Outlook
We expect a weak U.S. economy for the next three or four quarters. We are hopeful it will just slow down and not move into recession. If the Federal Reserve continues to aggressively ease the money supply and inject liquidity into the economy, we believe we will avert recession. 

Interest rates remain a significant issue. We believe the Fed needs to move short-term rates down below 3% and closer to 2% in order to create a normal-shaped yield curve and to change the direction of the economy. Housing and financials will likely stabilize in that type of interest rate environment, although it will likely take time for those sectors to come back. Without interest rate relief, we believe they would get progressively worse.  Eventually we will have to deal with higher inflation, but not right now. We’re in a sluggish growth situation. We don’t think the economy is going to move into recession. We do expect the market to begin discounting an economic recovery sometime in 2008.

We think the year will be positive for stocks, but not a huge year. It may be another year like 2007, with modest returns, and it’s likely that the same type of volatility and uncertainty that characterized 2007 will typify conditions in 2008. We expect it will be the same type of year where investors react swiftly to news of short-term significance and that will fuel volatility once again. In 2007, market problems included a China meltdown in February and the subprime meltdown in August and yet year-to-year the market was up. We think that’s what 2008 is going to be like, and we’re already seeing it, with all kinds of disruptions brought on by uncertainty. Still, if the Fed continues to do its job, the market should finish up in 2008.

The energy, industrials and materials sectors and commodities in general have been the most powerful economic engines in the past few years. We think these economically sensitive and global investments will continue to be market leaders as long as the world economy keeps growing. If the market begins to discount a recovery, some consumer discretionary companies, including retailers, could become more attractive.

U.S. GDP now accounts for a smaller percentage of global output than that of the developing countries. We are 27% of world production to developing countries’ 29%. As these emerging markets grow, we will grow with them. As Americans, we have long believed other economies would follow our lead in economic cycles. That may no longer be the case. It doesn’t necessarily matter if we have a weak housing market. We’re nearing the point where the world economy can pull us along.

Particulars

• We have sustained a big hit on one of the most important areas of our economy -- housing. It’s central to a lot of economic activity and is probably responsible for the slowdown in U.S. manufacturing activity late in 2007. Improved liquidity and interest rate relief will serve to stabilize this sector and mitigate the degree of downturn.
• We believe the level of manufacturing and magnitude of the decline in the manufacturing index is consistent with an economy growing at a 1% or 2% rate.
• If the world economy slows and China cuts its use of energy, then the price of oil is vulnerable and energy stocks will likely weaken. On a secular basis there is a good argument to be made that demand will continue to outstrip supply. If that situation changes and demand drops off, we would likely see a price adjustment. If the price of oil moves down significantly, energy stocks will likely be lower.

Opportunities and Threats

• We remain focused on energy, materials and industrials. These investments are dependent on continued global economic growth. We are relatively confident that growth will continue and energy prices will remain high, as will prices for industrials goods, materials and commodities.
• Our investment discipline is based on having confidence in the balance sheets and future cash flows of our portfolio holdings. Investors should think of us as credit analysts who buy and sell stocks. Where that confidence is absent, we retreat. In that context, we are currently able to find consumer discretionary companies suitable and attractive for investment. While these companies operate in unpopular areas of the economy they have strong balance sheets and visible cash flows. We think these out-of-favor companies make sense in our value portfolios.