Second Quarter, 2007

We start this report with a summary of factors which have influenced our thinking during the recently completed second quarter.

The Housing Picture

Sub-prime mortgage contagion continues to ripple through wider areas of the economy. However, leading Wall Street spokesmen and government officials continue to act in complete denial of the underlying trends. While the first phase of this debacle (loans to unqualified buyers and speculators) is winding down, the second phase (adjustable home mortgage resets at higher rates) is starting to kick in. Here the numbers of potential problem transactions are larger than before and repayment problems are starting to percolate up into the market for prime loan borrowers. According to Bloomberg news, $1.2 trillion of adjustable rate mortgages face higher interest rates in 2007 and 2008. Unfortunately, greater than 70% of this amount is in the sub-prime sector. Barring a meaningful decline in interest rates engineered by the Fed – which appears unlikely at the present time - home prices are now being projected to continue declining into 2009.

No contagion? Perhaps the following are merely co-incidental, but we believe the linkage to the sub-prime fiasco is stronger:

Meet the Sovereign Funds

Massive foreign exchange reserves among countries across the Middle East and Asia have lead to the creation of a new class of investor: the sovereign fund. Governments of wealthy countries around the world are demonstrating an increasing dissatisfaction with ownership of low-return U.S. treasury securities exacerbated by a declining dollar. As an alternative to short-term treasury securities, they are beginning to look for equity-type investments which offer the potential for much higher returns.

The sovereign funds are massive. Some examples:

The implications, as we see them, are that short-term U.S. interest rates may need to increase to attract foreign capital needed to fund our government deficits. Second, the fact that hundreds of billions, or even trillions, of dollars are sloshing around the globe looking for higher equity returns are bullish for global equity markets – including U.S. markets. One doesn’t actually have to buy shares of a company or of all companies in a market, to cause its price to rise. Frequently the perception that a purchase could occur is enough to elevate share prices.

Managers of sovereign funds are serious, long-term investors. Corporate purchases, when consummated, can entail seats on company boards of directors and other influences on corporate behavior. These funds are being called “black box” investors. They are secretive in their actions and they make politicians nervous. Politically, it is an unpopular concept for foreign countries to purchase major US companies or strategic assets. Dubai and China learned this lesson with their efforts to purchase management contracts at U.S. ports and a U.S. energy company, respectively.

After being rebuffed for its proposed purchase of Unocal, China then went on to invest $3.3 billion in the Blackstone private equity firm and 6.6 billion pounds in Barclays Bank, England. Secretive, government pools of capital buying up major corporate assets is a chilling thought, and is leading to growing protectionist pressures. Non-strategic businesses however, may be fair game for these sovereign wealth funds in the years to come which could have a positive effect on stock market valuations.

Because of the present state of the U.S. economy and the variety of financial pressures on the U.S. consumer, we continue to de-emphasize most investments that are predominately domestic in nature. We continue to focus on investing in companies which are foreign based and on U.S. firms which derive a substantial portion of their revenues from their overseas operations. General Electric, for example, recently announced that it expects to generate about 60% of its growth from emerging markets in the next decade.

A Few Thoughts on Fossil Fuels

There is no credible, meaningful energy alternative to fossil fuels during at least the next ten years, if not longer. During these upcoming years we believe the trend in energy prices will be ever upward. Of course, business cycles have not been eliminated and, from time to time, oil prices will decline. But we believe the long-term trend is upward and we have invested accordingly.

A number of factors has led us to this conclusion, including:

We remain as skeptical today as we were a year ago regarding the future of corn-based ethanol. Recently, a growing chorus of diverse groups are having increasing success in cooling Congress’ ardor for this sop to the giant agribusiness lobby. What’s the beef here? Ethanol production consumes huge quantities of water in competition with local farmers’ irrigation needs. Ethanol manufacturing facilities pollute groundwater supplies and contribute to global warming through production of carbon dioxide. Production of ethanol is believed to consume virtually as much fossil fuel in its creation as it saves when combined with gasoline and sold to consumers. In other words, ethanol production will have little impact upon our efforts to reduce our growing dependence on foreign oil imports. It has caused sharp increases in prices for various agricultural products in the US and abroad, which has harmed people living at or below the poverty level. It has to be subsidized by U.S. taxpayers. Only members of Congress who are the beneficiaries of substantial donations from agribusiness giants could love such a beast.

The irony here is that the U.S. has reserves of hundreds of years of fossil fuel alternatives to imported oil. These reserves are in the form of coal and oil shale. However, environmental concerns continue to trump their increased use. Eventually, technological breakthroughs will open the doors to possible full-scale exploitation of these resources. Then the price of oil may decline. In the meantime, we will continue to emphasize energy stocks in client portfolios.