Insight Line—December 17, 2007

My forecast for the coming year:

Economic growth in 2008 decelerates but does not enter into a recessionary period.
The current levels of corporate and household balance sheets, in conjunction with total personal and corporate income flows, suggest to me an economy diverse enough to withstand the adverse affects of historically high energy prices and the credit dislocations attributed to housing finance. By year’s end the year-over-year real (inflation adjusted) growth rate should achieve 2.3 percent.

The Federal Reserve Open Market Committee (FOMC) lowers the federal funds rate to 3 percent.
Credit restrictions evident in 2007 persist into early 2008. However, as the key short-term lending rate moves lower, the yield curve markedly steepens thereby reintroducing the opportunity for the financial community to attract money at a rate profitably below prevailing investment opportunities.

Equity investors experience the S&P 500 Index¹ climbing past its previous intra-day high of 1567 and perhaps even surpassing 1700.
However, the volatility witnessed in 2007 should again be evident as early gains fade mid-year, only to recover to new highs by year’s end. As an aside, if history is to be any guide, since World War II there has only been one incidence (in 2000) of declining equity returns in a presidential election year. With that said, I consider it of major importance—and central to my forecast—that the S&P 500, as measured by its earnings yield, is as undervalued as it has been since the onset of this current bull market in October 2002.

Relative outperformance by large growth stocks should carry over from 2007 into early 2008.
However, in a surprise resurgence, due in no small part to the FOMC’s continued lowering of short-term interest rates, small and mid-cap value stocks resurface in the second-half of 2008 and outpace their large cap brethren for the full year. As such, I continue to advocate a core position of large cap value stocks while using small and mid-cap stocks as a shorter-term (one-year) tactical strategic overlay. For investors including an international allocation in their equity portfolios, I offer a note of caution. My research leads me to favor dollar stabilization by the end of the first quarter leading to an outright increase its value on world currency markets by year’s-end. If correct, given my position on the relative undervaluation of the U.S. equity market, a disproportionate overweighting to developed international markets is no longer warranted.

Longer-term interest rates (10-year) between 3.5 and 5.3 percent
Influenced by slowing economic growth, FOMC policy and receding inflation expectations, long-term rates remain range bound between 3.5 and 5.3 percent.

What could go wrong?
The “wall of worry” faced by investors always has its bricks, and 2008 will be no exception. Among them will be: energy supply disruptions, an escalation of geopolitical tensions, Congressional and campaign rhetoric on taxes and protectionist trade policy, legal rulings from the Supreme Court (with regard to taxes and 401(k) plans), a major financial bankruptcy, and a drastic slowing of global growth as the Chinese economy responds to increasingly stringent credit conditions.

Additional commentary on my economic and market outlook for 2008 follows the summary in this month’s Factors Driving the Economy and Markets commentary.

¹ The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The index does not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 12/14/07

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

The release of November 2007’s employment data elicited a sigh of relief from investors worried the economy was taking a turn for the worse. Granted while the data was not spectacular it nevertheless recorded an increase of 94,000 payroll employment thereby moving total payroll employment to a record 138.467 million workers. Growth in the household survey, however, was spectacular. Despite the nation’s labor force expanding by 617,000 the ranks of the employed jumped 696,000 to a record 146.703 million total. As such, the unemployment rate remained at 4.7 percent. That said, the weekly unemployment claims data, in conjunction with anecdotal private business hiring expectation surveys, clearly establish slowing year-over-year hiring patterns. However, hours worked and wage trends do not appear to be confirming a major trend change is underway. Thus, I suggest the appropriate action on the table remains, circling Up.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

October 2007 personal income data offered some evidence for those positioning the plight of a beleaguered consumer. The overall income total did not grow meaningfully from September’s level of $11.8 trillion. On the other hand, for those of us forecasting slowing growth but no recession, the year-over-year growth rate of 6 percent remains a pillar of economic strength and perhaps the strongest argument against the onset of a recession in early 2008. Therefore, I suggest Up remains the appropriate circle on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

November 2007’s retail sales data clearly reflects a strong post-Thanksgiving. The monthly total of $386 billion was at odds with a downbeat consensus forecast. However, the internals of the report suggest high gasoline prices are indeed cutting into the season’s sales as sales at gasoline stations show a disproportionate increase (retail sales measure dollar changes not volume changes). Netting out the increase attributed to gasoline prices reveals the slackening year-over-year trends mentioned last month remains (5.3% vs. 6.2%). All of which suggests that consumers, while not down for the count, are a bit wobbly on their collective feet. I suggest the continued appropriate circle on the chart remains Down.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

Durable goods orders for October 2007 appear to confirm my forecasted drop in economic activity as the fourth quarter gets underway. Granted, manufactured goods did indeed rise; however, manufactured durable goods (those lasting more than three years) declined for the third month in a row. Shipments and inventory data, on the heels of stronger-than-forecast third quarter activity, are once again tracking at lackluster levels. To be sure, strong transportation orders have kept the unfilled orders component at record backlogs (perhaps a harbinger of things to come) and therefore acts as a strong counter-argument for those forecasting an imminent recession in 2008. Nevertheless, the overwhelming evidence, in my opinion, argues for leaving Down as the preferred circle of choice.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex- food and energy price changes, as of October 2007 registered 1.9 percent year-over-year. October’s report marks the fifth month running where core inflation remains within the FOMC’s preferred range of 1 to 2 percent. Therefore, I suggest the appropriate action is to move the circle from High to Low on the chart.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

Despite no formally approved fiscal 2008 budget, the federal government continued to operate within the directives of numerous continuing resolutions. Deficit spending continues to be the order of the day. In fact, the first two months of the fiscal year have indeed produced $20 billion more in red ink than at this time last year. That said, projections for fiscal 2008 balances do grow more difficult each day as officials assess the impact of slowing economic and financial activity. In that a surplus in the current fiscal year is beyond the scope of reality at this point, I believe it appropriate to argue that the federal government continues to stimulate economic activity with deficit expenditures thereby making the appropriate circle on the chart $In.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC reduced the overnight lending rate to 4.25 percent on December 11, 2007. Market participants were quick to express concerns that in light of the current financial dislocations in the short-term funding markets the FOMC arguably may be behind the curve. The removal of a balanced assessment of future risks in the monetary policy directive added to investor concerns. As stated last month, I continue to position a high likelihood of an additional rate reductions in the months ahead as the Fed addresses financial market instability. Therefore, please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was 134 basis points on December 14, 2007. For those following the Federal Reserve’s yield curve analysis the current slope places the probability of recession in the coming 12-months at just 5 percent. This is a dramatic drop from earlier this year, when risks were above thirty percent. Please Circle Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The nation’s GDP in the third quarter was, as I positioned last month, revised sharply higher from the initial 3.8 percent to 4.9 percent quarter-over-quarter annualized growth. But don’t look for a repeat anytime soon. As pointed out in this commentary, economic growth in the fourth quarter shifted dramatically downward early in the quarter. While I believe recession calls are highly suspect at this point in time, the prospect of slowing growth is all but certain. Therefore, please circle Below.