Robert N. Stein Astor Financial Focus: Economics and Futures Website: www.astorllc.com

Fourth Quarter 2007 Review

The 4th quarter of 2007 remained volatile for most markets and the catalysts for that volatility remained the same culprits; sub prime and loan defaults, housing, and a slowing economy. With 2% plus daily swings, the main difference in Q4 was the overall percent change at the end of the day, plus or minus 1% depending on the index. The Fed eased twice during the quarter with the Fed funds rate ending the year at 4.25%. Housing starts, sales and prices all declined well beyond expectations but then again expectations were pretty low to begin with. Inflation statistics moderated, but that was probably a statistical blip or a result of the slowing economy that should prove to be temporary. Metals consolidated most of the quarter in line with the ultimate statistics on inflation but jumped during December as a result of excess liquidity and inflation expectations for 08. The Dollar also found temporary support at very low levels, but I would not read much into that either.

One Of The Few Bright Spots

Interest rates on the short end moved down with the Fed (or ahead of the Fed as the case may be), but long terms rates held up as the yield curve continued to steepen. One of the few bright spots was employment as the economy added jobs in each month of the Q4. The Fed broke out the old text books as Bernanke and company cooked up novel, "old" ways to save the day; from urging use of the discount window by banks in need of liquidity, to increasing term repos and repo limits to the primary dealers and even creating new, new vehicles like term auction financing and central bank global coordination of swaps to its part in the SIVS. However, the end result of all this action is simply more liquidity akin to what the Greeenspan Fed would do in the old days but more direct with massive rates cuts and creating easy money. The question of whether the covert approach to adding liquidity in a targeted manner will produce different results remains unanswered thus far.

First Quarter 2008 Outlook

With much of the bad news out and perhaps behind us and the equity markets nonetheless posting positive results for 2007, it would appear from where I sit that 2008 in the end will be a surprise to the upside. While I hear much banter that the Fed should have cut rates by 50bps at the December 11th meeting instead of the 25bps they chose to do, I must say I have to disagree.

It's not a right of citizenship or equity ownership to insure that stock investors' shares should go up year after year. In fact, a little breather is welcome in asset classes as slowdowns, and yes, even recessions, are good things that thin the herd and cut the fat that eventually allows for stronger and more productive growth.

Did The Fed See What Was Unfolding?

I too believe the Fed saw what was happening and with the concern about inflation being a primary initiative intentionally decided to lay off the liquidity accelerator (at least in the obvious form of slash and cut rates ala the Greenspan Fed). The economy was not going to go into a recession solely because of the sub prime or mortgage mess. Even a slowing real estate housing market could only throw cold water on the economy as the heat from international and emerging markets kept things steaming along. With asset inflation at levels not seen in decades and equities fairly or maybe even undervalued this decade, this might be the buying opportunity we have all been looking for. With housing and stocks at levels well below their respective peaks perhaps this is a time to accumulate assets. Investors have the luxury of being able to be selective, as it appears to be the proverbial buyers market. With the various rescue packages in the works and an election pending later this year, everything and the kitchen sink will be thrown at the problems of yesterday creating tremendous tail winds for those investors who stepped in early when risk appeared the greatest.

Let's Take A Closer Look

Let's take a look at one of the specific problems facing the economy in 2008 - the sub prime lending market.

First let's review some statistical numbers: total housing sales new and existing; total housing starts; and total sub prime loss write downs. When I tally it all up, something seems off. Is it really possible that the total dollar value of the sales from 2007 to be anywhere near the total write-downs? Is every home sold in 2007 in default? Are there really that many bad deals over the last 5 years as a percentage of all homes sold? There must be some bath water being thrown out with the baby here and this will not only create opportunity but will ultimately prove less of a devastating result to the economy than the initial impact.

It leads me to ask if there was anything productive from the sub prime loans? Someone made some money, and certain deals got done that otherwise would not have. Loans were bundled and packaged to lay off risk to investors willing to accept a higher interest rate in return for more risk, which worked. Much of the risk had been dispersed so the banking sectors and pension funds and traditional lenders did not shoulder all the pain, which is a good thing, right? Also, many projects and companies that could not attract capital at market rates but could not afford to pay sub-prime rates could be blended to create a vehicle that would attract investors at rates acceptable to borrowers. This helps drive their businesses and the economy. Yes, admittedly, more of these loans defaulted than was anticipated but there was some greater good achieved as well and that seems to go unnoticed.

Who Really Is The Victim?

Without fraud or misleading lending practices, many new home owners had an opportunity to participate in the American dream. Maybe at a higher entry price point, but otherwise, they would never have had the chance to play. Most people who used the sub-prime market did so because they had no other alternative. In the past, that meant no mortgage. As for the lenders, hopefully the math worked. The higher interest rates earned would offset the higher defaults. The bottom line is there are winners and losers in this mess and the math does not suggest that this problem alone should cause the entire U.S economy to go into a recession. That being said I want to reiterate, recessions are a necessary part of our economic and capitalist process and the tipping point is hard to identify (unless perhaps you are Malcolm Gladwell). For us, employment is the canary in the coalmine, and so far that is not signaling recession. If it is (or when it does), so be it.

Let's Take A Look

Let's take a look at a few sectors and assets and review what might be in store during the first part of 2008

Equities

This decade so far has not been kind for the stock market. 2007 ends almost to the penny where 2000 began. If the economy enters a recession, it will be the first time I can recall that the end of one expansion occurs at the same place the previous expansion ended. That is why I think a huge rally is in the making. Equities were selling off at the end of 2007 and the beginning of 2008 because of unusual events in mortgage sub-prime and credit markets. This is causing a repricing of equities along with repositioning of risk, as banks and hedge funds reduce risk and leverage selling equities. Once this selling is over (it's anyone's guess when) the Fed will be forced to continue to ease aggressively the market will find stable footing. With growth unlikely to break below zero, this should ignite a surprising rally that should carry the equity markets 50% higher from current levels to finish the decade with a statistical return consistent with decades past.

Fixed Income

Much like some of the other asset classes mentioned in our introduction, fixed income was an area where tremendous volatility reigned, especially towards the second half of the year. As the world's debtor, the United States has a tremendous amount of our country's bonds in the hands of foreigners. This completes the usual cycle (which I talk about often) of how The U.S. is effectively 'lent' money to buy foreign goods. With interest rates falling, and bond prices rising, we saw a strong continuation of this in 2007, only with a few comments here and there from foreign constituencies squawking about dumping their U.S. bond positions (largely believed to be due to the weakening dollar). Regardless, the emotional factors of a flip-flopping Fed (first being hawkish on inflation only to relent by the end of the year to focus on cutting rates to fuel economic growth) seemed to be the major factors in fixed income for at least the second half of 2007. While days of 5.3% on the ten-year treasury seem like years ago, when in fact it was just in June of 2007 when we last saw it, the fixed income trade in 2008 looks largely dependent on equity market's performance, which has been lousy of late. Thus, we have been able to capture some upside in bonds as we await more fiscal and monetary stimuli to assist in reviving economic growth and adding calm to the markets.

Energy

One could argue that the 'long' energy trade in crude oil, and even to some degree natural gas (given typical seasonality), was the easiest money made during 2007. The fundamental factors were quite suggestive - an expanding global economy and global employment - which resulted in higher demand for the resource. Mix in a falling dollar (crude oil prices are denominated in dollars) and it seems there was nowhere for crude to go but up. And up it did go, nearly reaching the vaunted $100/barrel mark, but only to retreat by year's end as OPEC's supply increased alongside economic fears of a slowdown were negative factors for the demand side. We feel that the easy money in crude and natural gas has been made and much of the future price implications rest on the ability of the global economy to sustain an above average growth rate. Note that I said "above average", because every year we get closer and closer to alternative sources of energy. As prices continue to rise for oil and gas, the incentive and cost consideration start to favor more expensive energy alternatives. In other words as price rises supply, supply increases which will stable prices (at least temporarily). With double digit increases the past few years this might be the year we see a more traditional price pattern. Slowing economy, stabilizing dollar, and increases in supply should weigh heavily on further price advances.

Precious Metals

Much talked about but hardly ever accretive (over time) to a portfolio, precious metals came to light in a big way in 2007, especially towards the end of the year as more managers sought non-correlating and alternatives to equity positions. A weak dollar, a weakening global economy and just basic fear of a market crash all were factors that helped bolster the value of this asset class in positions like gold, silver and copper to name a few. We have been able to capture some of the performance from these trades and see similar situations setting up in 2008, but also are mindful about how far and fast the precious metals prices have run in the last few months. We do feel that this is a good asset class to allocate to in 2008 with the expectations that the quick, upward movements in the metals like we saw in Q4 2007 are not likely to be repeated. However, as far as a diversification from equities, this is an asset class that can benefit from liberal monetary policies as well as increased money supply. Over the years the best thing about metals was that the assets were not stock. Last year not only did it not correlate to equities, it was accretive to a portfolio. This year has similar promise but probably will under deliver. This is more of a statement on the anticipated equity market's performance than gold.

The Dollar

The U.S. Dollar continues to be the currency that nobody wants. There were several fundamental factors (other than negative publicity) that led the Dollar decline both in 2007 and years' prior. One of the key factors in our decision making when it comes to currencies is the money supply of the currency, and in this case, with our research showing the dollar's supply expansion not only being the highest in several years, but the rate of growth is also higher than other G7 currencies. We were expecting and rewarded by the Dollar's decline in 2007 and expect that tactics used to fight the global credit freeze and now a weakening U.S. economy will only pressure the dollar through the beginning of the year, and we are positioned to take advantage of that scenario. What happens after that depends largely on how well the fiscal and monetary medicine takes when it comes to rejuvenating the U.S. economy? While momentum and fundamentals continue to support a weaker trade deficit, the trade deficit may actually support the Dollar and the US economy in 2008. The dollar has reached levels that clearly make US goods and assets extremely attractive further the Chinese are allowing greater appreciation of their currency than previously expected. This may help to reverse the Dollar's fortunes for 2008 so we will be cognizant of this potential.

Emerging Markets

With a global economy in full swing, developing nations have clearly most benefited from the global expansion. These countries have opened up their economies and have benefited from demand for their raw materials and labor. As the global economy was strong for most of 2007, we saw a steady expansion of business activity in the developing nations represented in the EEM index (iShares emerging markets), and it finished the year as one of our most accretive parts (performance-wise) to our portfolio, as we had a long-bias to the sector. However, as economic winds around the globe are blowing with more caution, we have lowered our expectations for this sector and are now preparing to see less in the way of upside for these countries for at least the first half of 2008.

Real Estate

Real estate markets garnered much of the headlines in 2007 as a significantly weakening housing market and fallout from the global credit crisis greatly impacted building activity and prices around the globe. As we pointed out several quarters ago, there were clear signs that some markets were getting way ahead of themselves, and we suggested caution when approaching these areas.

It is in the areas where prices got very inflated that we are seeing the first and most notable impacts. With the easy money already made in the sector, it is time for a true rebalancing of risk/reward when it comes to prices. We feel that this will be healthy, as it will signify the asset class's reposition at appropriate valuations.

Conclusion

The 4th quarter of 2007 was a solid quarter for our funds. Our models performed within expectations and some benefits of the new restructuring have already paid dividends. We expect this to be an evolving process as we constantly look to optimize our business, and the transition to be complete during the middle of 2008. Again to reiterate, the hot hand in the 4th quarter were assets that in general were non-correlated to equities, and we were (and still are) intentionally under-weighted equities with no regrets. It is my belief that when the economically sensitive sectors become active again, and when we get it right (or even almost right), the payoff will be substantially better and worth the wait.

Asset class correlation through mid-year was the biggest problem for our funds in 2007 as the much talked about (by me, at least) liquidity searched for yielding investments. That has finally changed and we are seeing alternative sectors breakout as general equities have weakened. Additionally, economic trends remained intact most of 2007, with the fourth quarter's data arguably being the worst of the year. While this puts several asset classes in the first quarter of 2008 in a volatile mood, we feel that will create trading opportunities as the market drifts back toward long-term trends, especially in equities. Without having empirical knowledge of when that will occur, we will wait for this trend to be re-identified before placing any major bets. Our risk management is one of the most compelling features of our strategy, and the Fund's 2007 performance demonstrates how quickly we can seize opportunities in fixed income, metals, and energy, just to name a few.

About the Author

Robert N. Stein is the managing member of Astor Financial, LLC. Mr. Stein is the author of Inside Greenspan's Briefcase: Investment Strategies for Profiting from Key Reports & Data, published by McGraw-Hill. In 2003, Mr. Stein was named one of "The Best Unknown Managers" by BusinessWeek Magazine (January 20, 2003 issue). A University of Michigan graduate in Economics, Mr. Stein began his career as a project analyst for the Federal Reserve during the chairmanship of Paul Volcker. Moving to Wall Street, he eventually became Managing Director of several large financial institutions before returning home to Chicago in 1994 to form Astor Financial. Mr. Stein is frequently featured by the news media, including the BBC, CNN, CNBC, Bloomberg, Fox News Channel, The Wall Street Journal, and Investors Business Daily. Stein has lectured and has written several articles about the economy and the markets. He is also the Founder and President of the Dream of Jeanne Foundation and serves as Vice Chairman on the Board of Trustees for Glenkirk. Both organizations help the mentally challenged to participate fully in all areas of community life.

This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. This is no an offer to buy or sell securites. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown. Please refer to disclosure document for additional information