered for only decent, not extraordinary gains in most asset classes. 

Total Return

	'07	'06	5 Year (Annualized)
DJIA	8.9	19.04	12.05
S&P 500	5.5	15.61	12.68
NASDAQ	10.6	10.39	15.41
EFA (MSCI)	9.94	25.81	21.10

In 2007 and within the S&P 500, large companies and growth stocks were the place to be, a circumstance that we expect to continue in 2008. The charts below illustrate the winning and losing sectors last year.

Winners	Price Change	Examples
Energy	28.85%	Suncor, Transocean, National Oilwell
Materials	16.46%	Monsanto, Nucor
Technology	12.01%	Apple, AutoDesk

Losers	Price Change	Examples
Financials	-24.37%	Countrywide, Washington Mutual
Consumer Discretionary	-17.85%	Tractor Supply, Cabella's

A large factor in our outperformance in 2007 was our 50% weighting of the financial sector. While at the beginning of 2007 financials were 22.3 of the S&P 500, due to their abysmal performance they slipped to 17.64 at year’s end. Two notable exceptions were T. Rowe Price and, more recently, BlackRock, Inc. Much of the reason for our strong year can be attributed to fortunate stock picking in late 2006. Record performances in Monsanto, Apple, Precision CastParts and National Oilwell (a much older selection) in a mediocre year pulled us along nicely. The good news here – is that we feel they all continue to be well positioned for continued long term out performance. Hopefully we don’t buy stocks with only good short term fundamentals, we’re looking for an indefinite holding period. This will continue to be a stock picker’s market as overall earnings slow and the economy pauses. We are enclosing a chart borrowed from J.P. Morgan which highlights the stock market’s shifting focus among equity types. Please look this chart over closely noting that no one style ever remains the leader forever and any attempt to shift styles in concert with markets is a fruitless endeavor. We are committed to long term outperformance and feel that our process and it’s utilization of multiple market cap stocks, high EPS growth rates and clean balance sheets will be in your best interests over the long haul.

2007 was a good year. We appreciate your confidence over all market cycles and calmness in volatile times. As many of you know, we have added a third experienced portfolio manager, Bill Collier, to join Damon Coley and myself in managing your assets. Please call any of us with thoughts or concerns.

Fixed Income

The credit problems we are experiencing are expected to continue and will work to slow the economy (yesterday’s 4^th quarter GDP estimate was 0.6%) and increase unemployment. These and other economic slippages will almost certainly force the Federal Reserve to continue cutting interest rates well into 2008. So far the Fed’s actions since January 22, lowering rates to 3.0%, represent the fastest cutting since 1990. At this point the yield curve is normally sloping though at much lower levels along it’s length than just sixty days ago. The following points illustrate the current situation.

Yield spreads (financial companies versus treasuries) are at their widest levels in years. A limited number of them – those without subprime exposure represent bargains.

Municipal yields too have dropped precipitously. Note that the change in yields on N.C. Municipals (generic G.O.s) at the seven year point is a full 1% or 25%.

Since mid-year 2007, the best place on the yield curve (from a total return perspective ) has been in the eight to ten year range, but five to eight – our normal area, also has done well.

The question for today then becomes where to position new bond money on the yield curve and which instruments to use – Governments or Corporates. Since we have always been most heavily weighted towards high quality agency debt we now think there is room to take advantage of yields available in solid Corporates in the five to ten year range.

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