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Capital Markets Outlook

Since starting our Managed Allocation Portfolio program over three years ago, we’ve set out to invest client money optimally between different asset classes. Our asset allocation work has differed from most in two distinct ways. First, we approach asset allocation proactively, believing that optimal asset allocation should not be derived simply by looking at past return data but rather by looking at asset classes’ current and future return and risk potential. Secondly, we use exchange traded funds (ETFs) to implement our investment ideas. As index funds that trade like stocks, ETFs allow for liquid, efficient and inexpensive exposure to a myriad of investment types, regions, sizes, and styles.

The result, we believe, is powerful yet flexible portfolios able to post solid returns navigating through various economic and market environments. And thus far, we’ve been very pleased with our results.

It appears foreign capital and private equity are starting to agree.

High savings rates abroad combined with the trillions of U.S. dollars sent abroad have created huge cash hordes outside the U.S. These assets come back in the form of U.S. asset purchases in order to earn a rate of return. Higher credit quality and safety, combined with the U.S.’s higher nominal interest rates are especially inviting today to foreign capital. Demand for U.S. investments is on the rise: foreign ownership of U.S. equities and Treasuries stands at 14% and 43%, respectively versus 5% and 18%, respectively just ten years ago.*

In addition, private equity is proving to be the next juggernaut on Wall Street with $170 billion in capital raised in 2006 alone. Small and large cap companies alike should increasingly become acquisition targets; large companies should be of special interest as private equity funds seek large cap companies’ lowdebt and cash-heavy balance sheets. Already, Home Depot, Dell, and Deere are among the larger, higher quality companies rumored to be under the private equity radar. If anything, the private equity threat will force managements to operate more efficiently and increase shareholder value.

Our bullish view of equities comes with the assumption that oil prices will not significantly spike and the housing correction will be, at worst, a soft one. Should either of these factors prove otherwise, we would likely turn defensive.

Superb monetary policy by the world’s central bankers has investors convinced that low inflation is here to stay. Such confidence has contributed to the current flat yield curve with yields on shorter term bonds roughly equal to that of longer term bonds. While we believe in contained inflation will persist, we look now to the U.S. dollar. Any marked depreciation of the dollar may temporarily send long bond yields higher as investors speculate the inflationary consequences of a weak dollar.

The Rally Continues

2006 turned out to be a fine year for markets worldwide as a combination of good monetary policy and lower oil prices during the summer helped spur many worldwide equity indexes to new highs. Our bullish inflation outlook was validated as real estate and oil prices cooled, lowering inflation expectations and aiding the markets’ rally.

While real economic growth in the U.S. is expected to moderate to the 2-2.5 percent level in 2007, a recession doesn’t seem to be in the cards. However, prognostications have diverged on Wall Street with many thinking that the rally is long due for a pullback. Slowing economic growth and falling housing prices certainly aid the bears’ case.

The relative value of equities over other asset classes has been a fairly steady theme for us over the past few years as we’ve argued that robust earnings growth, clean balance sheets, low inflation, and low investor sentiment made equities a relative bargain.

Ample liquidity should provide continued demand for equities that also pose a better value to fixed-income. We are overweight stocks to bonds as the foreign capital and private equity binge continues through 2007.

While we believe large caps are relatively cheaper and safer than small caps as economic growth slows, small and mid caps should be the biggest beneficiaries of the private equity binge. However, we anticipate large caps to become increasingly attractive (and realistic targets) to private equity money.

Higher and more predictable earnings potential with increased dividends and value-like P/E multiples currently make growth stocks more attractive than value stocks.

A weakening dollar has made foreign equities more attractive, though we see some increased risk abroad, specifically with commodity-based economies. We’ve added the U.S. insurance and biotech sectors for growth potential and now hold gold and Australia (a commodity country) as weak-dollar hedges.

The current flat yield curve, combined with our lack of conviction regarding the direction of the dollar makes us wary of long term bonds. We’ve shortened bond maturities, content to pick up higher yields while being well-positioned should risk be re-priced into longer term bonds.

***

* Steven Wieting, Economic & Market Analysis, Citigroup publication, December 7, 2006.

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