Economic and Investment Forecast
December, 2007

The worldwide movement toward capitalism and the availability of information through the Internet has led to rapid economic growth in formerly underdeveloped countries. According to ISI Group, Brazil , Russia , India , China (BRIC) and other emerging economies now comprise nearly 1/3 of the world GDP, an astounding figure. Although the U.S. economy may no longer be the sole dominant economic powerhouse, we believe that U.S. companies are well positioned by experience, technology, productivity, and adaptability to benefit from the insatiable consumption pattern of the new rising middle class in these emerging countries.

In the short term, however, the U.S. economy appears to be slowing. The end of the housing boom and the de-leveraging of the credit markets in the wake of the sub-prime mortgage fiasco have put a considerable strain on the liquidity necessary for a vibrant economy. After years of good economic times and five years of excessive consumer spending, easy credit and the availability of cash from rising equity in residential real estate has come to an end. Not only have home prices declined in most areas ( California and Florida have been most affected), but household debt grew almost three times faster than income from 2000-2006. Meanwhile, unemployment is increasing in some areas, consumers across the country are struggling with rising energy and food costs, and a growing list of imported goods are now more expensive due to the weak dollar overseas. Consumer confidence has been slipping since July. While higher prices normally lead to increased inflation, or even stagflation, the personal Consumption Expenditure Index (the Federal Reserve’s preferred measure of inflation) is up 1.9% year over year in October, still within the Fed’s 1% to 2% target range for core inflation. The flip side of a weak dollar is that U.S. goods are less expensive for foreign buyers, thereby increasing exports which are more than offsetting the weak housing sector’s effect on the GDP. The preliminary 3^rd quarter GDP was a strong 4.9% but a portion of this was inventory buildup, and most economists are forecasting several weak quarters (1-2%) before housing begins to recover and inventories are worked down. Although a recession is certainly possible next year, we believe that the effects of the Federal Reserve’s recent interest rate reductions (Fed Fund rates currently 4.5%) and a likely cut in December or early next year should stimulate the economy by mid 2008. Global growth is expected to remain strong at 4.5% to 5% next year which should also aid in the recovery.

The stock market has been on a roller coaster ride this year with the S&P 500 index reaching 1553 on July 13^th, correcting 10%, rallying to 1565 on October 9^th, and again correcting 10%. Year to date, the S&P 500 Index is up 4.4%. This volatility will likely continue well into next year. However, U.S. stocks look attractive, especially large cap growth, as exports are strong, price to earnings ratios are reasonable, and fixed income yields are low. So far this year, foreign stocks have been the strongest performers, especially the volatile emerging markets, and we believe this will continue.

Diversified Financial Management, Inc.
A Registered Investment Advisor with the Securities and Exchange Commission.