January 2008

2007 - The Year in Review

Relative to the past few years of steady market increases, 2007 was a different kind of beast. “Riding out the market’s gyrations” warranted not only the patience of years past – but also an industrial-strength seatbelt. After all is said and done, the 2007 entry into the record books will show that the S&P 500 returned 5.5%. But that would miss most of the story.

The year began on the heels of a rather successful 2006. Interest rates were low (10-year Treasuries yielded roughly 4.6%), market valuations were low as well (stocks traded at roughly 16 times forward earnings), and “sub-prime” was a virtually unfamiliar segment of the mortgage market. Oil was $60 per barrel, inflation was around 2% annually, and “market liquidity” was poised to drive a buy-out spree that would propel stocks to new highs.

By the end of 2007, interest rates were still low (10-year Treasuries yielded about 4.2%), as were market valuations (roughly 15 times forward earnings). “Sub-prime” in connection with the housing market decline was on the front pages daily. Oil was well above $95 per barrel, inflation was threatening to creep higher, and a lack of liquidity in the market was threatening to send the U.S. economy into a recession.

As 2007 began, merger and buy-out activity was grabbing all the headlines. Years of strong corporate earnings growth fattened cash reserves and cheap money was available due to low interest rates. Merger and acquisition activity began the year at a record-setting pace and investors expected more of the same in the months to follow. In February, the first sign of trouble reared its head as the domestic Chinese exchange recorded a few days of massive losses. This caused U.S. investors to fear that the four-year bull market may be coming to an end. A few trading days netted losses of more than 3% - our first such days in over 4 years – and sent the major indices into negative territory for the year.

The market rebounded in April, as the Federal Reserve hinted that it was leaning more towards cutting rates than raising rates. Investors also became excited when first quarter profits continued their streak of 10%+ growth, signaling perhaps that more good times lay ahead. This positive attitude spilled over into May, as the major indices found themselves up over 8% year to date.

At that point market activity became more interesting. Choppy trading action characterized June and July, as the sub-prime mortgage issue began to spread. Major mortgage lenders, such as Freemont General and New Century, were on the brink of failure, loan defaults were rising, home values were falling across the country, and some investors were beginning to worry about how far this would spread. At the time, though, it seemed that more investors believed that this problem would remain relegated primarily to the housing-related industries. These optimists drove the Dow Jones Industrial Average to its first close above 14,000 on July 19^th, signaling America’s confidence in its economy. Corporate profits were growing at a double-digit pace, merger and acquisition activity was still fairly robust, and interest rates were low. With the market at its peak, however, the tide began to turn.

In the months that followed, the markets behaved in a turbulent manner. Over the summer, stories began to run about hedge funds that were failing due to leveraged bets on sub-prime mortgage securities. The first wave of bank write-offs began in the late summer, and the market responded by falling roughly 3 - 5% from its late spring highs. Second quarter earnings season was fairly strong with corporate profits growing by another 10%, and the broad economy grew at a healthy 2.6% clip. While the homebuilders and mortgage bankers continued to suffer, it appeared that these troubles would remain somewhat contained. This led to a false sense of security for many investors. The major averages all responded by rebounding from their summer doldrums to reach new highs in October following decent macroeconomic news and a 0.50% rate cut from the Federal Reserve in September. The Fed rate cut was viewed by many as a preemptive strike against tightening credit markets; historically when Greenspan had cut rates the markets soared.

But Greenspan had no precedent for dealing with the magnitude of a credit market problem like this. The trouble in the sub-prime mortgage arena began to affect nearly every other aspect of the credit market, making it extremely difficult – if not impossible – for borrowers to obtain the funds they sought. Lenders became hesitant to extend funds even to other banks, as the potential for multi-billion dollar write-offs threatened to erode the financial strength of borrowers. Rating agencies came under fire for “misleading” investors, having given their highest marks to structured credit vehicles that had suffered massive losses. Many of the corporate buyouts announced earlier in the year fell apart as acquirers were unable to borrow enough dollars in the market to fund their transactions. A couple such casualties were SLM and Harman International Industries. These credit market issues, coupled with disappointing third quarter earnings announcements and significant balance sheet write-offs from large banks, led to a sell-off in November that cost the equity averages roughly a third of their gains.

The end of 2007 was decidedly less rosy than its beginning. Central bankers around the world injected billions into the system in an attempt to facilitate liquidity, but turmoil in the credit markets still threatened to slow global economic growth. Commodity prices continued to rise – oil prices rose more than 50% for the year – which made this task more difficult as the measures that fight inflation and those that promote growth are often at odds with each other.

2008 – Looking Ahead

Much uncertainty still exists as we look ahead into 2008. The prognosis for the U.S. economy appears to be slightly positive at this point. However, a mild recession is still possible. Commodity prices should remain elevated as global demand is unlikely to fade away. The credit markets, while functioning more normally, are still uneven at best. Corporate profits are set to grow between 3% and 5% as profit margins are pressured by higher costs and the domestic economy experiences minimal growth. More positively, equity valuations remain reasonable on a historical basis with the S&P 500 trading at roughly 15 times forward earnings. Interest rates are low, with 30-year rates well below 4.5%, and emerging markets like China, India and Brazil appear poised to continue at a robust pace. At RiverPoint, we expect the broad market to appreciate in the mid-single digits due to mild earnings growth, dividend income and slight P/E multiple expansion. We have positioned client portfolios for such an environment by focusing on shares of large, well-established companies with strong balance sheets in diverse businesses. Many of the companies we own have significant exposure to overseas economies, which will allow our clients to partake in continued global economic expansion. We have been selectively adding high-quality corporate bonds and preferred stocks to our client portfolios, as we believe that these asset classes are likely to benefit as the global credit crunch eases and risk premiums return to more normal levels.

It has been our pleasure serving you this past year, and we appreciate your continued confidence as we head into 2008. We sincerely wish you and yours a safe and wonderful New Year!

Market Summary	12/31/07	YTD Price Change
Dow Jones Industrial Average	13,264.82	6.4%
Nasdaq Composite	2,652.28	9.8%
Standard & Poor’s 500 Index	1,468.36	3.5%

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.