We arrive at our domestic equity number by looking at the historical returns in combination with current valuations and our assessment of the state of the economy. Historically the S&P 500 has returned in the high single digits, including dividends, since 1970. The P/E ratio is around 14 times earnings, approximating the historic average but low for the recent decade. While the economy is slowing, it is still growing, with global growth, particularly in emerging areas of the world, strong.

Breaking the analysis down further, we expected domestic small-cap may continue to underperform due to overvaluation, reliance on a shrunken credit market and limited market access overseas. In the meantime, large-cap exporters have been greatly helped by a weak dollar. Consequently we believe that large-cap domestic stocks, which are fairly priced in our view, may offer the best value at the moment.

You may ask, “Why such a low number for domestic equity returns?” The answer is that we believe the market will eventually settle back down to its historic rate of return following the prolonged equity bull market of the 1990s. The market is unlikely to revisit those returns, at least for some time. The U.S. economy is mature and has an aging population, unlike most emerging market economies around the world. This will likely put pressure on the U.S. economy and, in turn, equity valuations and prospects for future growth.

In the fixed-income markets we see domestic bonds returning approximately mid-single digits, with international and emerging market bonds coming in slightly higher.

Many so-called market experts, chief investment strategists, forecasters, hedge fund managers, market pundits or, as we like to call them, manic depressives are predicting a recession over the coming year. They cite the slowdown in housing, excessive consumer debt and tight credit markets as ingredients for a major downturn. These problems are real and significant, but they are dwarfed by the overall economy. Jobs from housing are less than one-third of those generated by export-oriented sectors. The average consumer credit card debt is approximately $2,200 (see note 1) and approximately 60% of credit card users pay their balance in full each month (see note 2). Finally, financial firms that might be hit with a tight credit market will be bought out or else bailed out by foreign investors.

Sovereign wealth funds – large investment pools controlled by foreign governments – will likely be the savior of our financial system, if in fact our financial system needs saving. Unlike the U.S. which is a debtor nation, some countries overseas are awash with capital to invest. With these SWFs controlling $2.5 trillion today (and expected to grow to $27.7 trillion by 2022, according to Morgan Stanley), they will be looking to invest these assets in name-brand institutions that need capital. In this case, financial institutions such as Citigroup, Merrill Lynch and Morgan Stanley have received major infusions over the past quarter. The United Arab Emirates alone could purchase all of Citigroup’s shares for roughly $150 billion and still have $725 billion left to invest. Theoretically, the United Arab Emirates sovereign fund could purchase the top five financial institutions in the U.S., which includes Bank of America, Citigroup, the insurer AIG, JP Morgan and Wells Fargo for approximately $747 billion and still have a $150 billion capital surplus. In addition, the falling U.S. dollar only makes these assets more attractive to outside investors on a currency-to-currency basis.

So how will we be positioning client’s portfolios for the 2008 calendar year? Most of the main themes from 2007 remain the same, which means a focus on international investing, large-cap domestic equities, energy and natural resources together with flexible fixed-income funds. New additions to the strategy this year include an overweight position in growth stocks (and, conversely, less on value) and a position in several region-specific emerging market funds.

We still believe that international stocks offer a better value relative to domestic equities. This is due to lower valuations and higher growth rates for foreign companies. In addition, the falling U.S. dollar boosts international investing returns as foreign currencies appreciate against the U.S. dollar, which they did in 2007. In particular, we like Asia, a region with a young and educated work force. South Korea, Vietnam and Thailand have made strides in developing economies with strong capitalist elements. Among other initiatives, these governments have sought to attract capital while creating competitive economic advantages, particularly in the manufacturing sector. Japan may finally be transitioning out of stagnancy with controlled inflation and rising real estate prices.

Domestic large-cap stock valuations, we believe, still offer a good relative value versus small-cap companies. Typically, larger companies are better capitalized and have access to credit at a lower cost than smaller companies. And again, larger companies may have more exposure to international sales, which are growing faster than here in the U.S. Valuations of large-cap stocks are still near two decade lows. Institutional investors have moved the money out of this lagging asset class, which they likely overweighted in 1999 and 2000. Instead, a lot of money flowed into private equity and hedge funds, which, using derivatives and other forms of financial leverage produced much better returns over the past six years. Retail investors have sold out of large-cap holdings in favor of both hedge funds and small-cap equity, again chasing the best return over the past six years. Although large-cap stock outperformed for the first time in years, we still believe there is plenty of room to run in this asset class.

We believe there is still a disconnect between the supply and demand for natural resources around the globe and particularly in China, India and Brazil. Those three countries are expanding so quickly that global natural resource companies are having trouble providing adequate supply. There are a number of reasons why production increases are not on the immediate horizon. For one, there is a lack of a qualified labor firms can hire. This is creating major bottlenecks on new capital projects aimed at increasing production. Two, insufficient labor is hindering efforts to uncover new reserves natural resources. Three, scarcity of spare parts used for industrial machinery. Finally, money is simply going into the asset class through both straight equity investing (that is, the stock market) and private investment. A coalescence of these four separate but related factors in the commodities industry can most easily be seen at the gas pump: the price per gallon of regular gas has increased nearly 40% from $2.15 to $3.00.

Other commodities that may continue to experience increases include gold, copper and potash. Gold’s value increased due to a number of factors including traditional role as a hedge in times of economic uncertainty, a hedge against a declining U.S. dollar, and an increased demand as a store of value and social symbolism in countries like India. Copper prices continued to increase even in the face of a housing slowdown in the U.S., mainly due to growing demand overseas. Copper is used in many different construction components such as wiring and piping. Potash, or potassium, is an organic compound that is used in nitrogen-based fertilizers. Because of the government’s efforts to promote energy independence, subsidies are given to farmers to produce more corn for ethanol and bio-diesel. One characteristic of corn cultivation is that it needs substantial amounts of nitrogen to produce healthy crops. This has artificially pushed the prices of nitrogen-based fertilizer to record levels and has caused ripple effects throughout the economy in the form of higher priced agricultural goods.

We also believe oil and gas prices will continue to increase. In part that’s because we don’t think the government has adequately considered the consequences of its current energy independence policy. The current focus is on ethanol production here in the U.S., and on the surface this made sense since corn is a large part of the U.S. agricultural portfolio. Unfortunately, the policy makers didn’t do much more than scratch the surface in terms of analyzing the flow-through consequences on the environment, prices of other agricultural goods and the efficiency of ethanol and bio-diesel versus other crops that have higher fuel output and less fertilizer needs.

It remains to be seen if any action will be taken by a new administration. All candidates have a plan for energy independence, and all seem to incorporate nearly identical plans at this point. A reliance on the same energy policy of favoring an ineffectual source of cellulose – such as corn, which requires potash for fertilizer and natural gas for distillation – to produce ethanol augers well for investors in natural gas, natural gas infrastructure and services, fertilizer companies, and potash mining companies.

The fixed income markets have been very difficult to navigate and have offered lower potential returns in light of the Federal Reserve’s interest-rate hikes over the past two years. In response we have focused on investing strategies that have historically had the same risk/reward profile as fixed income but with reduced correlation with that asset class, adding to portfolio diversification. We are increasing our flexible bond funds since we are generally unenthusiastic about traditional fixed-income investments. However, we are exiting our position in merger/arbitrage strategies and convertible bonds. We believe that the merger/arbitrage strategy may not add value to our client’s portfolios over the next year in light of tight credit market and the risk that merger deals may not be completed. Although we still believe convertible bonds are a good investment, their discount no longer warrants an individual fund that specializes in this strategy. Instead, we will maintain exposure to convertible bonds through our investments in flexible bond funds.

One thing that has changed over the past two years is the high yield area of the fixed-income marketplace. We’ve been warning investors about investing in high yield fixed-income securities. With the lowest spread we’ve seen in years, we simply felt there was no adequate margin of safety in these securities. However, as the credit crisis has unfolded over the past couple of months, high yield spreads have widened to a point were a neutral position, or very slight bullish position, is reasonable.

A new strategy for 2008 is an emphasis on growth-oriented companies. Money has been flowing out of the large-cap area of the market, and in particular the large-cap growth area of the market due to excessive valuations during the stock market bubble in the late 1990s. Over the past seven years, the fundamentals of these businesses have continued to improve while the valuations of these firms have declined. In some cases the stock prices are 50% lower now than they where seven years ago. Now that valuations have come back to earth our underlying fund managers have the opportunity to buy growth companies at a reasonable price. And if our thesis about a mature and slowing U.S. economy hold true then the market may put a premium on companies with sustainable franchises that continue to grow.

The second new strategy for 2008 is region-specific mutual funds, which may benefit from particular macro-economic trends in Asia, the Middle East, and South African region. Many institutions either are much too large to access the liquidity needed to invest in these areas or have mandates that prevent them from investing in what is called “frontier markets.” That is, true emerging market economies with very small, semi-regulated stock markets. Despite some notions that many of these economies are light years behind the U.S. in terms of law and regulation, they are not. We would roughly equate conditions in these markets with what existed in the U.S. during the Industrial Revolution, with similar potential for growth.

In Asia, we have already discussed some reasons why we like the area, including valuations, growth prospects and a young and educated work force. In the Middle East, as well as South Africa, there has been a lack of capital investment despite record commodity and (in the case of South Africa) agricultural prices. Consequently, this has led to accelerating wealth creation, increased spending and improved diets with all the societal benefits that implies.

We currently have the opportunity to act with the foresight and tap into a nascent economic expansion in those regions. We have researched ways to invest in these regions and we will look to add opportunistically to these positions over the next couple of quarters.

1. Source: MSN Money

2. Source: Federal Reserve Bank of Philadelphia