The U.S. economy’s fundamentals are weakening more than previously expected. We are experiencing a major credit crunch which needs to be resolved to prevent further deterioration of economic growth. Economic cycles and investor psychology are often self-reinforcing and today’s major policy initiatives are designed to stabilize the financial and real estate markets. We believe these initiatives will help restore confidence and growth, but with a lagging effect. Economic slowdowns are helpful as they reduce excesses and set the stage for future growth. In the near-term, the stock and bond (excluding Treasuries) markets will remain nervous until these measures stabilize the economy and improve confidence.

The Federal Reserve, corporate executives and the majority of economists now expect the U.S. economy to experience a recession during a year of sluggish growth. Our economy is expected to be slowest in the first half of the year and gradually improve into 2009. In contrast, world growth (ex. U.S.) is estimated to be +4.5% in 2008, with developing economies outpacing the developed regions. The U.S. slowdown and worldwide credit problem is moderating world growth. The health of the consumer sector is the dominant issue because of weak household balance sheets caused by declining real estate and stock prices and rising energy and food prices. The employment situation has weakened and consumer spending growth is tepid. We have not had a consumer driven recession since 1991, so a difficult period is likely as consumers repair their balance sheets and moderate their spending. We have begun a new era – The Deleveraging of America. Government spending and export growth are the most visible sources of near-term support for the economy as the consumer, residential and non-residential sectors moderate. The budget deficit is likely to increase to 2.8% of GDP and the trade deficit will improve to 3.9% of GDP. The major risks are focused on consumer spending, credit risks, corporate profits and inflation.

A variety of fiscal and monetary initiatives are being considered to support our economy. These initiatives include tax rebates for individuals, larger depreciation deductions for businesses, higher conforming loan limits for mortgages and relief for individuals facing foreclosure. Additionally, regulators have allowed Fannie Mae and Freddie Mac to participate more aggressively in the secondary mortgage markets and urged them to raise additional capital for similar activities. The Federal Reserve has arranged $400 billion in lending programs in recent months to bolster liquidity, stimulate credit activity and reduce stress in the financial markets. The Fed has also reduced the federal funds rate 300 basis points from 5.25% to 2.25% since the initial cut in September 2007 and will likely reduce rates further. Additionally, the Fed has increased liquidity by allowing major banks greater access to funds for longer terms while accepting lower quality collateral than usual. The Fed also agreed to lend funds to investment banks for the second time in its history and is providing banks with easier terms in the hope they will pass along this improved liquidity to private sector borrowers. JP Morgan was given special assistance to manage the takeover of Bear Stearns and the Fed assumed some risk associated with the securities acquired from Bear Stearns. More importantly, the combination of these initiatives is unprecedented and reflects that the Fed will act as necessary to ease the “crisis of confidence.” The IMF estimates that risky mortgage backed securities will cost $1 trillion in losses worldwide. Global coordination by central banks to combat the credit squeeze is necessary.

Longer term considerations suggest that a strong foundation is being established for an infrastructure spending resurgence in the years ahead estimated at $41 trillion through 2030. However, business capital spending might be soft in the near-term as projects are delayed by economic insecurity. The energy and transportation sectors will require substantial projects over the foreseeable future to rebuild old assets and improve efficiency. These include airports, bridges, LNG terminals, ports, power plants, refineries and transmission lines, etc. Investment spending fell significantly in the “business recession” of 2002, but is not likely to meaningfully detract from today’s economy since the level of capital investment is near the lowest levels in 10 years. The stage is set for a rebound in capital expenditures in the future.

The dollar has substantially declined versus the euro over the past six years and is at a 40 year low, but is still in a downtrend. Recently, the Fed’s reduction in interest rates has weakened the dollar further despite continued improvement in our trade deficit. Today, there is an increasing number of economists and technicians that believe the dollar is oversold. The euro appears overvalued and is hurting Europe’s economy. In addition, Asian currencies are beginning to let their currencies appreciate more – a positive for the dollar. The dollar may have reached a trough and is more likely to strengthen in the years ahead – especially after our economy recovers and the Fed begins to increase interest rates again. Ultimately, currency values are determined by relative rates of return on capital and the U.S. has a decided advantage with its strength in wealth generation, productivity growth, research, product innovation and strong institutions of higher education. In Europe, the rapidly aging population will increase the governmental financial burden at a pace far faster than the U.S. Also, many European countries – especially France – have far higher debt-to-GDP burdens than the U.S., especially when estimates of their unfunded pension liabilities for government employees are included. The permanent demise of the dollar is premature.

SWF are investment funds established by governments that will have an increasingly positive impact on U.S. assets in the years ahead. Above average world growth and the high price of oil have generated significant assets. This trend is called the Growth of State Capitalism with SWF established by Abu Dhabi, China, Dubai, Japan, Kuwait, Norway, Oman, Qatar, Russia, Saudi Arabia, Singapore, South Korea, etc. These funds have assets of $3 trillion with projections of $10 – $20 trillion in five years. SWF invested $22 billion in U.S. companies last year with an increasing amount in 2008. Recently, major private investments were made in Blackstone Group, Citigroup, Merrill Lynch and Morgan Stanley. Today, the IMF is working with many SWF to construct a code of “best practices” to insure that they are investing to make money and not for political gain. Also, the U.S. Interagency Committee on Foreign Investment and many countries are developing rules to govern foreign investment. This is a new source of demand for U.S. assets that will grow rapidly in the future.

We experienced wild market swings during the first quarter with fear, panic and uncertainty. The average equity mutual fund declined -9.74% – the worst quarterly performance in six years. The NASDAQ composite declined -14.07%. We did not expect the magnitude and panic of this decline. The major concerns included the liquidity crises, a recessionary environment, the inflating impact of rising commodity prices and the continuing decline of the dollar. Clearly, the headwinds buffeting the economy are stiff, but good long-term investment opportunities are surfacing. When growth is scarce, real growth is at a premium and we believe our universe of small and medium sized growth companies is attractively positioned. Most of the companies in our universe have above average profitability with little or no debt, lessening the impact of the current credit crunch on their ability to grow. We are continuing to see merger activity among our stocks of interest, indicating value in the eyes of corporate executives. Finally, this is the Chinese Year of the Earth Rat – the first sign of the Chinese zodiac and a symbol of good luck and wealth. It also signifies new beginnings, progress and success. In our opinion, the market is likely to strengthen in the months ahead despite the uncertainties. We are bullish on America!

The stock market has positive returns most years with a higher probability of gain during election years. The market appears inexpensive and is selling near its lowest levels of the past 30 years based upon various quantitative measurements. Investment strategists consider the market to be undervalued by 10% – 20% based upon the current level of inflation and interest rates and projected earnings growth of our economy over the intermediate term. The stock market has been in a correction since early October and is exhibiting the classic pattern of a final liquidation phase. The market has declined approximately -25% since October following the classic pattern of an intermediate correction. It appears oversold and reflects the economic negatives and psychology of fear and uncertainty. With the Fed now reducing rates, it is interesting to note that since WW II, within 12 months after the Fed’s initial rate cut, the S&P 500 has increased 90% of the time with an average gain of +19%. And, if we have started a recession, the market increased 83% of the time for the first six months after every recession over the past 40 years with an average gain of +12%.

Supply and demand factors are very favorable for the stock market. Mergers, stock buybacks and takeovers have reduced the net number of shares available for purchase by 10% over the past three years. This occurred as potential demand is increasing significantly from domestic and foreign investors. The weak dollar makes our market more attractive to foreign investors since they can buy more shares because of their stronger currencies. Also, the huge flow of funds into oil producing countries needs to be reinvested and many are gradually increasing their U.S. investments. Finally, the housing market weakness and illiquidity has increased the attractiveness of the inexpensive liquid stock market. Quantitatively, the stock market has a total market value of approximately $20 trillion. Cash in money market funds has increased 40% in recent years to $3.5 trillion – a major increase in buying power. Individuals are underweighted in the stock market with equities representing 21% of household financial assets versus 37% in 1999. Private equity and hedge funds have tremendous buying power. Also, the low yield on bonds has made the yield on stocks more attractive. Overall, there is tremendous buying power available for the U.S. stock market.

The technical position of the stock market has improved significantly. Recently, the market had two days where 90% of all stocks were up on heavy volume. That has only happened a few times over the past 40 years and the market experienced good gains within 6-12 months thereafter. In addition, Investor’s Intelligence recently reported the highest percentage of bearish advisors since 1998, the American Association of Individual Investors has more members bearish than at any time since 1990 and the University of Michigan sentiment index is at a 26 year low. These sentiment indicators are usually very positive for the market. In addition, the 40 year old Arms Index – which compares advancing and declining shares to advancing and declining volume to see if advancing stocks are getting more volume – has moved into positive territory for the intermediate to longer term. Usually, high volatility is associated with market bottoms. Also, insiders are buying and the sell/buy ratio equals its level of the 2002 market lows.

We recognize the economic and financial risks in the world economy, but expect the stock market to strengthen over the intermediate term with continued volatility. Patience is the key ingredient for above average returns and that will be more important in the current environment.