Economic and Investment Forecast
February, 2008

The U.S. stock market began 2007 with record low volatility and rising stock prices. However, volatility surged in the second half to its highest rate since 2002 and stock prices began a decline which has continued into this year. This reversal was primarily caused by interest rate increases instituted by the Federal Reserve to contain inflation, the collapse of the overpriced housing market, and increased energy costs, which together resulted in consumer spending slowing dramatically in the 4^th quarter of 2007. In addition, last summer's meltdown in the complex sub-prime mortgage securities market created a worldwide liquidity crisis, which necessitated an infusion of capital into the world banking system. Although this crisis passed quickly, it resulted in significantly tighter credit, at least temporarily, which is a barrier to economic growth. The shockingly high losses associated with this sub-prime fiasco will have mostly been declared and written down by the affected institutions by the end of this quarter. The U.S. dollar fell sharply against many major currencies this past year, but is expected to gradually strengthen in anticipation of a stronger U.S. economy as it has in the past 4 out of 5 recessions. A sharp rise in the dollar could make our exports more expensive overseas as well as adversely affect overall foreign investment returns.

The Federal Reserve's past and probable future interest rate cuts should have an increasing positive economic effect in the next several quarters, including slowing the rate of real estate foreclosures. Residential real estate prices will likely stabilize this spring, at least in some areas of the country. Although we do not see any relief from high energy costs, the U.S. is slowly adapting with more efficient energy use. The odds are only about 50% that this economic slowdown will qualify as a recession, 2 consecutive quarters of declining Gross Domestic Product. Those economists that are forecasting a recession expect it to be shallow with a recovery beginning in the 2^nd half of the year. This slowdown, unlike most previous slowdowns or recessions, does not have the usual high business inventories, nor the high unemployment, which may help shorten its duration. However, inflation, which has been fairly benign, picked up unexpectedly in the 4^th quarter with core prices - excluding food and energy - increasing at a 2.7% rate, the largest quarterly increase since the spring of 2006. Should this trend continue, it could complicate the Fed's job of trying to energize the economy while keeping inflation under control. Inflation is currently the primary concern in many foreign countries.

The U.S. stock market will likely remain volatile until it's clear that a recovery is underway. However, at current pricing levels, there are attractive investment opportunities as price to earnings ratios are generally low, earnings projections remain relatively strong, and the global economy, although slowing some with the U.S., appears stable with moderate growth. This year's best performing categories are forecasted to remain the same as last year; emerging markets, especially the BRIC countries (Brazil, Russia, India, China), foreign developed countries, and U.S. large cap multinational growth.

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