This yearend commentary is broken into several highlighted sections and is longer than our usual missive.  It takes about 12 minutes to read.  We cover issues which impact portfolios and explain the rationale behind Cumberland’s strategy. 

“Alan Greenspan really made a mess of all this.  He pushed out too much liquidity at the wrong time.”  Joseph Stiglitz

“We know that the downsides happen far more rapidly than the upsides.”  Alan Greenspan

This debate will go on for years.  It is important to historians and academics.  It is purposeless for investment advisers.  In the business of managing portfolios one must be forward looking at all times.  History only offers guidance.  To apply it one must exercise discipline; thus, we also need to recall the wisdom of George Santayana: “Those who cannot remember the past are condemned to repeat it.”

We say Happy New Year to our readers as we enter 2008.  It is a political year fraught with high risk and characterized by dysfunctional credit markets, inflation above the Fed’s comfort zone, housing prices falling at an accelerating rate, $95 oil, Iran starting up a nuclear power plant and a suspected H5N1 bird flu outbreak in a cluster of 8 people in Pakistan.  December has also witnessed isolated H5N1 deaths in China, Egypt, Indonesia and Myanmar.

We will end this introduction by saying Happy New Year to Kathleen Casey-Kirschling.  She is the first “baby boomer” to receive social security.  She was born a single second after midnight on January 1, 1946.  At age 62, she leads the march of 80 million Americans achieving social security eligibility over the next 20 years, a rate of 10,000 per day.  She marks a milestone where the federal government will be paying out the largest single promised benefit program, in absolute terms and in relative terms, in the entire national history. 

So how come we feel optimistic about 2008?  It’s because the bad news is “old” and it’s because the markets are setting up for opportunity.  Some bullets follow.

Central banks and dysfunctional credit markets. 

After several false starts and some poor communication, it appears that the US Federal Reserve now understands that dysfunctional credit markets can morph into a contagion and reach from Wall Street to Main Street.  This summer the Fed showed its inexperience.  It would not listen to markets.  It needed to see this contagion risk firsthand in order to become a believer.  At the Governor level only Don Kohn was in the Fed during the last crisis.  At the president level only four of the twelve regional bank presidents have this experience.  Remember, an academic studies and theorizes history; a surviving practitioner lives through it and learns from the scars he accumulates. 

The Fed has tasted credit market dysfunction. And now the Fed is finally “catching on.”  Only in the last half year did they realize that the destructive seeds were not “contained.”   Dysfunction that originally showed up as the subprime meltdown became a “contagion.”  It threw commercial paper markets into turmoil.  It reached into the Muni market and tainted the bond insurers.  It caused a unit of Bank of America to “break the buck” on its “Strategic Cash Portfolio.”  Dysfunction reached state investment pools in several jurisdictions when their failure impacted local governmental units and school boards.  So far, Florida is the biggest one.  Dysfunction has caused some contraction on Main Street.

With inflation relegated to a temporary second place, credit market dysfunction triggered Fed response.  They acted by (1) cutting the Federal Funds Rate a cumulative 100 basis points, (2) lowering the Discount Window Rate a cumulative 150 basis points, (3) implementing many procedural changes and liberalizing lending collateral rules, (4) introducing swap lines with foreign central banks and (5) activating a new tool, the Term Auction Facility (TAF.)  

The TAF adds raw cash reserves to banks just like a loan from the Discount Window.  The collateral requirements are similar.  The difference between the Discount Window loan and the TAF is in the determination of the interest rate.  Discount Rates are known in advance of borrowing and are set by the Board of Governors of the Fed.  TAF rates are set in an auction where each bank can determine how much it is willing to pay and bid accordingly.  Two TAF auctions of $20 billion each have been held to date.  They succeeded at interest rates below the Discount Window Rate and above the Fed Funds Rate.   A $10 billion parallel auction in Europe under the European Central Bank auspices also fell within this band.  We expect this band between the Fed Funds Rate and the Discount Rate to continue.  If the TAF is successful over a longer term, the auction rate will tend to fall into the lower end of the band.  In theory, a bank would not pay above the Discount Rate since it can take the same collateral and borrow at the Discount Rate at any time.

In London, LIBOR Rates responded and fell after the TAF was introduced.  In other market areas, credit spreads narrowed.  The London interbank rates are the reference price of $150 trillion in financial assets worldwide (Bianco Research calculation).  That includes derivatives.  They are a large factor in pricing mortgages in the US.   LIBOR rates have not fallen anywhere near the decline in the Fed controlled rates.  LIBOR is the interest rates that banks use to loan money to each other.  High LIBOR indicates seizing credit markets and dysfunctional and distrusted relationships between and among banks.  That is why it is so important and that is why the Fed is now (finally!!!!) focused on it.

It is pretty clear that the Fed will continue to use the TAF until spreads have returned to some semblance of normalcy.  That is their stated commitment.  The TAF adds a powerful tool to the Fed’s arsenal.  The Fed is offsetting some of the additional credit provided by the TAF with other transactions.  The TAF’s $40 billion to date isn’t all fresh new money; some amounts to a lateral transfer from other Fed portfolio holdings.   The key is that this tool is designed to target the widened credit spreads.  It is those spreads that reveal market dysfunction.  It is LIBOR which drives mortgage pricing.  Thus the Fed is trying to bring LIBOR down.  So far it is succeeding.  Lower LIBOR means housing mortgage resets in the future will be at lower interest rates than otherwise. 

The cooperation with other central banks warrants a comment.  It appears that this swap structure was solidified in November at a conference in Cape Town.  It is in play with the Fed and ECB and also the Bank of England, Bank of Canada and the Swiss central bank. Others like the Bank of Japan are not directly involved but are certainly kept informed.  That suggests these banks are likely to be holding rates steady or cutting them over the nearer term.  They will probably continue this posture for the first half of 2008 and/or until the credit markets normalize.   Central bankers will worry out loud about inflation.  But for now, their fight is not with inflation.  It is aimed at normalcy restoration.  Hence the world is looking at an easing monetary bias for at least the first several quarters of 2008.

Cumberland believes that the global central bank consortium will succeed and that risk premiums will narrow.  Liquidity expansion is a powerful financial force.  This is bullish for global stocks and very bullish for spread product in the bond world.  We are especially favoring longer duration in the Muni market.  We also like well selected corporate bonds and taxable municipal bonds.   And, yes, there are some excellent buys in mortgages and Government Sponsored Agency (GSE) credits. 

As for Fed policy, we expect one more rate cut in the Fed Funds Rate to 4% at the end of January meeting.  Beyond that remains a function of how quickly the credit markets respond and how economic releases indicate the degree of slowing in the US economy.  To that end we are watching the Chicago Fed’s National Activity Index (CFNAI).  It has been negative for more than a year and can be used to judge the likelihood of a recession.  It is designed to show the current state of the economy.  As of November it was flirting with a recession assessment.  See http://www.chicagofed.org .  The Fed will not go back to inflation fighting until the US economy has turned up and the credit markets are calmer.  CFNAI is a good indicator of the economic piece just as the TED spread, or the VIX, is one of the good financial market risk measures.

Energy.

Americans are clearly getting used to $95 oil and $3 gasoline.  We just keep motoring along.   Wall St. Forecasts routinely take the oil price above $100.  Are they solidly grounded?  So far the price of energy shows little “elasticity.”  This has been true of low “demand elasticity” which means consumption hasn’t declined as the oil price tripled over the last four years.  Price elasticity of supply has also seemed to be stuck.  Normally high energy prices would bring out more supply after this long a period.  So far it hasn’t happened.  We expect that supply stickiness to change over time as market forces start to work their market magic. Natural gas rig counts are up.  US refining capacity expansions are finally happening although it is still at a snail’s pace.  Tar sands and shale oil activity intensifies.  We may even start the permitting of a nuclear power plant after a three decade hiatus.

US politics has hampered energy price elasticity.  Politicians cannot easily accept that market forces are a better discipline than price controls, protectionism or predatory taxation.  The higher price will eventually turn the politicians because angry citizens will see that the markets leave them without choice.  Witness Hawaii.  It instituted and then repealed wholesale gasoline price controls after the state suffered shortages. 

On the national scene we are not allowing market forces to help us.  We still do not search for oil on most of the continental shelf.  As my friend, Loren Scott, says “all the oil is in four states, Mississippi, Alabama, Louisiana and Texas and the dipsticks are in Washington.”  Loren forgot Alaska but that behavior is excusable for a Baton Rouge resident.  Back to the dipsticks who are assuredly in Washington.  Because of them we don’t open up drilling in new areas and we do threaten to tax oil companies for their “high profits.”  And then we wonder why they don’t spend money on exploration and expansion of supply.

Regrettably, the US is still committed to the huge federal ethanol subsidy.  This is one of the dumbest and costliest government polices in modern times.  Election year politics being what they are, this wrong headed federal handout will be with us for a while longer.  Again we blame the dipsticks, this time led by Iowa Senators Harkin and Grassley.  Iowa-based Archer Daniels Midland Corporation receives a large chunk of the federal ethanol subsidy.

Cumberland has eliminated its over weight energy position.  And we are not seeking exposure to ethanol; it is an economic failure.  Without massive federal subsidy it would not exist.

Iran and geo-political risk.

This type of risk will always be with us just like bird flu pandemics, hurricanes and tsunamis.  The difference is that they are natural while terrorism and nuclear war are manmade.  After several years of hearing about Iran’s nukes we are now told that they are not a threat.  The same folks who tell us this are/were the ones who told us about Iraq’s nukes and poisons.  A sad fact: our country doesn’t believe its government.  That is the scope of a national tragedy that the nation inherits from the present administration.  Sadly, it also has opened the political arena and there lies much risk.

For market strategy purposes we are cautiously hopeful with our risk assessment from geo-politics.  We find it interesting that some jihadists (Egypt) are changing their tune and have reversed themselves on the use of violence as a tool.   Now before I get 100 emails telling me my head is in the sand, let me quickly add that I do not trust them.  I know that a few editorials do not change the mindset of a young lad in a terrorist training camp.  But we have seen some behavioral changes and that suggests there could be more forthcoming.  Recall how Libya has altered its belligerence and now has active oil exploration concessions.  The Saudis continue to arrest terrorist suspects.  Who knows, Mahmoud Ahmadinejad may even lose the election in 2009.  Why not?  Chavez just lost in Venezuela.  In Thailand, the junta was rebuffed at the polls.  Even North Korea’s Mr. Kim is less bellicose.  A surprise in 2008 may be some diminution of belligerence in geo-politics.  Cumberland believes that the geo-political risk premium in energy pricing will shrink.  We have sold our over weight position in energy stocks.

Housing.

The Case-Shiller housing measures show declining prices in the big cities.  Miami and Washington DC are the worst in the East.  Las Vegas and Los Angeles show the biggest present and future price declines in the West.  Housing remains in trouble.  The peak month of floating rate resets is in May, 2008.  After that the number of resetting mortgages falls off and is substantially lower by yearend. 

It is still too soon to bet on a housing bottom and recovery; however, that time is getting closer.  Home builder stocks have traced a pattern similar to when the tech bubble stocks increased and collapsed seven years ago.  Now we need to see the inventory situation clear to a more normal level. 

New home inventory has peaked.  There are still a lot of unsold new houses but the number is no longer growing.  It topped out above 3.5 million units and has declined to about 3.2 million to date.  For reference this measure of housing supply was closer to 2 million unsold new units before the economic recovery commenced in 2003. 

The unsold inventory of existing homes has not peaked and is close to 4 million.  This measure, too, was nearer 2 million in 2003.  America’s housing price weakness will continue until existing home inventories get worked lower.  That will take time.  It will occur sooner if we have no recession and lower interest rates.  It will take a lot longer if the economy stalls and/or if rates rise.  Cumberland is still extremely underweight housing and the related investment sectors.

Sovereign Wealth Funds.

Much has been written about this growing source of investment funding.  Citigroup ($7.5bn) and UBS ($10bn) raised new capital from Abu Dhabi.  Morgan Stanley’s capital infusion ($5bn) came from China.  Merrill Lynch’s new money originated in Singapore ($5bn).  In Cumberland’s view this inflow of sovereign wealth is only the beginning.  It will encompass lateral investment choices where a country will exchange low yielding US treasury securities for higher performing equities or convertible debt instruments.  And, not to be dismissed lightly, it will emphasize the allocation of the continuing new money flows received by the surplus countries. 

Consider that, in 2008, seven countries combined will amass about $1 trillion of current account surpluses (CAS).  They are China, Japan, Norway, Russia, Saudi Arabia, Singapore and Taiwan.  Those seven combined CAS are 1.8% of global GDP in 2007, up from 1.6% in 2006, 1.4% in 2005 and under 1% in 2004.  This huge capital pool is the world’s newest assemblage of savings.  Much of it will come into the United States and other advanced economies in the Americas and Europe.   We thank Barclays Capital for these estimates.

US politics has hampered this flow, too.  We had a national furor over the original attempt by a Chinese company to take over Unocal.  The US government blocked it.  A repeat of a political error happened when the Dubai port deal encountered opposition.  These behaviors slowed inflows.  It gave pause to potential investors from abroad. 

This time around it is clear to the US government that our capital markets need the money.  And it is clear to the politicians that stopping these inflow investments runs the risk of more financial turmoil and that will bring out the citizen’s ire on Election Day.   So we are seeing the inflows welcomed now.  So far, the foreign investor is quite content to take a significant but minority position.  This may change as more and more flows come into more and more US firms.   In the nearer term this is a bullish phenomenon for US stocks.

The Dollar.

While the world’s creditors grow their surpluses as indicated above, the US current account deficit (CAD) is actually improving in relationship to the US GDP.   Our current account deficit peaked at 6.8% of GDP at the end of 2004.  We are now running a CAD of about 5%.  Our export growth contributes to this improved flow while also adding about 1% to our GDP growth.  Some economic slowing is reducing imports from where they might otherwise be.  And the weakness of the dollar has helped on both sides of this exchange.  In addition, our net investment income has actually improved nicely to $20bn in the last quarter and our net surplus in services is also slightly improved.

In the past few weeks we started to see the dollar firming against other large currencies.  Cumberland believes that trend will continue into 2008.  Furthermore, we now see the action of the Fed adding to a prospective economic upturn sooner rather than later.  That means the US will improve before Japan and Europe.  This will add a bullish force to the dollar.  For 2008, we project that the euro will fall below 1.40 against the dollar and that the British pound will decisively break below the $2 level.  We also expect the Japanese yen to weaken as we approach the March 31st fiscal period end in Japan.

Does this mean we expect a multi-year prolonged period of dollar strength or is this 2008 outlook a temporary rally in a continuing dollar bear market?  This is the great question for which no answer exists.  Currency exchange rates are driven by many forces.  Very few currencies actually trade cleanly.  Political intervention in currency exchange rates usually takes a long period to correct.  Market forces eventually prevail but the process of re-pricing currencies can take years.  Our best guess is that the US will not permanently fix its strategic imbalances.  We say that based upon our very low opinion of our domestic US political forces and politicians.  We would prefer to be pleasantly surprised but fear that our political system is now so damaged and corrupted by money and imbedded personalities that it will be difficult to repair.  Strategic query: does it take a constitutional convention or major upheaval to achieve structural political change in the United States.    

Election year risks.

“Do you pray for the Senators, Dr. Hale?” someone asked the Chaplain.  “No, I look at the Senators and pray for the country.”  Edward Everett Hale.

Most eyes will focus on the 2008 presidential race.  This should be expected.  A second battleground is in the US Senate.  The Democrats have a slim 51 seat majority.  It really takes 60 votes to get control of the Senate because of the rules that require this super majority to close a debate.  Republicans are defending 22 seats in 2008; Democrats have only 12 seats at risk.   If the Democrats get close to 60, it will occur with their party also controlling the House of Representatives and certainly the White House.  A Democrat sweep is likely to bring a top federal income tax rate in the mid-40s percent.  It also implies a cap gains and dividend rate of between 20% and 28%.  It guarantees extension of the AMT.  Other significant and adverse items will apply to corporate taxation and possible penalty taxation on foreign sourced income and investments.

Maybe, just maybe, some political journalists will focus on how the election process is holding the Federal Reserve hostage.  Maybe they will examine Senator Christopher Dodd and his policy of not holding hearings on Fed Governor nominees.  A Democrat sweep means three new Fed Governors in 2009 and a likely new Chairman one year into the new presidential term.  Some may like this idea.  We don’t.  We cannot recall a single time in the post World War Two period when a political party was targeting the Fed.  Maybe, just maybe, 2008 electioneering will expose this challenge to central bank independence and what it is doing to our markets and our pricing of certain securities.

We think that economics and tax policy will become a center piece of the 2008 election.  We expect that Iraq and foreign policy will remain issues that command attention but they will have competition for the top of the list.  Americans traditionally vote their pocketbooks when they enter the voting booth and most politicians know it.  Housing prices and foreclosures will drive discussion.  So will the issue of estate taxation.  The 15% federal tax rate on capital gains and dividends is certainly a subject for political debate.  So is the Rangel proposal to raise the top federal income tax rate to 44%.  And there will be the expected diatribes against the Alternative Minimum Tax (AMT).  One has to wonder how this awful and counter-productive tax remains on the books while every single Member of Congress goes back to his/her district and denounces it.  That is why the Congress has such a low approval rating.  The citizens see them as outright liars.

As this is written, there is no clear victor in either party’s presidential primary.   Many in the country hope it continues that way.  They nostalgically long for suspense and interest and for true participating conventions choosing the candidates.  Many wish for something other than a staged theatrical performance.  They hope that a close contest will bring out more and new participation from a jaded and cynical citizenry.  We hope so, too.

That personal view said, we acknowledge that stock markets like clearer outcomes during election years.   Uncertainty breeds volatility.  Ned Davis database starting in 1888 shows Election year gains averaging 14% when the incumbent party wins and 18% if that incumbent party is Republican.  When incumbent Republicans have lost, the average Election year gain is under 2%.   Since WW2, there have been three Republican Party turnovers.  Kennedy’s election year of 1960 had a 3% declining stock market.  Carter’s 1976 victory over a post-Nixon disgraced Republican Party was celebrated by a booming 19% up market.  Bill Clinton’s 1992 win over incumbent Daddy Bush saw a 5% upward market move. 

A little historical note:  Since 1980 there has been either a Bush or a Clinton (1992 it was both) on every presidential year ticket (includes VP).  Hillary’s Democrat party nomination victory would continue that trend. 

Let’s sum this up. 

Cumberland favors nearly fully invested positions in the world’s stock markets as we enter 2008.  We believe stocks are headed higher because of the coordinated effort of the world’s central banks.   Markets will shrug off the bad news of today and look forward to an economic upturn tomorrow. 

In the US we now like the financial sector.  We think that the accounting ruling of FASB 157 has brought out a more conservative structure, higher quality reporting and helped clear the air for 2008 and beyond.  We expect the housing market to eventually bottom but cannot say if that will occur in 2008, 9 or 10.   Therefore we are still under weighted the home builders and related sectors.  We continue to be over weighted the tech sector and believe we are on the threshold of a long bullish worldwide tech cycle.

In bond portfolios we have extended duration targets in order to capture the very appealing yields on corporate and municipal bonds.  High quality, tax-free Munis now yield over 100% of corresponding treasury maturities.  High investment grade corporate and taxable municipal bonds are yielding more than 200 basis points (2 full percentage points) above equivalent yielding treasury maturities.  These extraordinary spreads exist because of the turmoil in this dysfunctional credit market.  The normal arbitrage forces that would close these spreads are not functioning.  The flight to treasury debt has widened credit spreads and created opportunities that must be seized by astute bond investors.