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COMMENTARY
GDP growth increased 4.9% in the third quarter, reaching its fastest level in four years. Consumer
spending increased by a stronger than expected 2.8% in the quarter. The biggest surprise came from a
19.1% increase in exports. The US dollar’s continued slide versus other currencies led to a dramatic
increase in exports as US produced goods became cheaper for foreign buyers.
Despite very strong economic growth in the third quarter, a majority of the economic data released in
the fourth quarter was negative. Oil continued its upward climb and spent most of November and
December over $90 a barrel. The PCE price index, the Fed’s preferred measure of inflation, rose at an
annual rate of 2.2% in December, above the Fed’s stated 2.0% ceiling. Higher inflation makes it more
difficult for the Fed to cut rates because lower rates may spur additional inflation growth. Employment
numbers weakened in the fourth quarter. The 4-week average initial unemployment claims figure
jumped from just over 300,000 in October to 345,000 at the end of December.
As has been the case since the first quarter of 2006, housing was again a significant drag on US
growth. Residential construction reduced US GDP growth by 1.1% in the third quarter, the largest
amount since third quarter 2006. Pending home sales fell 2.6% in November and was down 19.2% in
the last 12 months. New home sales slid 9.0% in November and 34.4% for the trailing 12 months. The
US homebuilders index, initiated in 1985, hit a record low in December. The market continued to
struggle with tighter lending standards, rising defaults, and a growing supply of homes.
The Fed lowered the Fed Funds rate by 0.25% at both meetings during the quarter. The reductions, in
addition to the 0.50% cut in September, pushed the Fed funds rate down to 4.25%, the lowest level in
two years. Perhaps more important, the December Fed meeting minutes stated that risks to growth had
risen since the last meeting in large part due to deteriorating credit markets. The question is did the Fed
act quickly and aggressively enough to prevent a recession?
EQUITIES
Stocks fought off much of the bad news in the third quarter and prices pushed higher. The stresses of a
weakening economy, higher oil prices, a depressed housing market, tight credit, and a slowing job
market proved to be too much in the fourth quarter. Stocks succumbed to economic pressures and
prices fell. Small, mid, and large cap stocks as well as value and growth stocks all suffered losses.
Larger cap stocks held up better than smaller cap stocks. Larger cap stocks benefitted from reasonable
valuations, globally focused revenue sources, easier access to credit, and a history of relative
outperformance during economic slowdowns.
Growth indices, which have minimal exposure to the Financials sector and heavier exposure to
Technology and Healthcare, outperformed value indices. Financials’ stocks were hammered due to
huge write-downs in subprime mortgages, minimal M & A activity, and an overall seizure of the credit
markets. Healthcare and Technology stocks were basically flat in the quarter.
Technology stocks are generally able to grow earnings even in the face of slower economic growth.
Healthcare stocks held up relatively well as they are perceived to be defensive and less economically-
sensitive.
For the second quarter in a row, developed international stocks performed similarly to domestic stocks.
International large cap stocks outperformed smaller cap stocks and growth stocks outperformed value
stocks. Returns were helped by continued dollar weakness. The US dollar dropped 2.7% versus the
Euro and 2.8% versus the Yen in the fourth quarter. Many European countries posted losses due to
spillover from the US credit crunch and subprime crises. In addition, there was heightened concern that
a US recession and a rising Euro would dramatically slow exports. Japan notched the weakest major
market performance as a US recession would significantly hurt Japanese exports. Although the EAFE
index was down 1.8% in the quarter, it still outperformed domestic indices.
Emerging market stocks provided stability and positive returns during a period of economic weakness
and global stock price declines. Historically, weakness in the US economy generated a sell off in this
volatile asset class. Strong domestic economic growth and rising commodity prices provided support
and the MSCI EM index responded by rising 3.6% in the quarter. Resource rich countries in Latin
American and Europe were the top performers while export focused countries, such as China and
Taiwan, struggled. Investors clearly favored growth stocks in the quarter and for the year. The MSCI
EM index was the top performing index in 2007, rising 39.4%.
FIXED INCOME
Strong returns in the fourth quarter pushed the LB Aggregate Bond’s return above the S&P 500 Index
for 2007. During the fourth quarter Treasury bond yields dropped to levels not seen since late 2004,
when the Fed Funds rate was below 3.0%. Investors were not buying Treasuries for their yield, but
rather safety amid increasing economic uncertainty. The Treasury curve steepened sharply as short
term yields fell in response to slower economic growth and the prospect of future Fed rate cuts. Longer
term Treasury yields didn’t fall as much due to continued inflationary concerns. Longer term bonds are
more sensitive to inflation expectations.
Financial institutions were pressured during the quarter with additional write downs, rating agency
downgrades of holdings, and liquidity issues. Several large banks were forced to raise additional
capital from sovereign wealth investors. The Fed responded to banking problems and slowing growth
by injecting liquidity into the market and reducing the Fed Funds rate from 4.75% to 4.25% by quarter
end. In addition to rate cuts, The Fed worked collectively with global central banks to pump cash into
the banking system by reducing borrowing costs and loosening acceptable collateral standards. The
Fed also held two auctions in December and injected $40 billion into the cash strapped market.
Credit quality was again the most important determinant of return in the quarter. The highest quality
government backed securities had an outstanding quarter as investors bid prices higher. The LB
Government Bond Index jumped 3.7% in the quarter as investors flocked to safety. Within government
backed securities, longer duration bonds posted the highest returns. High yield bonds posted a loss,
with the LB High Yield Index dropping 1.3%. Securities with any default risk were punished as credit
spreads (extra yield versus comparable Treasury bonds) widened.
2008 MARKET OUTLOOK
The US economy enters 2008 on shaky ground! The housing decline that started in 2006 shows no
immediate signs of recovering. Financial institutions are struggling with huge write offs of subprime and
collateralized loans and credit has become increasingly scarce. Consumer confidence fell sharply as
the unemployment rate jumped to 5.0% and oil and other commodity prices pushed living expenses
higher. The likelihood of a recession has increased dramatically over the last few months. However,
even if the US enters a recession, we don’t think it will be very deep or prolonged. The Fed has been
actively reducing rates and has indicated it will continue to do so if the economy stumbles. US
corporate balance sheets are in great shape and the global economy looks to enjoy another solid year.
Growth expectations outside the US have fallen, but they remain relatively attractive. The World Bank
projects global growth of 3.3% in 2008, while growth in the US is projected between 1.0 and 2.0%.
Growth among the developed countries is projected to slow primarily due to the global credit crises.
The emerging market countries are again projected to lead global growth. Despite a multi-year run of
strong stock price performance, emerging market stocks still look compelling from a growth
perspective. Overall we believe the growth potential of international stocks looks favorable in
comparison to domestic stocks. However, aggressive easing by the Fed could help the US economy
avoid recession and could lead to higher stock prices as investors have pushed stock prices lower in
response to a potential recession.
Bond yields moved in two distinct directions in 2007. High quality government-backed bond yields fell
and credit (non government secured) bond yields increased. Throughout the first half of 2007 investors
gravitated toward credit securities and spreads were very tight with Treasuries. This trade was reversed
in the second half of 2007 and spreads widened significantly. Entering 2008 the yield on government
backed bonds is very low by historical terms and the upside potential for further price appreciation
seems limited barring any major economic decline. However, until liquidity returns to the market, it is
likely that spreads will remain elevated. If the US avoids recession, Treasury bond yields will likely rise
and credit spreads will tighten.
TACTICAL POSITION
As of December 31, 2007, portfolios’ were positioned with the following tactical allocations.
• Overweight international equities (developed and emerging markets) relative to domestic equities.
• Overweight large cap domestic stocks relative to mid and small cap stocks.
• Underweight real estate.
• Underweight high yield bonds.
• Increased weighting to intermediate bonds and reduced exposure to short term bonds.
• Intermediate bond exposure split between domestic and international bonds.
• Overweight growth stocks in relation to value stocks.
During the first week of January the Investment Committee determined that given the economic outlook
it is prudent to reduce equity exposure and increase fixed income exposure. Given the low yields
available in the fixed income market, proceeds from the sale of equities will be held in short term cash
accounts until a better option is identified.
We continue to work diligently to help you achieve your investment goals. Please call us if you have
any questions.
Very truly yours,
AKT WEALTH ADVISORS, LP INVESTMENT COMMITTEE
Darin Richards Scott Barchus Toby Daniels Charlie Zieky
Doug Davison Julie Robinson Carl Pinkard
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