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Quarterly Letter to Clients

January, 2008

Indices at quarter-end (December 31, 2007):

Dow Jones Industrials: 13,264.82 4Q'07 -4.54% YTD +6.43%

Standard & Poor's 500: 1,468.36 4Q'07 -3.82% YTD +3.52%

A recent cartoon shows a tumble-down gas station on the edge of a deserted highway with a sign: “Last $2.75 Gas Next Ten Years”. (Perhaps it should have read “Last $3.25 Gas”.)

It has been a volatile, manic quarter, capping a volatile, manic year. To illustrate the sharp swings, let me summarize the twelve months: We had a 5% decline during the first quarter. This was followed by a powerful rally of some 14% in the second quarter. Everyone was feeling pretty good when the third quarter started off with a bang, rising roughly 5% more. But then it began falling, giving back just short of 10%. During the first two months of the final quarter the Dow rose to fresh new all-time highs, tacking on nearly 12% more before again tumbling 10%. Finally, in December, an anemic rally lifted stocks to their final mark: a gain of 6.43% on the DJIA and 3.52% on the S&P 500 for the year.

The action has made stock-picking difficult to say the least, but has provided many dips to buy. I feel that in this environment you must be looking at individual issues and not the market as a whole. Informed intuition (with the emphasis on informed) will often lead to rational speculation.

A recent headline in the Wall St. Journal said “Interest Rates Defy Fed’s Recent Cuts”, and the article pointed out how the market was moving rates higher while the government was pushing the other way. Basically, bonds were not the best place to be in 2007, and are unlikely, in my view, to be in that category for the next few years. Lately I have been finding a few short-term issues to buy, and my strategy in fixed income continues to be one of shortening maturities in order to protect capital.

As we all know, the major concerns of the past year have been the war, the weakness in the dollar, the housing collapse, and the sub-prime lending debacle. Oil prices have also been a concern, although I sense that Americans are becoming somewhat inured to prices at the pump. Oil and other commodities, from gold to agricultural products, have risen in a reflection of the greenback’s fall. The general populace has little confidence in the government’s inflation figures.

I expect all of these factors to continue to weigh on the market in 2008. Given all of the question marks it is rather remarkable that stocks were able to remain positive at all. I said last quarter that I believed stock prices should be lower, and I have not changed that position.

As for the above-mentioned inflation and the dollar, here is my opinion, once again: as long as our government continues to spend more than they bring in, the dollar will decline in value. There are many factors in this problem, but balancing spending with revenue is the sine qua non. In drafting this letter I came up with two dense pages on the subject. In order not to bore you I condensed it into this brief paragraph. But it is an involved subject, and if you wish to explore it further, I invite discussion; call me or email me.

I am fond of starting these letters with anecdotes. This time there were so many good ones I had a tough time choosing. I would also like to end with one that sums up the year pretty well:

A recent cartoon shows Fed chairman Bernanke on TV, saying, “Falling home prices, rising foreclosure rates, a weak dollar and high oil prices, not to mention a crisis of confidence in credit markets, all suggest a period of moderate, but positive growth going forward.”

Reality doesn’t hold a candle to wishful thinking. Information and rational thinking will see us through even the most unsettled times. In the New Year, as always, I will strive to provide a sane, reasoned investment strategy. I wish you a happy, healthy and prosperous New Year.

Jim Pappas