ECONOMIC & INVESTMENT SUMMARY
JULY, 2008

---

The global economy (ex. U.S.) is expected to grow +4.7% this year and somewhat less in 2009. The developing nations continue to outpace the industrialized countries with China likely growing +10% and India almost +8%. The emerging markets, Latin America and the Pacific Rim are all growing at an above average rate. But Europe is beginning to show the strains of stagflation with growth under 2% while inflation doubled to 4% over the past year. The European Central Bank (ECB) has maintained tight monetary policy and recently raised interest rates in early July to fight inflation. In fact, the only major central banks to reduce interest rates in the last 18 months are the Federal Reserve and the Bank of Canada. Japan’s economy is also slowing again after showing modest strength over the last few years. Inflation and interest rates remain very low in Japan.

The latest data show the U.S. economy growing slowly with projected real GDP growth of around 1.3% in 2008. It has been a year since our “credit crunch” started and it is much broader than expected with up to $1 trillion in potential losses. This problem has negatively impacted our economic growth. Recently, payrolls have declined for six consecutive months for a cumulative loss of 438,000 jobs (last year payrolls grew by 1.1 million) and the unemployment rate increased to 5.5%. Consumer confidence is at the lowest level since 1991. The U.S. has not technically entered a recession, but the signs of fatigue are clear. The economy is slowing without large positive influences to stimulate growth. The strongest components of growth are government expenditures, exports and certain sectors of business investment spending. Government stimulus is necessary to offset the weakness in the consumer and housing sectors. As a result, the federal budget deficit is likely to increase to greater than 3.0% of GDP. Net exports will benefit from the weaker dollar, stronger economic growth in the developing world and reduced consumption of imports. Business spending is stable because corporate balance sheets are relatively healthy and infrastructure development is needed. Overall, the economic environment is sluggish and it will take at least a year before real GDP growth recovers to a more normal pace. We also expect the continued formation of a “Rescue Plan” to stabilize our financial system and stimulate growth

The housing sector remains depressed. This year will be the third consecutive year of the housing correction and the cumulative effect of the downturn is mounting. The number of existing homes sold is 16% below last year’s level and median prices are down -6% in the past year. The inventory level of homes available for sale is at 20 year highs and double the level of three years ago. New housing starts are at the lowest levels since 1991 and 50% below the level of three years ago. With the volume and price of home sales down, the dollar value of home transactions is substantially less than previously experienced. This decline in economic activity impacts incomes and spending patterns for a large number of households. Due to increasing delinquencies and loan losses, banks are reducing the availability of credit to borrowers. As a result, mortgage rates have increased during the course of 2008. It will take time for the supply and demand fundamentals in housing to improve and we do not expect meaningful contributions from residential investment until 2010.

Real estate is a local business and certain parts of the country are experiencing a more severe contraction than the national indicators suggest with sharp declines in Las Vegas and Miami. Conversely, some regions remain relatively healthy such as Charlotte, Dallas, Houston, Louisville and New York City. For example, New York City experienced an 11% increase in the median sales price of apartments in the second quarter of 2008. But there are signs of peaking as the volume of transactions is down from last year’s record levels, inventory is increasing and prices are beginning to weaken. Additionally, the market may soften with layoffs and lower bonuses impacting employees at financial services firms which represent 25% of the local economy. In general, the City benefits from foreign buyers who can take advantage of the weak dollar and the relatively low utilization of mortgage financing for apartment purchases, which minimizes the potential for leveraged speculation.

Inflation is accelerating worldwide primarily because of the surge in food, oil and other commodity prices. This is likely to generate an intense focus on potential inflation risks. U.S. inflation will average over 4% this year – the highest level since 1991. However, “core” inflation (excluding food and energy) remains in the 2%-3% range demonstrating that rising commodity costs have not yet impacted other goods and services. Inflation is likely to moderate in 2009 as more slack builds in the economy because of sluggish growth. In addition, we may get help from lower energy prices over the intermediate term. Oil has been a cyclical commodity for 140 years and appears to be in a “Classic Bubble” after rising +1,218% from $11 in 1998 and doubling to $145 over the past year. Historically, bubbles correct 50% on average which would produce an oil price of $67. While worldwide demand increases gradually, we expect lower prices because of a cyclical slowdown in demand growth combined with modestly increasing supply. This will have a positive impact on inflation as lower energy prices ripple through our economy.

Slowing growth and rising inflation challenge central banks to trade-off the consequences of “easy” versus “tight” monetary policy. The ECB and other European central banks are showing a greater willingness to fight inflation with tighter monetary conditions while the Fed is prioritizing economic growth with an accommodative monetary policy. Given the Fed’s stance, higher inflation is a key risk. Unexpectedly higher inflation could create a cascade of consequences resulting in higher interest rates, slower growth and lower asset values. Alternatively, lower inflation next year should have a positive impact on stock prices since the recent decline has been partially triggered by fears of higher inflation.

The Federal Reserve reduced the federal funds rate by 3.25% (from 5.25% to 2%) over the last year to aid the banking system and stimulate the economy. At the same time, the yield on the 10-year Treasury note declined from 5% to 4% producing a positive yield curve. This is an early bullish sign and a powerful aid in restoring bank balance sheets. Historically, a negatively sloped (or inverted) yield curve anticipates slowdowns and a positively sloped yield curve precedes recoveries. It is also encouraging that the level of interest rates remains low by historical standards. A key risk to the near-term outlook is higher interest rates. As long as inflation expectations do not accelerate, the Fed should be able to maintain low short-term interest rates until the economy and banking system stabilize. Ultimately, the Fed will raise rates since real interest rates are negative which is unsustainably stimulative for the long-term.

The stock market has declined approximately 25% from its October 2007 highs. During the second quarter, the market rallied strongly into May with better than expected first quarter earnings, but declined quickly with new lows established in July because of worries relating to instability in the banking system, higher inflation, lower global growth and higher energy prices. We expect the market to remain highly volatile until the banking system stabilizes and inflation worries diminish. Stock market declines are always frightening, but they are a fact of life for investors. Today, we believe that stock market valuations reflect the negatives. For example, since 1960, the average price earnings multiple of the stock market was 20x when core inflation averaged 2%-3% and 15x when the average was 4%-5%. Today, core inflation is under 3% while the market’s p/e is 14x next year’s adjusted earnings. The U.S. stock market is inexpensive – especially for those buying with stronger currencies. U.S. real estate and stock prices are “On Sale.”

The following factors confirm that negative sentiment is high and the market is overdue for a recovery. First, short positions increased 55% since October 2007 to a record high suggesting that “bearishness” has become the consensus. In addition, greater than 36% of S&P 500 stocks have over 5% of their shares short. Significant incremental buying power exists if this level of shorting were to cover quickly and, typically, short positions are not held for long periods. Second, the ratio of stocks on the NYSE hitting lows relative to highs is greater than 15:1, a historically high ratio typically experienced during market bottoms. Third, the Conference Board Consumer Confidence Index is at a level indicating extreme gloom. At this level, the stock market has always been higher within 12 months with an average gain of +23%.

Fundamentally, the healthy level of takeover activity indicates executives are finding value in the market. Furthermore, intra-industry deals, such as, Dow Chemical/Rohm&Haas, Hewlett-Packard/EDS, InBev/Anheuser-Busch, Mars/Wrigley, Roche/Genentech, Teva Pharmaceuticals/Barr Pharmaceuticals and Verizon/Alltel are motivated by industrial strategy and less by LBO-style financial engineering. This approach is a positive development for continuing to reduce the supply of shares in front of potentially increasing demand.

We recognize that the troubled banking and housing sectors combined with the threat of higher inflation and geopolitical risks pose major threats. Thus, the market is likely to remain more volatile. However, we remain confident in our approach of investing in quality small and medium sized growth companies with good profitability and financial strength. Our sluggish economy makes it especially important to own companies that will sustainably increase their revenues and earnings at above average rates. Furthermore, we continue to believe that this is an attractive period for long-term investors to invest in our market segment. It is riskier to miss market strength than to experience market declines. Bull markets often begin with high levels of pessimism and grow on skepticism.