August 2007

Editor's note: The following review is based on the most recently available information as of August 24, 2007.

Stock and bond markets around the world have entered a period of high volatility over the past month-and-a half. The S&P 500 has suffered nearly a 10% correction since reaching an historic closing peak of 1553.08 on July 19th. Other domestic and international stock markets have had similar declines.

To put this in context, however, note that the S&P 500 has not had a significant correction in almost four-and-a-half years, an unusual hiatus. And the volatility of the S&P 500 (as measured by the VIX index), although doubling since the end of June this year, has only just spiked to levels typical of average levels of volatility during the late 1990's and early 2000's. We've experienced an extended period of stock price appreciation and uncharacteristically narrow corporate bond spreads. It is perhaps only surprising that we haven't had such a correction sooner in this market cycle.

Despite the recent turmoil in markets, we remain confident in our forecast as articulated in our recent Economic and Market Perspectives. We expect the global economy to continue growing at a healthy pace, and we expect the domestic economy to continue to grow, although probably at a reduced pace for a bit longer than we suggested then. Corporate profits should also continue to grow at a single digit pace, as they have during the past two quarters. And corporate balance sheets will remain very healthy by historical norms as cash flow generation and responsible capital spending keep coffers full. In short, we do not anticipate that recent disruptions in credit markets will lead to a recession either domestically or globally.

The primary reason for our confidence in this outlook is the fact that the Federal Reserve, along with other key central banks throughout the world, has begun to aggressively respond to the fallout from the sub-prime mortgage crisis. Two weeks ago, the European Central Bank (ECB), the European Union's counterpart to our Federal Reserve (the Fed), injected $130 billion into the Eurozone banking system. At the same time, both the Federal Reserve and the Japanese central bank engineered similar, though smaller, liquidity enhancing maneuvers. Additional, but smaller, injections continued for a few days thereafter in each region.

More dramatically, last week, in response to the risk of a rumored potential bankruptcy of Countrywide Credit, the largest mortgage lender in the United States, and more importantly, to the fear that such an event would create among all lenders, the Federal Reserve issued two back-to-back statements. The first announced a 50-basis-point reduction in the Discount Rate (the rate charged to banks on overnight loans), as well as an extension of term from overnight to as much as thirty days at the request of the borrowing bank, and the acceptance of certain types of mortgages as collateral for such loans. In addition, the Fed explained that it was taking this unprecedented action "to promote the restoration of orderly conditions in financial markets," because "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward." Furthermore, modifying its recent contention that the potential for rising inflation was more worrisome than prospects for declining growth, the Fed stated, "downside risks to growth have increased appreciably."

The most interesting thing about the Fed's actions is that they were directed more toward ensuring that credit remains available for the day-to-day operations of businesses than toward bailing out investors who had made risky, leveraged bets. There will be other casualties of the sub-prime blowup besides a few failed hedge funds, bankrupt mortgage lenders, and banks in need of government assistance. But the Federal Reserve, and other central banks around the world, are essentially charged with the responsibility to ensure that their financial systems stay liquid, and their economies continue to expand with relative price stability over time.

That, of course, is no guarantee that markets won't decline, or even that economies won't fall into recession. But history suggests that such monetary intervention is usually successful at thwarting an economic downturn as the result of panic in financial markets. The evidence: the stock market crash of 1987, and the emerging market crises of 1997 and 1998. Both of these episodes carried the potential to lead the world into recession, but strong and coordinated global monetary action helped right the ship rather quickly.

We would also note that the recent market turmoil and "credit crunch" happen to have come at a time of unprecedented global economic growth. Estimates of the growth rate of the global economy, based on GDP-weighted growth, are currently running at about 4.5%. Of over 120 countries providing GDP statistics, none had negative growth, and only four had rates of growth less than 3.0%. Economic liquidity (i.e., cash flow generation) remains extremely robust even while financial liquidity (i.e., cash willingly loaned to borrowers) has intermittently dried up in various corners of the system. The strength of the global economy provides a near-term cushion for the bumps we will continue to experience in the financial system as credit conditions stabilize.

With regard to the portfolios we manage on behalf of you, our clients, we're pleased to note that all of our internally managed equity funds are meeting or exceeding their respective benchmarks, as are our bond funds. With specific regard to our bond funds, we note that we've never owned any sub-prime mortgage securities, and we have reduced our non-government-backed mortgage exposure to a minimal percentage of the bond portfolio. In general, our investment philosophy is to seek long-term returns that outperform the respective benchmarks and outperform competitors on a risk-adjusted basis. This philosophy derives from the fact that the assets we manage on your behalf are dedicated to supporting your longer-term needs, in particular, during retirement. Short-term volatility and price declines are a reality of investing, but focusing on longer-term performance and day-to-day risk controls go a long way in helping preserve and grow your assets over time. Our process for implementing this philosophy is based on broad diversification, relatively sector-neutral positioning, and excess return generation through superior security selection based on a combination of quantitative screening and in-depth fundamental research. We believe these disciplines provide the best opportunity for ensuring the security of your investment portfolio.

INDEX COMPARISONS

Source: Wall Street Journal

S&P 500 and S&P MidCap 400 are registered trademarks of The McGraw-Hill Companies, Inc.; Russell 2000 is a trademark of the Russell Investment Group; and MSCI EAFE is a trademark of Morgan Stanley Capital International Inc. All other third party marks are marks of their respective owners.

The views expressed in this article are subject to change at any time based on market and other conditions, and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.