• Sit back and take some time with the Bullets.  There is a lot to read and digest, but we believe it’s important to discuss at this time.  In spite of all the turmoil, including a decline of almost 10% in the spring, and eventually a 10% correction in the fall, the Dow Jones Industrial Average finished up for the year at 6.4%.  The S&P 500 did not do nearly as well, but still had a gain of 3.5%.  The NASDAQ, which had a great deal of up and down movement, finished with a positive return of 9.8%, and the MSCI EAFE finished up 8.6%.  The Russell 2000, however, declined -2.7%.  This is the fifth year in a row that the equity markets have moved in a generally positive direction and, of course, the question now becomes what will happen in 2008? 

Before trying to analyze that question, let’s look back at the Bullets from this time last year.  We talked about GDP growth “somewhere in the neighborhood of 2.25% to 2.5% with the latter part of the year likely coming in stronger than the first part.”  Well, we will give ourselves credit for getting the total GDP number correct, but clearly, the fourth quarter, with the sub-prime mess was a lot weaker than the middle part of the year.  We said that the consumer would show a slight increase in spending but “look for businesses to pick up some of the slack.”  Both clearly happened.  We said that the dollar is “expected to remain weak during the early part of the year” (got that right) and “strengthen later in the year” (got that wrong).  In fact, the dollar continued to weaken even more, and while not in a free fall, it is a growing concern around the world.  On the interest rate front we said, “In fact, it is possible that there may be at least one or two declines in short-term interest rates during 2007.”  We got that right, but we also said that, as it related to the Ten Year Treasury, “It is possible we will see an increase in this rate during 2007.”  We got that wrong, as interest rates on U.S. government bonds actually declined.  We explain once again that we are always reluctant to make the inevitable call on what the market will do, but we said that we would be satisfied with a “return of somewhere in the 7% to 9% range”.  We got close on the Dow, but the S&P 500 was below this range, while the NASDAQ was just above it.  Trying to be objective, we will give ourselves a B minus grade for our 2007 thoughts.  Now, let’s turn to the rest of the Bullets and look ahead to 2008 and beyond.      

The best offense will likely be a good defense.  Those who own Index Funds are again likely to be disappointed, as good stock pickers, i.e., money managers who don’t own the entire market, should be able to pick companies and/or industries which have the potential to out-perform.  This was basically true in 2007, and we expect it to continue in 2008.  Further, having a well diversified portfolio that is rebalanced as necessary will allow you to “sell winners and buy losers” i.e., “selling high and buying low”.  You must avoid the natural inclination to stay away from the investments that are not doing well at any given moment.  Buy when the stocks are on “sale”.  Companies with good earnings and accelerating growth are likely to fare better in your portfolio during downward movements in the broad market.  Perhaps the best defensive play is to continue to remain focused for the long-term.  Even if we have subsequent 10% corrections in the market or worse, a recession, and perhaps an “official” Bear market where the market declines by 20% or more, it is important for investors to maintain a long-term perspective.  Those holding excess cash should consider dollar cost averaging into the market and potentially accelerate the process during market pull backs.

Some economists are calling for a recession in 2008, including Alan Greenspan who says the “odds are 50/50.”  We guess this means he will always be able to say he was “right.”  The fact is, while growth is likely to slow down, particularly during the first two quarters of the year, it is unlikely we will go into a classic recession given current facts and circumstances.  Even if we do, it will probably be a relatively mild one.  Why?  Two reasons.  First, the weak dollar is allowing American manufacturers to sell goods and services overseas, and as a result, the balance of payments, (i.e., trade deficit), has fallen dramatically in the last half of 2007.  There is nothing on the horizon to suggest that the dollar will strengthen materially.  Therefore, American goods and services should remain competitively priced, causing foreigners to continue to buy them.  The second reason is government spending, particularly at the Federal level.  Congress passed the Appropriation Bill, which made the President somewhat unhappy because of the pork barrel payments, but after all, this is an election year, and all the politicians want to make sure that as many people (voters) as possible are feeling like they are “getting their fair share”.  Further, when you look at the economy in general, getting away from the financial and housing sectors, it is doing pretty well.  That doesn’t make for good headlines, so we don’t hear much about it, but that doesn’t make it any less true.  Although unemployment is likely to creep up over 5%, it should still be below 5.5% which is the historical average for the last 25 years.  Consumers, although spending at a slower rate, will most likely spend a little more than they did in 2007.  Finally, there has not been a recession in the United States during a Presidential election year since the Second World War.  That is not to say that this year could not be an exception, but at the end of the day, it’s hard to build a case for a recession given the growth that is occurring around the world. 

Speaking of the world, overseas stocks will probably continue to out-perform U.S. stocks, but the margin will likely not be as large as it was in 2007.  The fact is, on a worldwide basis, U.S. stocks are probably under-valued.  Investors should expect some shocks from some of the foreign economies around the world which have done so well for the past few years, and this will likely play havoc temporarily on U.S. stocks.  Again, we urge everyone to keep a long-term focus. 

What will happen with interest rates is anyone’s guess but it seems like the Fed will continue to ease short-term rates during the beginning part of the year and will then likely have to “stand pat” due to inflation fears.  They want to spur just enough growth to keep the economy out of a recession (through lower interest rates and larger money supply), but not too much growth which would accelerate inflationary pressures.  Inflation is likely to be a problem again in the coming year as businesses try to pass on some of their increasing costs.  They are likely to be somewhat successful in this endeavor, but competitive pressure being what it is, prices will not be going up nearly as much as some are predicting.  Long-term interest rates are a breed apart.  These are not controlled by the Federal Reserve but rather by the bond market itself, which is often considered to be the “most sophisticated” investor in the world.  Interest rates on the Ten Year Treasury edged down in 2007 and finished the year at 4.03%.  This is definitely below the historical norm.  The bond market is indicating that inflation is not going to be a long-term problem, but the lower interest rates are also due to a flight to quality, especially over the past six months as the sub-prime credit mess has unwound.  Expect long-term interest rates to drift upward, but unless inflation gets totally out of hand, there should not be a big spike in these rates.

Because of this, investors are likely to turn to either tax-free bonds where the after-tax yield for those in the top tax brackets will be much better than being invested in U.S. government bonds,  or high-yield bonds which currently average double the rate of the Ten Year Treasury Note.  This will likely occur later in the year if some of the fear of recession begins to abate.

What about the price of oil?  In a word – “high”!  It’s hard to remember that only seven years ago a barrel of oil was selling for $12.  A large portion of the increase is a direct result of growth worldwide, but clearly, much of it is also related to political tensions - especially those in the Middle East.  Although there will be brief flurries of rising costs of oil, perhaps even rising above $110 a barrel, on average we expect that oil will be priced around $90 per barrel plus or minus a few dollars.  If we have another mild hurricane season this year in the Gulf of Mexico, it is entirely possible that oil will be selling for less in December of 2008 than it did in December of 2007.  Although there is a lot of talk about alternative forms of energy and additional research money being committed to this area, where is the massive influx of capital one would think would be given to the energy crunch if it were really as big a crisis as it is often made out to be?  By the way, we think it is a crisis on a long-term basis and a problem in the short-run. 

It’s hard to leave our thoughts for the year ahead without having some discussion about the political front.  Notwithstanding the “stubbing of her toe”, most believe Senator Clinton will end up with the Democratic nomination.  The Republican race is still up for grabs, but at the end of the day, many believe it will be Giuliani, although his recent hospitalization causes some concern - particularly since he has been so tight lipped about why he was there.  What looked like the potential for a Democratic sweep in 2008 this time last year - because of the disgust for many of Bush’s policies and the euphoria of a newly elected Democratic Congress - has dissipated.  While filled with lots of rhetoric last January, the Democrats have failed to deliver on most of their promises.  As a result, today voters are equally as disgusted with Congress as they are with the White House.  Don’t be surprised if a lot of new people are elected to the House and Senate once again.  No matter who gets elected, our politicians need to be brave visionaries with strong backbones to do the tough work that needs to be done.

Before we leave this section, we should also discuss taxes.  This will be a major issue in the upcoming Presidential election.  President Bush’s tax cuts will expire during the next President’s term and Congress will need to deal with these issues.  Since we expect the Democrats will continue to control the House and possibly the Senate, we think the pressure for increasing taxes is likely to continue.  In fact, if Congress does nothing, there will be a significant tax hike as many of the Bush tax cuts will sunset after 2010. 

Finally, at the risk of repeating ourselves, we think investors will be challenged in the upcoming year and will need to look past the daily headlines to the long-term nature of their investments.  This will be difficult at times.  Although we are five years past the last Bear market, it was so severe that investors are afraid and don’t want to see their portfolios decline like that again.  Bear markets are a natural part of the investing process.  A well diversified portfolio should help mitigate losses in that type of market, but they won’t eliminate losses. 

Okay – that means we now have to give our required “best guess” for the year.  We believe the market will be up when the year is done, but the significant volatility experienced in 2007 will continue.  We will likely have several downward movements that will approach or exceed 10% and perhaps even one that might be as deep as 15%.  Having said all that, at the end of the day we believe the market will ultimately post a modest gain for the year.  We also believe that there will be some positive surprises along the way that will fill investors will euphoria but that there will be surprising disappointments as well.  Remember, it’s what we don’t know or can’t anticipate that can trip up a plan in the short-run.  However, it is unlikely that those surprises will derail the plan for the long-run.

• A few weeks ago, the government reported that inflation rose at a rate of 0.8%, led in large part by energy prices, especially gasoline.  On an annualized basis, 0.8% translates into 9.6%, and while we are certainly not projecting that type of sustained rate for inflation, an increase of this magnitude cannot be ignored.  Even when you eliminate the so-called “volatile food and energy prices” from the Index, we had an increase of 0.3% in core inflation.  This is well above the target set by the Federal Reserve.

While we try to avoid getting caught up with the numbers that appear in the headlines month-to-month, these types of numbers cannot be ignored.  Juxtaposed against this is the ironic fact that real estate prices across much of the country, especially in places like California, Nevada, Texas, and Florida, are dropping dramatically.  In the Tampa Bay area the year-over-year decrease in real estate prices was 14% and it’s probably not over yet.  The Federal Reserve Board is continuing to lower interest rates, as they weigh the need to stimulate the economy against the threat of inflation. 

Is the Federal Reserve still capable of controlling inflation the way it did “back in the day”?  The answer is…probably not, but they can still have a lot of control.  How could we commit the heresy of suggesting that the Federal Reserve does not have as much power as it once did?  We are much more tied together as a global economy than we’ve ever been.  This is not only likely to continue but to accelerate.  This is especially true in those situations where economies have pegged their economic fortunes to the dollar.  Throughout the Caribbean, the dollar remains the preferred form of currency.  Much has been said about China pegging the value of its yuan to the dollar.  Other economies around the world have done the same thing.  When goods are exported to the U.S., we usually pay for those goods in dollars.  The companies then swap the dollars for the local currency to pay their workers.  Then, the foreign governments generally sell the dollars in the world markets and buy back their own currency.  However, many of these countries, especially China, are not currently doing this.  They are buying back the dollars from local merchants, but they are printing more of their own currency which is fueling their own country’s expansion (inflation) beyond belief.  Rather than being used to purchase the local currency, the dollars are being reinvested back into the U.S. which has led to our unusually low interest rates.  Make no mistake, every time the “easy” path is taken there is a price to pay for it and the longer this “easy” path is tread, the bigger the shock is when the path finally ends.  We’ve seen what five years’ worth of “easy” money has done to our economy and are now paying the price.  Just imagine how big of a shock the Chinese economy, (and perhaps others), is in for after having tread this “easy” path for almost two decades. 

As is always the case, it’s the unknown that causes the greatest amount of concern.  Few were talking about the credit crunch and sub-prime mortgages this time last year, but only six months later it exploded and we are paying the price.  Thus, we must remain ever vigilant and nimble as we head into 2008. 

• Last year, we suggested that the housing market would not recover in 2007.  We said that things would still have to get worse before getting better.  Unfortunately, this seems to still be the case, especially in states like Florida, California, Texas, Arizona, and Nevada.  On a national basis, home prices fell 5% in 2007 according to Merrill Lynch, who estimates that they have to fall another 10% in 2008.  These are national averages, and some places around the country could see housing prices decline by 25% from their peak values a couple of years ago.  There are several things to remember.  First, this decline only means something to those who are selling (or buying), except, of course, those living off home equity, which obviously is a very dangerous thing to do.  Three years ago there was an “inflation mentality” in housing, i.e., buy it today and flip it tomorrow and make a big profit because prices are going up so fast.  Today, we have a somewhat deflationary mentality in that buyers, assuming they can get credit, continue to hold off buying in hopes that prices will be even cheaper tomorrow.  With all of this doom and gloom, the fact is that we are actually beginning to see some break occurring, albeit a small break.  It is still well under the surface.  If you’re selling in a place like Florida, you’re probably having to put your pride away, as we have recently seen homes selling for 15% to 20% below the asking price.  Just as importantly, banks are starting to lend money again on “reasonable” terms, i.e., 20% down.  For those without cash, don’t even think about it; there simply is no money except Fannie Mae and Ginnie Mae.  Recently, we heard an excellent talk on the sub-prime mess given by a partner in Wilshire Associates.  Our favorite loan from the sub-prime marketplace was the NINJA loan.  Yes, that stands for No Income No Job or Assets.  Hard to believe, but these loans actually did exist.  When the real estate market does turn around, the turn around won’t be recognized until six to eight months after the bottom has been hit.  For those hardest hit, it will likely be at least the third or fourth quarter of 2008.  For others, it might happen sooner. 

• Just before leaving for the Christmas holidays, Congress passed a Bill “fixing” the AMT problem for another year.  In typical Congressional fashion (this extends to both sides of the political parties), the tax “quilt” created by a “patch here and a patch there” was extended further.  In fact, Congress violated its own rules in that the money that will be lost by the $50 billion “fix” was not “made up” somewhere else because Democrats could not get enough Republican support to target and tax private equity managers and hedge fund managers as they had promised to do.  The AMT was first introduced in 1969 to catch a small group of very wealthy people who paid virtually nothing in taxes.  Basically, it eliminates preference items and offers an alternative (hence its name) approach to taxes.  Over the years, Congress has extended more of these preference items to a greater number of taxpayers including those in the middle income level, and slowly but surely the AMT now not only catches very wealthy people, but also a significant number of those in the middle income area.  In fact, the White House estimates that $1 trillion will be raised by this tax over the next ten years.  This may make it very difficult for Congress to extend the so-called Bush tax cuts which basically expire in 2011.  While there will likely be a lot of rhetoric concerning tax reform in 2008, don’t expect any significant reform during the election year.  Having said that about 2008, life as we know it in the tax world is likely to change significantly in 2009, regardless of who gets elected to the White House and/or to Congress.

• Let’s take a few moments to talk about the recent auctions being held by the Federal Reserve Board.  Exactly what are these “auctions” and why were they created?  The first place a bank can go to get money is from the federal funds market.  This essentially means that one bank lends money to another bank.  The banks flush with cash (mostly those who steered clear of the sub-prime mess), were reluctant to lend money to the banks that needed it, essentially drying up the market.  This left the banks with the unpleasant alternative of going to the discount window and borrowing directly from the Fed.  Over the past 20 years, banks have come to believe that by going to the discount window others will perceive them as being “weak”.  This stigma would then make it even more difficult to acquire funds.  Nonetheless, Bernanke attempted to cajole the banks into using the discount window.  It simply didn’t work.  Thus, he came up with the idea of holding auctions for the money.  Yes, it comes from the same place…the Federal Reserve Board.  Because this was a new alternative, however, it did not carry the same stigma.  Initially, the Federal Reserve said there would be a couple of auctions.  The first one was for $20 billion and 93 banks bid on $57 billion.  At the second auction, 73 banks were bidding for another $20 billion.  The interest rate paid by the banks was one-tenth of one percent below the discount rate.  Just before the Christmas holidays, the Federal Reserve indicated that these auctions would continue every two weeks as long as there is a demand for the funds.  This will eventually give the banks the cash they need, allow them to begin lending again, and set the economy on a good course.

• Several times throughout the years you’ve heard us talk about not being a huge fan of Index Funds.  This is based on research of performance between 1966 and 1982 when virtually nothing was earned by the Dow Jones Industrial Index except the dividend income.  Let us repeat that.  From February 1966 to October 1982, the Dow Jones Industrial Average started and finished in essentially the same place, although there were positive and negative cycles within that time frame.  During that same 16.5 year period of time, however, there were actively managed mutual funds that earned average annualized double digit returns.  Now comes an article in the December 19th edition of the Denver Post written by Aldo Svaldi titled, “One Step Up, One Step Back”.  In this article, Denver Money Manager, Vitaliy Katsenelson with Investment Management Associates, commented that “buy and hold investors are likely to be very disappointed if the markets stay in a broad trading range”.  He talked about the Dow Jones being worth 995 on February 9, 1966 and then being worth 995 again on October 25, 1982 – sixteen and a half years later.  It was at this point that Katsenelson talked about a buy and hold strategy not working in a “range bound market” and the importance of picking good stocks when they are low and selling them when they hit or exceed their fair value.  What a concept!  Given the fact that Katsenelson is an adjunct faculty member at the University of Colorado in Denver, perhaps credence will finally be given to our “unofficial study” that we’ve been talking about for the past 20 years.

• Recently, there was some concern about sub-prime mortgages that the Municipal Bond Insurance Association (MBIA) might have insured.  Because MBIA also insures municipalities for tax-free bonds, some of the fear spread into this market out of the concern that MBIA might either be very weakened, or in the worst case scenario, fail.  According to Moody’s and the Wall Street Journal, over the past 37 years ending December of 2006, only 41 municipal bonds actually defaulted.  The most famous were the Orange County bonds that were wrapped up in the fiasco of the late ‘80s and early ‘90s.

• This past year there was a significant increase in mortgage foreclosures, “short sales” (homes sold for less than owed on the mortgage), and loan restructuring.  At any point along the way that debt is forgiven, it is treated as taxable income.  However, Congress provided homeowners, especially those caught up in the sub-prime mess, with a big present just before leaving for the holidays with the law signed by the President on December 20th.  Homeowners with an adjusted gross income of $100,000 or less who would normally be taxed on this loan forgiveness, were given a reprieve.  The law was retroactive to January 1, 2007 and will continue for tax years 2008 and 2009.  Homeowners with an adjusted gross income over $109,000 will be able to take a partial deduction on this debt.  Homeowners with an adjusted gross income over $109,000 will not receive any tax break.  This is a significant “present”.  Suppose a homeowner bought a home for $500,000 at the height of the market and put down 5% or $25,000, taking out a mortgage for the difference?  Now that the housing market is depressed, suppose the home is sold for $400,000 and the homeowner walks away from the $475,000 loan?  Typically, the difference between what is still owed and the sales price would be taxable income to the original homeowner (in this case around $75,000).  This could put the seller into a significantly higher tax bracket which would be a slap in the face after losing so much money on the sale of the house.  Under this new Bill, nothing is added to taxable income.  Another major part of this Bill is the deductibility of the cost of mortgage insurance, often referred to as private mortgage insurance (PMI).  Anyone who does not put down at least 20% on the purchase of the home, must pay for this insurance against a potential default.  The premium cost for this insurance has not currently been deductible like interest.  However, the Bill says that anyone who obtained a mortgage after December 31, 2006 will be able to deduct the cost of this insurance for 2007 through 2009.  Who says there’s no Santa Claus?

• Let’s take a moment to talk a little about the credit bubble, which obviously occurred in the housing market, especially in places like California, Nevada, Arizona, Texas, and Florida.  As this bubble gets worked out there are many who are suffering, most of whom are speculators.  Unfortunately, some people who bought homes at the height of the market who are now being forced to sell those properties are finding that not only are they not making money, but they’re losing money when they sell the houses.  Homes are being sold in many places around the country, but in some cases such as in Florida, they are selling somewhere between 15% and 30% below the asking price.  At that point, a mortgage must be secured by the buyer, and only people with the best credit ratings are getting mortgages, even for federally insured mortgages which now go as high as $417,000.  In the jumbo mortgage marketplace, even for high quality credit risks, the interest rates are probably higher than they really need to be.  Banks have money and are willing to lend this money – it’s just that they are not lending it so willingly in the housing market.  We hear the “talking heads” prattle on about a “liquidity crisis” and it’s simply not true in the current environment.  A true liquidity crisis occurs when the demand is very high and the supply is very small.  This would lead to very high long-term interest rates, which is simply not happening to either the short or long-term rates.  As the housing industry begins to recover we might find ourselves with somewhat of a liquidity crisis as people will want to buy but the banks will remain reluctant to lend the money.  If this happens, we believe it will be a very short-term occurrence.

As always, we encourage you to give us a call if you would like to discuss anything further.  We will visit again soon.

PROVISE BULLETS ©

(December 31, 2007)

CORRECTION

• We have a correction regarding the ProVise bullets sent out earlier today:

• Regarding the Mortgage Forgiveness Debt Relief Act of 2007 approved earlier this month by Congress, there are no income restrictions for the loan forgiveness.  The phase-out range of $100,000 to $109,000 adjusted gross income applies only to the deduction for government or private mortgage insurance premiums.   Both items were part of the 2007 bill.

• The bill also temporarily extends the deduction for qualified mortgage insurance premiums for three years, through December 31, 2010, rather than through 2009 as stated in the Bullets.

• We apologize for any inconvenience or confusion.

RAY, KIM, ERIC, BRUCE, and LOU

©12/31/07 ProVise Management Group, LLC

This material represents an assessment of the market and economic environment at a specific point in time.  Due to various factors, including changing market conditions, the contents may no longer be reflective of current opinions or positions.  It is not intended to be a forecast of future events, or a guarantee of future results.  Forward looking statements are subject to certain risks and uncertainties.  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in these Bullets,, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Moreover, you should not assume that any discussion or information contained in these Bullets serves as the receipt of, or as a substitute for, personalized investment advice from ProVise.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Information is based on data gathered from what we believe are reliable sources.  The information contained herein is not guaranteed by Provise Management Group, LLC as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.  The indices mentioned are unmanaged and cannot be directly invested into. .  If you do not want to receive the ProVise Bullets, please contact us at:  info@provise.com or call:  (727) 441-9022.  Please visit our Web Site at:  www.provise.com.