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FOR IMMEDIATE RELEASE October 26, 2007 By Mat Johnson "If past history was all there was to the game, the richest people would be librarians." — Warren Buffett This past week, investors spent the most of their time contemplating this week's events, namely what action the Fed will take at tomorrow's FOMC meeting. Expectations for a rate cut of 25 bps have been priced in since the surprise decline in August payroll figures. Last week's weaker than expected economic reports not only solidified that expectation, but gave some hope for an even deeper rate cut. Stocks were higher this past week, led by large cap blue chips. For the week, the Dow Jones Industrials advanced 2.5%, the S&P 500 rose 2.1%, while NASDAQ ended the week 1.4% higher. Small cap stocks, as measured by the Russell 2000, climbed 1.0%. Notably, this market advance occurred in the face of oil prices rising above $80 a barrel, which often incites inflationary concerns and fears over rising interest rates. However, given the dominating concern being economic growth, and what the Fed will do to temper a slowdown, the increase in oil prices was cast as a drag on growth, and therefore yet another reason for the Fed to act. With the Fed in focus, little else will matter until the policy announcement occurs. Given that the market has been prone to rally after Fed announcements, last week's bidding up of blue chip stocks looks a little like front running the Fed. However, it may also reflect diminishing concerns over recent financial sector liquidity constraints. Either way, it's deemed as being in the Fed's hands now. While we're not ones to attribute the market's performance all to the Fed, they do have an impact, though principally through the economy's performance. Even on this score they do not determine the economy's outlook, but merely play a role. What is at question at the upcoming meeting is whether they should act today to fend off the possibility of future economic weakness. To many the answer is a clear yes, as their concern is that the subprime mortgage fallout will spill over to the consumer sector and “needs to be” dealt with by the Fed. This is despite the fact the market seems to have done a good job of dealing with it as mortgage rates have already fallen with market yields. Many are looking at the Fed's past as a sign that they will act, and act aggressively in the face of these market rattling concerns. However, many are citing their sharp cuts of a few years ago. One caveat to this is that a few years ago, deflation, not inflation, was a concern. This played a key role with respect to not having to be overly concerned about inciting future inflationary pressures - their job in fact, not easing investor concerns. Today the Fed does have to be concerned about future inflation trends, and how their current actions impact inflation in the future. It is widely regarded that today's rate policy changes take 12-18 months before being fully felt in the economy. This requires that the Fed be cognizant of how their desire to provide support to a slowing economy, will also impact future inflation. The current debate surrounding Fed expectations is how much they will cut rates, i.e., 25 or 50 bps, and not whether they will cut rates. While we would love for the Fed to not play any role with respect to businesses doing business, and consumers being consumers, there is a case that the Fed not making any rate changes in the past year, has been punitive for both. It is our view that the rate the Fed sets their target fund level at is measured in “real” terms, i.e., less core inflation. Below, we have put together a chart that does just that and combined with reported GDP growth. We have also aligned the Fed's actions from 15 months ago with current GDP growth. While not a perfect correlation, it does appear representative. In “real” terms, the Fed has actually increased rates by about 40 bps over the past 12-months. Even though the Fed has not changed their target rate from 5.25%, core inflation has fallen from 2.4% a year ago, to 2% today. Expectations are that core inflation is continuing to fall. Accordingly, the Fed has in essence been increasingly restrictive on a “real” Fed funds basis by doing nothing, and easing rates 25 bps tomorrow will only remove some of this restriction. If the Fed was to reduce rates by 50 bps, they would only be modestly reducing rates versus a year ago — by a mere 10 bps. In other words, whether tomorrow's decision to lower rates is 25 or 50 bps, it is really much ado about nothing. In the long-term, it will be the fundamentals that hold sway over the economy and financial markets, with decisions made by businesses and consumers being the primary determinant of the economy's health. What role the Fed may play is in easing the current anxiety in the market place. Despite even 50 bps not being that meaningful of a reduction in “real interest” rates versus a year ago, it may be too much of a change in policy to raise another concern — “what does the Fed know that we don't.” Given the continuing volatility in the market, and heightened focus on the Fed, we've provided a brief summary of the big picture fundamentals as we see them. It is the “big picture” that helps us make the most of attractive long-term investment opportunities. On this front, the picture is somewhat mixed, where even the Fed has recently shifted from a high level of comfort in economic prospects, to being concerned enough to possibly cut its Fed Funds rate on September 18th. Economy:  Neutral to Weaker U.S. GDP trends appear to have stagnated recently. While second quarter GDP growth was recently revised higher, from an annual rate of 3.4% to 4%, there has been increasing concern that third quarter growth has slipped. Retailers reported modest growth, and August payrolls were reported lower from the prior month suggesting that businesses at the very least put some new hires on hold in August. Expectations at the Federal Reserve had been for moderate growth in the second half of the year, though in recent speeches Fed members have intimated increased concern about the sustainability of the recent pace of growth. Inflation:  Improving Core inflation has continued to ease lower over the last several months. At this point, the key benefit of lower inflation is likely to be giving the Federal Reserve greater latitude in easing rates to stave off a weakening economy. Longer-term, the true benefit of sustained levels of lower inflation are lower market interest rates, which impact business investment decisions, as well consumers via financed purchases and refinancing mortgages. Interest Rates:  Neutral The 10-year Treasury yield has continued to drop in recent weeks, from roughly 4.80% a month ago to 4.35% and this is from 5.15% back in May. This sizable decline below 5% most likely reflects a “flight to quality” investment given the market volatility, more than an improved interest rate environment. Therefore the full drop in market yields is not entirely a positive for the economy or stock market, as we expect that once investor concern subsides, rates will rise somewhere back between 4.5% and 5%. Valuations:  Neutral to Positive The P/E ratio for the S&P 500 now stands at 15.6x, down from 16.3x four weeks ago. The decline is in part due to the market's decline, but also owes to the above expected increase in earnings through the last reporting season. At current levels, valuations reflect decent value and should provide support to the broader market. With respect to the current earnings season, operating earnings for the S&P 500 are expected to rise just 3.2%, year-over-year, down from the second quarter pace of 9.5%. Should third quarter expectations prove too pessimistic, as was the case in the second quarter, this could further push valuations lower and equities higher heading into the end of the year. Bottom Line The backdrop of volatility and concern isn't likely to suddenly disappear, though neither are the fundamentals listed above likely to abruptly deteriorate. Thus far it appears that the worst of the fears surrounding the subprime issues aren't materializing, though the risks remain heightened. So long as the fundamentals remain intact, time should favor investment discipline over investor psychology.

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