The stock market as represented by the S&P500 provided modest gains for investors in 2007. The index started the year at 1418 and finished at 1468, returning 3.5%, before dividends. The market experienced volatility not seen since the winter of 2003 preceding the invasion of Iraq. The volatility was driven by the meltdown in sub-prime mortgage debt that was dispersed throughout the financial system by a process known as securitization. Securitization involves bundling mortgages together and selling them as a single security, like a bond. The housing market, which underpinned this debt, weakened significantly in 2007, leaving borrowers unable to refinance existing mortgages or sell their homes in order to repay mortgages whose payments they were no longer, or oftentimes never able to meet. Due to securitization, lenders did not know, and in many cases still do not know, who has exposure to this debt. This uncertainty led many to fear that the credit (lending) market could seize up, leading to broader financial and economic turbulence. As a flight to safety amid the turmoil, Treasury securities rallied. The benchmark ten-year note began the year at 4.71% and ended it at 4.04%. The Federal Reserve cut overnight interest rates in 2007 from 5.25% to 4.25% in response to the sub-prime-crisis.

While the sub-prime debt saga continues to unfold, we believe a related, yet more significant issue facing financial markets is the health of the American consumer. After seven years of debt-driven consumption growth, consumers are faced with a series of obstacles in continuing their spendthrift ways. The American consumer has been the single biggest driver of growth during the current expansion. Consumption now makes up more than 70% of total US GDP, an all-time record. As such, the financial condition of the consumer is of utmost importance to the continued health of the overall economy.

First and most importantly, the residential real estate market is facing its most significant declines since the Great Depression. Prices are currently down over five percent nationally, with no sign of stabilizing. Because people have borrowed so heavily in past years, either to purchase or extract equity, the decline in home prices is having an amplified effect on people’s net worth, and thus propensity to spend. For instance, if you have 10% equity in your home, and the price of your home declines by 5%, your home equity declines by 50%.

Secondly, with the fallout from the highly publicized sub-prime lending crisis, consumers are experiencing greater difficulty borrowing money to fuel their consumption. Having been wounded by sub-prime mortgage loans, in some instances critically, lenders are becoming more disciplined and restrictive in their lending practices, specifically to poorly capitalized individuals. Most alarming in recent days has been the dramatic deterioration in credit card debt, with defaults and delinquencies increasing by a rate of 25% year over year. This could potentially result in a further downdraft in the financial sector, as credit card debt has been securitized (i.e. packaged and sold as a security like a bond) and spread throughout the industry in much the same way as had sub-prime mortgages.

The Federal Reserve has been typically slow in dealing with the restrictive credit environment. Although they have cut overnight interest rates between banks by a full percentage point, the overnight rate continues to lie above the ten-year Treasury note rate. Such an “inverted yield curve” does not bode well for economic expansion, as it restricts credit creation by pressuring bank lending margins. We expect the Federal Reserve to continue to cut overnight rates well into 2008, although whether or not the pace of cuts is adequate to forestall a breakdown in consumption remains to be seen.

Third, elevated food and energy prices continue to serve as a drag on consumption. With oil prices near record levels and the government mandated drive for greater use of corn-based ethanol pushing up food prices across the board, consumers are seeing their discretionary incomes pressured with the result they will have less money for non-essential purchases.

Holding the American economy together in the face of these three significant obstacles faced by the consumer is the current high rate of employment. Unemployment stands at a historically low rate of 4.7%. As long as people have jobs, they seem willing to continue to spend in the face of their almost complete lack of financial savings and declining real estate wealth. Herein lies the ultimate vulnerability: The American consumer, the driver of the American economy, has almost no ability to withstand a meaningful increase in unemployment. If the economy were to weaken sufficiently to increase unemployment, the whole house of cards could come crashing down, as the consumer has next to no savings to tap to maintain consumption. This could further weaken the economy, leading to further layoffs, and so on and so forth.

While the consumer is highly vulnerable, American businesses are generally robust. This serves as a significant bulwark against job declines, particularly with dollar weakness and global economic strength driving gains in exports. When considering the overall environment, the US economy faces a serious risk of recession in 2008. Whether or not there is a technical recession, US firms are going to face muted if not difficult business and economic conditions. As such, we forecast a relatively high amount of volatility in the US stock market in 2008 with modest overall gains at best. We do not see a serious risk of a bear market in stocks given current valuations, which are generally moderate. We estimate the range of the S&P500 for 2008 will be a high of 1600 and a low of 1300, with low end of the range seen in the first half of 2008.

As always, our focus continues to be on developing a diversified portfolio of shares in high quality companies at a reasonable price. We may contract and expand your overall equity exposure based on our general market forecast. Please feel free to contact us at anytime to discuss your individual investment position. Patrick Mauro Investment Advisor, Inc. is regulated by the Securities and Exchange Commission (SEC). Federal regulations require that you be offered a disclosure document (ADV-Part II). This form is on file with the SEC and is available to you by merely writing a request to this firm. We appreciate the confidence you have shown in us, and will endeavor to continue to earn that confidence.

Patrick Mauro, Daniel Mauro, Henry Criz