The stock market was surprisingly strong last year despite the various problems. After modest gains through April, we experienced a meaningful correction with the market indices bottoming at different periods during the summer. The remainder of the year was strong. The Chinese “Year of the Fire Dog” with its leadership traits of confidence and strength continued its high probability of double digit gains. What is the economic and investment outlook for 2007?

The world economy is expected to increase +5% in 2006 and +4% in 2007 - close to its highest pace over 20 years. Real GDP growth in our economy is projected to decline to +2% this year versus +3.2% in 2006 with a rebound to +3% in 2008. The U.S. led the global expansion, but is now further into its slowdown and will impact world growth. Our economy should experience a “soft landing” led by the slowdown in auto sales and housing which is now spreading to the business, consumer and foreign sectors. The slowdown has caused excessive global inventories, production cutbacks and lower commodity and energy prices. Our quarterly progress should be slowest in the December and March quarters with gradual strengthening throughout the remainder of the year with support from lower energy prices. Two major positives include a reduced trade deficit because of strong exports and lower imports and a lower than expected budget deficit because of rising tax revenues. In addition, Henry Paulson, our Treasury Secretary, is beginning to have a positive impact on the world stage.

Corporate profits have been rising at double-digit rates for 17 quarters, but are now beginning a period of single digit growth because of our slowdown. Looking ahead, the current levels of productivity and profit margins should produce above average gains when our economy begins to strengthen. In the meantime, we expect steady growth from a combination of job gains, strong exports and support from business, consumer and government spending. Worldwide inflation is moderating and our rate is expected to decline somewhat, but the Fed is still concerned about the risk of higher inflation. The December inflation and producer price index numbers were somewhat higher than expected. The problem is that there is underlying strength in some sectors of the “core” inflation rate and these need to moderate. The Fed has kept interest rates steady and the next move is likely to be down, but will depend upon the strength of our economy and inflation. We need to watch these trends carefully.

The stock market has been strong since last summer and its technical position is positive. A correction is possible over the next few months and we would view it as a buying opportunity because of our favorable outlook. The stock market appears reasonably priced at 15.4x estimated 2007 operating earnings of $93 per share for the S&P 500. After three years of P/E multiple compression, we expect rising multiple expansion if inflation and interest rates moderate. In addition, there is tremendous liquidity worldwide fueling demand for stocks and bonds. The “Urge to Merge” continues at a high rate with worldwide M&A up 30% to a record $3.8 trillion in 2006 and U.S. volume up 24% to $1.5 billion. Corporate cash levels are high resulting in above average dividend increases and accelerating stock buybacks with a reduction in total shares outstanding. And hedge funds have $14 billion in buying power. Finally, margin debt of $270 billion equals the 2000 level and is a major source of buying power that will moderate any correction or support further strength. The fundamentals are in place for a continued favorable stock market environment. Also, the world economy is becoming more balanced to the benefit of many U.S. companies. For example, 41% of revenues from the S&P 500 companies came from overseas in 2005 versus 32% in 2000. Interestingly, we are now in the third year of the presidential cycle and during this period stock prices increased +18% on average since 1945 with gains 93% of the time. We are aware of the worldwide economic and geopolitical risks and are watching them closely. But we like the odds for higher stock prices over the next two years.