• May Market Commentary by Kenn Lamson
• Governor Otter to Keynote Global 21 International Conference
• April Market Commentary by Kenn Lamson
• March Market Commentary by Kenn Lamson
• February Market Commentary by Kenn Lamson
• January Market Commentary by Kenn Lamson

This month's market commentary focuses on the most-studied yet most enigmatic creature that generates about 70% of US economic activity: The American consumer. We've identified four key economic areas in which the consumer is being squeezed: Housing, commodity prices, availability of credit, and employment. Given the pressure that consumers have felt in these areas, it will come as no surprise that readings of consumer confidence are down. Way down, in fact. April's University of Michigan survey posted the lowest level since March 1982, when the economy was suffering through a deep and protracted slump. By contrast, while the situation for the American consumer is surely not pleasant, the sour confidence readings seem to be as much based on expectations for further deterioration as actual pain being suffered.

The deflating of the housing bubble is well documented. One would have been out of touch with economic reality to be unaware of the decline in home prices that has transpired since mid-2006. Restating a statistic cited in last month's commentary, the quarterly S&P/Case-Shiller home price index showed an almost 11% annual drop through January, and chances are good that when the index's February reading is released later this week it will show significant further declines. In addition to the psychological reasons noted above, the decline in home values has very real financial impacts. Obviously, the drop in home prices has the direct effect of reducing consumers' wealth. Also, many have used the equity in their home as a ready source of funds, which spurred much of the growth in the US economy in the early part of this decade. The decline in home values not only reduces or eliminates that potential liquidity source but saddles the borrower/owner with an increased debt load owed on a depreciated asset, creating a situation that is not only psychologically uncomfortable but impairs the ability of the borrower/owner to sell the house without additional expense.

The dramatic rise in commodity prices has also been widely discussed. Gasoline, corn and rice are but a few of the products that have seen sharp increases that have squeezed consumer pocketbooks. These price hikes come at a particularly troublesome time; recall that the price of a barrel of West Texas Intermediate crude oil rose almost 500%, from $17 to $77, between October 2001 to July 2006, but since home prices were also rising and employment was solid those price hikes merited little more than a curious shrug from most consumers. Coming as they do now, at a time of increasing uncertainty, the price hikes are, like home price slippage, both psychologically and financially detrimental.

Consumers, along with their commercial counterparts, have been the unfortunate beneficiaries of a spreading drought of lending as banks have "pulled in their horns." As their earnings take a beating from write-offs of loans and securities gone bad and increased allowances for potential losses, financial institutions have grown reticent to lend, often even to the most qualified customers. Unavailability of credit, or higher cost of credit, is the particular ailment that the Federal Open Market Committee has attempted to cure by its series of Federal Funds and Discount Rate cuts.

Americans have also nervously watched as employers have begun to shed jobs at an increasing rate, with employment roles contracting by 63,000 and 80,000 in February and March respectively. The unemployment rate has risen from a March 2007 low of 4.4% to its current 5.1% level. The consensus among economists surveyed by Bloomberg LLP¹ is for the unemployment rate to rise to 5.5% by the fourth quarter of 2008, with some analysts expecting an unemployment rate a full percentage point above that level. To link this observation to one above, according to economist Paul Kasriel of Northern Trust Global Economic Research, at least 35% of the new jobs created between the end of 2001 and the end of 2005 were housing related.²

Offsetting, to some degree, the quadruple headwinds felt by American consumers, are the advantages of a weak US Dollar to US-based exporting businesses. While business activity obviously represents a minority of US economic growth, its strength in recent periods has kept our economy from descending into a deeper slump. A positive that has yet to be realized is the taxpayer rebate program that will begin in coming weeks.

Given the obvious linkage between economic growth and stock market valuations, the question is begged: With all of the weight being borne by American consumers, is the historically modest 11% decline in the S&P 500 (peak to 4/28/08) enough to bring stock values in-line with potential growth? While it's true that stocks are well-known as a discounting mechanism, I suggest they may test their early March low if any of the issues mentioned above prove more stubborn than the bulls would prefer.

It's less well understood, but bonds are also tightly linked to economic growth; however, their values tend to rise in times of economic uncertainty and malaise. It's this inverse relationship that makes them such a powerful diversifier and hedge even for the most aggressive stock investor. Idaho Trust's clients most often have some combination of stocks and bonds, and other asset classes as well, the types and proportion of which have been carefully chosen to maximize the risk-adjusted return of each portfolio.

While we can offer no simple solutions to the four issues faced by the American consumer, we are certain that clients with the portfolio structure described above will avoid some of the punishment suffered by less well-diversified investors as the economy and markets find their way.

¹ "How Housing Has Affected the Economic Ecology", April 18, 2008
² Survey of 61 economists taken April 8, 2008

(Boise) May 1, 2008 - Governor C.L. "Butch" Otter will keynote the first annual "Global 21 International Business and Investment Conference" Tuesday, May 13 from 9:00am to 1:30pm at the Boise Centre on the Grove and hosted by Idaho Trust National Bank.

"Foreign markets are critical to Idaho's successful economy," said Governor Otter. "My years of international trade experience in the private and public sector promoting Idaho products have shown me that our state and the business community must continue on this marketing path to keep Idaho's economy healthy."

Idaho Trust National Bank President Tom Prohaska called the first year conference the culmination of many conversations with Idaho businesses and investors who seek to expand and diversify their business opportunities and improve their investment portfolios.

"My hope is that every participant takes away at least one idea that can help them take advantage of the substantial opportunities available in the world marketplace," Prohaska said.

The conference will also include panels that discuss available state and federal resources to Idaho businesses, and a real world perspective panel of companies that have had successful overseas trade experiences. Speakers will also address how to integrate international opportunities into your investment portfolio and discuss today's world economic conditions.

Lunch will be included in the conference and there will be a registration fee of $25. All proceeds will be donated to the Idaho Trust Global 21 Scholarship for business education at Boise State University.

Contact: Leah Raymond, 350-2017

Thanks to the disciplines of diversification and strategic asset allocation, Idaho Trust's clients have typically fared much better over the long term than investors who try to "time" the market. Timing the market, though, is something that is on people's minds a lot right now. In particular, much discussion is going on over water coolers, at the dinner table and at gatherings of friends about whether the U.S. stock markets have weathered the storm of the last several months and will be heading a different direction soon. It's with a degree of curiosity, then, that I note this anticipation surrounding when we'll reach The Bottom. Of the market, that is.

The term "bottom" seems to have mostly negative connotations. "Bottom dollar", "bottom of the barrel", and "bottom-feeder" come to mind. "Rock bottom" is a phrase that seems to be most often uttered by someone referencing the price of used cars or furniture they're trying to sell us, so I put that one in the negative column as well (apologies to auto or furniture salespeople). Bottom is also a character in one of my favorite Shakespearean plays, "A Midsummer Night's Dream"; but I digress.

We're all waiting for The Bottom to arrive, although unlike the bottom of the swimming pool we dove to touch as children we won't know the moment it happens. Actually, chances are pretty good that it will be hit more than once as the market tests downside support levels before making a sustained move higher. Of course, a lucky few market-timers will buy at the right moment and will no doubt later claim they recognized it at the time. But most market-timers will kick themselves later for not buying at that point, just as they now punish themselves for not selling at last October's high point. This uncertainty and unpredictability underscores the value of Idaho Trust's strategic investment philosophy of diverse portfolios using multiple levels of asset classes, asset styles and managers.

Nonetheless, since it is a popular topic for discussion, let me share with you my thoughts on The Bottom and other anticipatory and retrospective topics. While, as noted above, we won't know whether we've hit a market low until after it's passed, I can offer a few guideposts to those who are on the lookout.

First, poor investor sentiment is a hallmark of market bottoms. The logic is simple: Most investors are reactive and emotionally driven, not forward-looking and dispassionate. They tend to sell when the market is low and buy when it's high (the great risk of a market-timing strategy). Very negative sentiment indicators, then, historically have suggested low points. Many if not most sentiment indicators currently rest at levels not seen since 2003, when investors had suffered 3 years of a grinding bear market.

That negative sentiment creates the environment that allows for the second hallmark, capitulation selling. Now, the definition of capitulation, like many things, is in the eye of the beholder. However, it's reasonable to think of it as a wave of selling wherein investors are downright panicked, trying to get out at any price. It's arguable whether we've seen this wave yet in this cycle; while the Standard and Poor's 500 stock index has seen 13 daily declines of greater than 2% and one of more than 3% since its October 9th high I'm skeptical that we've had panic selling in the stock markets. Yet, it's worth mentioning that according to investment firm Brown Brothers Harriman, had the US markets not been closed for the Martin Luther King holiday on January 21, the day of the global markets' most dramatic sell-off, the S&P 500 would've dropped to 1230. For those keeping score, its actual closing low was 1273, set March 10th.

There are those, too, who consider the recent collapse of Bear Stearns to be a watershed event of the type that often occurs near market lows. Stocks were higher months after 1990's failure of Drexel Burnham Lambert, the 1994 Mexican peso devaluation, and the implosion of hedge fund Long Term Capital Management in 1998.

As you are likely aware, the stock market is considered to be a leading indicator of the economy that discounts the anticipated environment 6-12 months in the future. Given that residential real estate is the center of the economic malaise, it's worth pointing out the first data in awhile that could be considered somewhat positive. In short, the number of unsold existing (i.e., not new) homes fell 126,000 in February to a little over 4 million. While this is still 1.5 million above what forecasters consider an equilibrium level, the trend is in the right direction. Reinforcing the point is that unsold new homes also declined, by about 200,000.

A recent Wall Street Journal column discussed the growing number of foreclosed homes and the intensifying downward pressure being placed on home prices. Through January, the S&P/Case-Shiller home price index shows a national year-over-year price decline of almost 11%. While I'm surely not a real estate expert, this phenomenon may be the beginning of the real estate market's analog to the capitulation selling discussed above.

Finally, it's important to remember that stock market lows and highs are relative. Investors that purchased stocks during the second half of 2007 have probably sustained losses, paper or otherwise, on their investments. The S&P 500 index declined -15.7% in the 5 ½ months from its all-time high to March 28th. However, stocks purchased in earlier periods may be at a gain; even with the recent slump, the S&P 500 has posted a 12% annualized return from its low in October 2002. Also, not all investment markets are created equal; investors in high quality bonds have done well since mid-2007 despite the dreadful turmoil in the credit markets. A broad measure of high quality bonds, the Lehman Brothers Aggregate index, is up 5% over the same period.

Again, at Idaho Trust we aren't market-timers and we hope you aren't either. But, now maybe you've got some information that will help you next time your discussing the topic of the current state of U.S. equity markets over coffee with you best friend. And that's the "bottom line."

March is known among oil investors as a "shoulder" month. Not quite winter and not quite spring (in Idaho, at least), March's calendric ambivalence mirrors the malaise currently seen in the markets. Certainly, some segments are anything but boring — consider the travails of "mono-line" bond insurance companies and the sudden and dramatic contraction in the Auction Rate Securities market. Despite wrenching volatility, however, the macro picture of the markets has remained remarkably stable over the past month. The major US stock indices are mostly slightly higher through February 27, led by mid-sized companies and trailed by NASDAQ. Bond markets have seen similarly uneven performance, with short-term Treasuries little changed but long-term yields rising significantly.

The primary driver of those higher long-term interest rates is evidence of surging inflation, particularly at the wholesale level. The continued rise in commodity prices has obviously played a part in this measure, as have other factors. The financial press has begun to raise the specter of "stagflation" to describe the current environment of slowing growth with rising inflation. All in all, poor economic and market news — continued drops in the housing market, oil prices climbing to over $100 per barrel, tightening of the credit markets, asset write-downs by financial institutions, etc. — have left investors worried and looking for guidance.

A close friend of mine recently shared with me a grim but fascinating book, Deep Survival, by Laurence Gonzales. The author, Contributing Editor for National Geographic Adventure magazine, examines and analyzes the behaviors and qualities of those individuals who've survived life-threatening circumstances, particularly in the wilderness, and those who haven't. Required reading, I suggest, for those of us who pursue a lifestyle in which we might find ourselves in harm's way. Also not a bad read for those who don't necessarily pursue that lifestyle but who may confront other highly stressful situations — divorce, career setbacks, physical infirmity, etc. The common behavioral thread Mr. Gonzales finds among the survivors reads like a to-do list for those currently active in the investment markets. I recite a truncated version below, with my own interpretation of how it may apply to investors in the current environment:

• Perceive, believe, then act. Understand the new reality, accept that reality, then act accordingly. Some investors still cannot accept that the markets may be in the midst of anything but a temporary setback. Recognizing the reality of the weakened economy and markets, Idaho Trust clients have avoided the worst of the punishment.
• Avoid impulsive behavior. Panic kills. One of the most difficult things to do when the markets are gyrating is — nothing. A well thought-out and executed strategic investment plan gives investors comfort that leads to clarity of mind.
• Know your stuff. One must know how to use the tools one's given in order to maximize the chance for success. Idaho Trust's years of professional investment management experience provides clients a deep understanding and "feel" for the markets and the tools used to reduce risk or generate return.
• Get the information. Study your environment. Availability and accuracy of information is most critical at times of greatest uncertainty. Idaho Trust is dedicated to constant vigilance and research to uncover opportunity and avoid pitfalls.
• Commune with the dead. Learn from the mistakes of others. Examples abound of investors who became overconfident or that made other catastrophic errors.
• Be humble. Avoid overconfidence. The best investors don't brag about their successes, and try to learn from their failures.
• When in doubt bail out. If your gut is telling you to avoid something, you should pay attention. Investing is as much art as science; after all of the research is done, one must evaluate how one feels about the circumstance. As mentioned above, a solid long-term strategy provides the clarity needed to stay on the path to investing success.

Idaho Trust relies upon the time-tested strategy of constructing portfolios that are diversified among a variety of asset classes, then periodically rebalanced to their agreed-upon target construction, to assist and guide clients to their goals. The key to long-term success is to implement that strategy whether the economy and markets are booming, falling, or, like now, muddled.

As always, we thank you for the opportunity to assist you with achieving your financial goals and look forward to discussing your situation or the comments above.

Since this column last appeared the outlook for the world economy and markets has become increasingly bleak. House prices and the stock markets continued to decline, the Federal Open Market Committee has slashed short-term rates further and the consensus is that the economy will slump into recession sometime this year. Headlines shouting "US Warning Signs Point Toward a Deep Recession"¹ and "It's Rough Out There"² give pause to even the most committed market bull.

Like the snow-squalls that seem to haunt me when I go outside in winter, things are flying fast and furious, making the way unclear and the formerly friendly trail seem treacherous. After those storms, though, we lovers of the mountains find the bluest skies and the best powder snow. Here are "silver linings" Idaho Trust sees forming around the dark clouds now hovering.

• Because the economy and markets are, in their simplest form, expressions of the psychological state of participants, and those participants, being human, experience periods of fear and greed, economies and markets travel in cycles. Cycles are normal and healthy for both economies and markets. We may not enjoy the downside of those cycles but they are absolutely necessary for the long-term success of capitalism.
• The financial markets have seen an explosion in the number and types of investors over recent years. Of course, easy money attracts competition and creativity, which is one of the key benefits of capitalism. However, the pendulum often swings too far. A market downdraft will separate well thought-out strategy from fads and investors from speculators. The strong, like Idaho Trust clients, will survive.
• Consumers, particularly in the US, have been on a debt-fueled spree for many years. To the extent that American consumers revise their spending and saving patterns to those more common among previous generations (a.k.a., living within one's means) the economy will be better off in the long-term.
• America's clarified awareness of its role as a participant in, but not exclusive governor of, the international economy can also rightly be characterized as a benefit of the downturn. Rather than a suggestion of inferiority, awareness leads to discovery of opportunity and improvement.

Here are a few additional positives for you to consider.

• It's very unlikely that the US will parallel Japan's experience of a prolonged economic malaise for two key reasons. First, the US banking system is far more robust than its Japanese counterpart, and systemic problems like negatively capitalized banks and worthless loans that cannot be charged off are not permitted by law. Second, the Japanese central bank continue to raise short-term rates for a year after their real estate and stock market bubble burst in the 1990s, whereas our FOMC has already made liberal use of the interest rate hatchet, as noted above.
• Exports, which have been growing rapidly thanks in part to weakness in our Dollar, represent twice as large a portion of US economic activity than does home construction.
• Growth of economies outside the US, while slowing as a result of the inter-relationship with our tepid one, is expected to remain significantly positive and therefore a driver of growth for US exports.
• The number of homes for sale declined in December as inventories dropped from 10.1 months supply in November to 9.6 months in the final month of 2007. While one month does not a trend make, this interruption in the recent ballooning in the number of houses on the market may signal an important shift in the supply / demand equation.
• With the exception of the beleaguered financial industry, US corporations are in solid shape, with low debt and high liquidity levels.
• Finally, it's important to remember that bad stock markets are the very mechanism that creates the best investment opportunities for astute long-term investors. While it's true that market sell-offs are scary events and it's foolish to try to declare the bottom, faithfully rebalancing one's portfolio to the predetermined asset allocation has proven the best tool for investors to reach their goals.

Idaho Trust relies upon the time-tested strategy of constructing portfolios diversified among a variety of asset classes, then periodically rebalanced to their agreed-upon target construction, to assist and guide clients to their goals. In the economic and market "blizzard" in which we find ourselves, that strategy is a sure guide to safety.

As always, we thank you for the opportunity to assist you with achieving your financial goals and look forward to discussing your situation or the comments above.

¹ Wall Street Journal, January 21, 2008
² The Economist, January 24, 2008 edition

Early January seems the appropriate time to offer a review and outlook of the economy and financial markets. It occurs to me, though, that you've probably read plenty of summaries of the year recently passed, so I'll hit the high points (or low points, if you will) and concentrate on sharing with you the view forward.

REVIEW

The weakness in the economy and markets experienced during the second half of 2007 can easily be traced to a single source—housing. Lenders, borrowers, bond rating agencies, bond insurers, and investors all made mistakes and are now paying the price as the residential real estate bubble deflates. The reason this particular infection is more cancerous to the world economy than, say, the "tech wreck" of the early 2000s is that the financial system itself contributed to and is part of the disease. Banks and other parts of the financial sector are literally the heart of the global financial system. Without the ability to provide capital, manage the money supply, and other vital functions the global economy literally grinds to a halt; a fleeting and mild example of this phenomenon occurred in August 2007, when banks and investors began to refuse to trade due to their mistrust of one another, leading the Federal Reserve to lower rates and inject liquidity.

As noted above, housing, and its impact on the US consumer, was clearly the headline story of 2007. "For Sale" signs sprouting across neighborhoods like dandelions in suburban lawns, tightened lending standards from lenders already burned, and rising foreclosure volume certainly set an ominous tone that will be monitored closely in 2008.

Despite the volatility seen in the latter half of the year, major US stock market indices ended the year higher. The Dow Jones Industrial Average and S&P 500, both large company indices, posted mid-single digit gains, while the NASDAQ's 10% gain can be attributed in part to strength of technology firms. After several years of lagging, growth-style investing outperformed value-style as investors looked for opportunities to capture growth in a slowing economy. A similar transition was observed among small vs. large companies, as investors chose the relative safety and higher dividend yields available among large company stocks for only the second year since 1998. Despite rallying in December, each of the above indices turned in a negative fourth quarter performance for the first time in 10 years.

Bond investors did relatively well in 2007—so long as they were conservative. In fact, the more conservative the better. Treasury securities outperformed all other investment grade and junk bond categories by a healthy margin as investors fled the mortgage-backed and corporate bonds of which they'd be enamored only a few months before.

OUTLOOK

As suggested above, the outlook for 2008 is centered on the performance of the housing market and the consumer's reaction to it. At the moment, investors trying to stay abreast of market prognostications must feel a little like potential voters in early presidential primaries, being constantly harangued by forecasters extolling the virtues of their particular viewpoint. There are three distinct "candidates" at the moment, each with compelling arguments, making analysis and sober consideration even more important than usual.

The first "candidate" believes that the significant and increasing weakness in the housing market will lead to broad and sustained macroeconomic downturn in the US, and potentially global, economy: Recession. The followers of this rather morbid fellow are deeply concerned about the housing downturn, coupled with rising unemployment and slowing corporate earnings, and implore the Federal Reserve to drastically cut short-term interest rates and provide other liquidity to keep the economy moving forward.

The second "candidate" sees not downside but upside risk to growth in 2008: Inflation. Partisans point to the impact of a continually weakening US Dollar and rising commodity prices as evidence that the greatest risk to the economy is runaway prices.

"Candidate" three acknowledges the concerns of the first two but believes that the markets and/or government will make the necessary adjustments to save the day: Goldilocks. Members of this party, which have become fewer in number of late, cite attractive stock market valuations and the possibility that growth in foreign markets may provide the needed boost to American manufacturers.

Like our political system, adherents may be organized in a few large categories but there is a spectrum of opinion even within each camp. I've provided below the consensus view on the 2008 outlook, after which is my color commentary.

• Economic growth (real GDP): 1.0% in 4Q07, 1.5% in 1Q08, 2.1% in 2Q08
• Federal Funds rate will be cut to the mid-3% range by mid-year 2008
• Residential real estate values will decline through mid-year 2008, after which a period of flat prices will ensue
• Corporate earnings will sag in the first half of 2008 but will rebound in the latter half to increase almost 15% for the year
• Stocks will gain in the high-single to low-double digits
• Banks and investors will need to write off $200-$400 billion of bad loans and bonds, in addition to the $100 billion already acknowledged, before the credit crisis has run its course
• The US Dollar will stabilize as growth in foreign economies slows in concert with the US
• Commodity prices, including oil, will ease due to slower US economic growth

I believe the risk for the economy and markets is far greater to the downside than upside. The forecasts in which I have the most confidence, and the markets themselves, are girding for a period of very slow or negative growth. Liquidity will not fully return to the credit markets until participants feel certain that all the subprime "skeletons" have come out of the closet, requiring significant further write-offs. A recent Wall Street Journal article cited write-off estimates upwards of $700 billion, a potentially crushing blow to the economy. While the consumer has remained resilient, I doubt they will remain so in the face of rising unemployment, high gasoline prices and the worry about being unable to sell their home or seeing friends, neighbors or family embroiled in foreclosure.

Further, I am concerned that the US may have a brush with, although not collapse into, the quagmire of an economy experiencing slow or no growth but with upward pricing pressures, known from the 1970s as "stagflation." The Fed is caught "between a rock and a hard place", with the prospect of a slumping dollar exacerbated by the very rate cuts enacted to bolster the sagging domestic economy. Not only might the declining dollar worsen the inflationary situation, but it might lead overseas investors to move much-needed investment elsewhere.

Several things provide me comfort enough to not simply "pull the covers over my head and hide" for the next year:

• The Fed seems to be on the case (finally) and understands the urgency of the situation. The FOMC has cut the Fed Funds rate three times thus far in the cycle, lowered the rate at the Discount Window twice and has injected liquidity through market operations numerous times since the crisis erupted in August.
• Banks are beginning to take responsibility for their poor investments. Citigroup, the premier creator of Structured Investment Vehicles, moved almost $60 billion of the funds onto their balance sheet after charging off or increasing their loss reserves on more. Other firms have made similar moves.
• Private equity firms, hedge funds, foreign sovereign wealth funds and same-industry competitors are among savvy investors taking advantage of low valuations to snap up assets on the cheap.
• Stocks of homebuilding companies have begun to rebound after having fallen around 50% from their high point in late 2005. Historically this group has been a good leading indicator for the housing market.

IDAHO TRUST'S APPROACH

In such a turbulent environment, it is worth remembering that our clients largely enjoy portfolios that are both conservatively structured and managed. Our bond holdings, for instance, are heavily weighted to those issued by US government agencies, considered to be second only to Treasuries in credit quality. Our stock positions are skewed towards those of large US companies which should provide some measure of shelter from a market storm. Foreign stock exposure, either through a mutual fund or Idaho Trust's International Equity strategy, is both diversified and a hedge against further weakness of the Dollar.

We appreciate the opportunity to assist you in reaching your financial goals, and wish you success and health in 2008. If you would like to discuss the particulars of your specific situation, please contact your Idaho Trust representative, or me at 208/350.2049.