Sell the Rallies

Prior to last week’s 3.4 percent slide, the S&P 500 had mounted an impressive rally that brought the index to within 3 percent of where it began the year. Declining home values, surging energy prices, rising food costs and tightening credit conditions are pushing the U.S. economy to the brink of recession. Our best guess remains that we will avoid a classic, textbook recession (two consecutive quarters of negative GDP growth). Nevertheless, Main Street may feel like it’s in recession as the roller-coaster pattern of tepid economic growth may persist into 2009.

With oil now approaching $135.00 per barrel, soaring energy prices are understandably weighing on the consumer. In the short term, we believe this recent spike in energy prices has been fueled more by speculation than fundamentals and will ultimately be unsustainable in the face of decelerating global growth. We view rising energy costs as more of a “tax on growth” than a source of near-term inflation. In short, the rising energy expenditures tend to crowd out other discretionary consumer spending. As demonstrated in the graph below, current spending on energy is far from unprecedented.

As we have stated in our last two mid-quarter updates, we believe the first half of 2008 will be challenging for equities (i.e., volatile) and a rebound in both the market and the economy may not gain traction until late in the year. Ultimately, the Fed will win. In other words, the combination of monetary stimulus (rate cuts) and fiscal stimulus (tax rebates) will reinvigorate the economy. Clients who are uncomfortable with the heightened volatility of the past year should use market rallies to reduce their allocation to equities, though we would not advise reducing equities to below the midpoint of the target allocation range.

Please do not hesitate to contact me or your portfolio manager with any questions or comments you may have.

Best regards,

George W. Hosfield, CFA
Chief Investment Officer