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Review & Outlook

Summer 2008

Investor's Update
It has been a trying time for investors as growing concerns over record energy prices, troubled credit markets and higher inflation have tested investor’s convictions. There have been very few places to hide other than commodities. Stock performance, globally, has been generally dismal, while fixed income issues failed to provide much upward valuation momentum on a year-to-date basis. In fact, U.S. Treasuries put in their worst quarterly performance in four years on inflation concerns.

On a total return basis, the Dow Jones Industrial Average recorded a -13.4% return for the first six months of 2008, while the S&P 500 declined 11.9% and the Nasdaq decreased in value 13.2%. The five year and ten year U.S. Treasury Bond increased in value during the first half of the year 2.6% and 2.5%, respectively, benefiting from investors uncertainty. The Lehman Brothers Intermediate Government/Corporate Bond Index advanced 1.4%, while the slightly longer duration Lehman Brothers Aggregate Bond Index registered a positive 1.1%.

Economic Outlook
As the second half of the year gets underway, the fall out from the housing and credit crisis continue to pose meaningful downside risk to both domestic and global economic growth. Despite the stimulus from the Fed and government, we expect a prolonged period of sub-trend growth well into 2009. Specifically, we expect second-half growth of GDP to be 1.0% or less, with the trend continuing into 2009.

Our work points to a period of stagflation. Since our last communication, the downturn in housing and the associated credit dislocation has spread to other sectors of the economy. Many indicators suggest that the labor market is weakening and unemployment could exceed 6.0% by year-end. Moreover, from a wage standpoint, the average worker is losing ground to inflation. Weekly wages increased at a 2.8% pace in the past 12 months through June, while the CPI increased 4.0%. Manufacturing and non-manufacturing activity is equally stressed. Unquestionably, consumer spending has been impacted by the escalation in food and energy prices, placing the Fed in a very difficult position.

We believe the Fed will remain on hold for at least the next few meetings. As much as the Fed may want to remove liquidity from the monetary system to address current inflationary pressures; the fragility of the financial system, the pending election and the weakened state of business and the consumer, preclude them from doing much other than jawboning. Additionally, we must also see some stabilization in housing and a break in energy and food prices before they can even consider a more aggressive monetary stance. The U.S. economy is just not sturdy enough, at the moment, to handle higher real borrowing rates particularly when coupled with present tight lending standards.

As we have related previously, there is no quick fix to what we view as a multi-year deleveraging process. The Fed has reduced short-term rates by 325 basis points since the fall of 2007, with little impact on growth. Most credit related yields, other than Fed Funds, are either level or higher than when the accommodative process began. The credit cycle, on all levels (financial institutions, businesses and consumers), must play out and deliver the resolute level of pain before we can look beyond the economic trough to the next growth cycle.

Capital Market Analysis
We continue to believe, as expressed in our spring newsletter, that it is critical to recognize the heightened level of risk in all asset classes give the uncertain fundamental underpinnings. Thus, our posture has not changed and we remain cautiously participatory with a focus towards further potential impairment to overall economic growth, corporate earnings and margins as well as general asset valuations. We think we are in for a slow second half of the year, which deserves tempered expectations, particularly if the trends in commodities prices and the labor market weakness continues.

Our strategy is to position portfolios to endure and when possible take advantage of what we believe will be a highly volatile environment over the next few months. Clearly, more EPS visibility will be required to spark any sustainable rally and that catalyst does not seem to be in the immediate future. Nevertheless, one does need to recognize that a lot of bad news has been discounted by the capital markets to date and strong, reflex, counter-trend rallies are possible during this extended bottoming process.

Hopefully, at some point within the next few months, news and downstream visibility should improve and the market will begin to look beyond present uncertainties. In the interim, however, a recognition of risk and the appropriate amount of caution seem prudent.

Summary
We expect the present environment of confusion and indecision to persist. The deleveraging process and transitional phase of slower growth could prove challenging. With the prospect of inflation and lower profit margins, we feel investors should proceed with caution. Historically, this trend has not been favorable to fixed income investors and has proven problematic for equity valuations.

We appreciate your confidence and urge you to contact us if you have any questions or if we can be of service.

Past performance is no guarantee of future results and investing involves risk, including the possible loss of principle.

120 South Warner Road • P.O. Box 837 • Valley Forge, Pennsylvania 19482 • 610-687-6800 • FAX: 610-687-1848
One Righter Parkway • Suite 150 • Wilmington, DE 19803 • 302-478-2036 • FAX 302-478-3084