Quarterly Newsletter: December 2007

Click here to view the Index Returns for 4th Quarter 2007
 (PDF,94kb)

Asset Class Performance
The fourth quarter yielded mixed results amid continued volatility. After a significant drop in November, US stocks rallied on the news of an additional Fed rate cut, but ultimately finished the quarter in negative territory. Inflation Linked Bonds lead all asset classes with a 5.0% return for the quarter followed by Emerging Markets (+3.6%) and Intermediate Term Bonds (+3.0%).

For the full year 2007, Emerging Markets was the top performer with a nearly 40% return, followed by Large Cap Growth Equities (+11.8%), which broke out of their slump and Inflation Linked Bonds (+11.6%). Large Cap Value Equities and Small Cap Equities yielded marginal losses and Real Estate finished 15.7% lower than a year earlier. Quarterly and annual results are illustrated in the chart.

In The News
With the exception of Hollywood's childhood stars acting badly, the Federal Open Market Committee (FOMC, the "Fed" or Federal Reserve) arguably grabbed more headlines than anyone in 2007. The Fed struggled, along with the majority of Wall Street, to forecast the severity of the subprime fallout and the credit crunch that ensued. In all fairness, however, the Fed's job is to balance economic growth with inflation, not to provide a safety net for poor investment decisions.

Fed 101
The FOMC balances growth with inflation through monetary policy, which influences the supply of money and credit in the economy. Monetary policy tools are reserve requirements or the level of capital member banks must maintain, the discount rate that the Fed charges member banks to borrow and open market operations, which is the buying and selling of government securities. While the Fed does not directly control the more important federal funds rate (the rate member banks charge each other for funds to meet the Fed's reserve requirements), it does use the tools mentioned above to manage money supply so the target rate is achieved.

Monetary Policy: Theory Into Practice
The last 10 years provide an illustration of how the Fed has used the target federal funds rate to encourage economic growth while keeping an eye on inflation. The target federal funds rate, the consumer price index (CPI) or inflation and the S&P 500 Index are illustrated on a percentage change basis in the chart below. The CPI averaged a steady annual rate of just 2.3%, which is illustrated by the positively sloped, but relatively straight line. The target federal funds rate began the period at 5.5% and after 8 months at a peak of 6.5% in 2000, tumbled to 1% over the next 2 ½ years in response to the tech bubble burst and the S&P 500 losing over 45% of its value.

By July 2004, sentiment had shifted among Fed policy makers to concern over inflation and the target federal funds rate steadily increased until reaching 5.25% two years later. As many economists and investors were quick to point out, at 5.25%, the cost to borrow was higher than expected economic expansion, as measured by Gross Domestic Product, which would have negative implications for corporate investment.

The Fed reversed course in the middle of 2007 as concerns over subprime's far reaching effect on economic growth took center stage. While the Fed prefers to set monetary policy and give clear guidance, it is currently in a "wait and see" mode. The series of target federal funds and discount rate cuts that began in the Fall are likely to continue into 2008 as the Fed weighs the impact of tight credit and weak housing on consumer spending against lingering inflation. Add in an approaching election year, devaluation of the dollar and talk of recession and you have the perfect recipe for unnerving and distracting market volatility.

Implications For Investment Strategy
For certain, there is much to be restless about these days, but the same could be said during any stage of a market cycle. Unless your personal circumstances have changed, we don't advise making big portfolio changes. Instead, we support rebalancing portfolios back to target asset allocations and using cash inflows or outflows to true-up asset classes by buying low and selling high.

Thank You!
Arbor reaches its 10 year anniversary in 2008. We greatly appreciate the opportunity to help manage your financial goals and objectives. Thank you for your business and your confidence.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Arbor Investment Advisors, LLC. Please remember to contact Arbor Investment Advisors, LLC if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.

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