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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
January 3, 2008

The View from Edgewood

The U.S economy actually had a good year in 2007, with real GDP growth of around 3% and CPI inflation of around 2.5%. With the headwinds of high priced oil and the weakening of housing construction the economy’s growth was buoyed by a strong increase in exports thanks to the weak dollar. This is a key development. While it may cause pain for Americans traveling abroad the weakening of the U.S. dollar against major currencies should be the crucial element in keeping the economy growing in 2008.

Despite the strength of the economy the year will be remembered for the ending of the housing price bubble as it became evident early in the year that house prices were no longer appreciating on a national basis and, as would be evident later, were actually declining. When we last wrote to you in early October it looked like the markets had weathered the tempest of August in good shape. While there were credit problems they appeared to be quite manageable. It is now apparent that the toxic paper turned out over the last few years, and the attendant derivative investments made on top of those credits reached further than most had dreamed (or feared) in August. From the expected (Citigroup and Merrill Lynch) to the unexpected (H&R Block and E-Trade) the spread of this problem has taken many by surprise. At the end of the year only coordinated Central Bank intervention between several G7 countries kept some liquidity in the system as banks became very reluctant to lend to each other (which is one of the major foundations for healthy functioning of the financial system) or to businesses on a short term basis.

As 2008 begins the world economy sits somewhat uneasily between two outlooks: more subdued growth as the sub-prime mortgage mess and the closely related housing price decline takes a bite out of U.S. and world growth, and an outright recession as the major economies of the world cannot fight the freezing of the credit markets and a decline in consumer spending in the United States.

While the global economy has been able to operate so far without much detrimental effect a healthy economy needs smoothly functioning credit markets to prosper over the long term. The Bank of England recently lowered rates and the European Central Bank (ECB) has moved from talking about rate increases as late as September to hinting that the next move they make could be a rate decrease. The U.S. Federal Reserve has lowered rates three times, each time insisting it was reluctant to move because of inflation fears. The Fed knows, however, that if the economy slows too much, or falls into recession, inflation will not be a primary issue. We think they will continue to lower rates through the spring.

The major stock market indices had a subdued year with the Dow Jones Industrials up 6.4% and the S&P 500 up 3.5% (excluding dividends in both cases). A lot of their weakness was due to the large weighting of financial service stocks in their ranks. At the start of 2007 financial services was the largest sector in the S&P 500 with a weighting of 21%. The Russell 1000 growth index was up 11.8% (it has very few financial service companies in its makeup), confirming what we have been saying for more than a year: growth stocks were attractively valued and would begin to outperform.
With the economy poised between the two scenarios we mentioned earlier stocks with earnings growth not tied intimately to the business cycle should outperform whether we enter a recession or see slower economic growth for the first half of the year. Many of the companies in Edgewood’s portfolio have significant international revenues, which will further enable them to avoid a domestic economic slowdown or even a mild U.S. recession. Add to this the further rate decreases we expect from the Federal Reserve and still attractive valuations of your holdings and we expect a solid year from large cap growth stocks.

We want to wish you a happy and prosperous 2008.


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