With the Dow Jones Industrial Average hitting new highs day after day and the S&P 500 Index not far behind we thought it might be wise to do what other investors have been doing and look for the silver linings in the economic clouds. After all, focusing on the risks in the economy and stock market as we have has not really paid off as the market has bounced back from every hit it has taken over the last year. Maybe it is time for us to focus more on the positive things that are happening in the world and less on the risks that we see. Let’s give it a try.

It has been said by prominent investment professionals that you have to be an optimist to make money in the stock market. You have to believe that the U.S. economy based on capitalism provides an environment where the entrepreneurial spirit thrives and businesses flourish and reward their shareholders in the process. We do believe because history has clearly shown this to be true.

With the American model of capitalism spreading in Europe and Asia there is reason to be optimistic about the long-term investment opportunities overseas. Europeans are making great strides to transform their economies to be more competitive with the U.S. They have been eliminating some of their costly social programs and employment protection laws.

Over the last three years U.S. companies have taken productivity to a whole new level and generated profit margins not seen since the 1950’s. Investors like us have been blown away with upside surprises and double-digit earnings growth quarter after quarter. That has been why stocks have done better than we expected they would.

This earnings streak has continued on into 2007 in the face of those of us expecting a significant slowdown. With about half of the S&P 500 companies reporting so far for the first quarter of 2007 the earnings are up about 10%, which is more than double what they were expected to be. This recent rally in the market reflects this good news.

These latest quarterly earnings achievements are surprising considering that the U.S. economy only grew at a real (inflation adjusted) rate of 1.3% in the first quarter. That is the slowest growth rate in four years. The silver lining in that dark economic cloud was that consumer spending (70% of the economy) grew at an annual rate of 3.8%, which was faster than the prior quarter and in the face of higher gas prices.

We have been worried about the effect of the severe housing slump on the economy. While some economists argue that housing only represents about 5% of our economy, we think that the percentage is much higher when you include related jobs like mortgage lending, realtors, landscaping, furniture, etc.

Beyond the effects of lower employment in the housing-related businesses, our primary concern has been more focused on the negative wealth affect from the evaporating home equity. Many people had been using their home equity as a source of funds to pay off credit cards so that they could spend again. We expect that this will slow consumer spending but so far it hasn’t.

Despite the fact that core inflation (excluding food and energy) has crept up to around 2.5% it has been much better behaved than what we had expected to see by now. While it is true that the Federal Reserve would like to see it below 2%, they have to be feeling good that inflation is this tame this late in the business expansion.

Another silver lining for the economy and the financial markets has been the relatively low and stable interest rates. With the exception of a few minor spikes from time to time, intermediate and long-term U.S. Treasury rates have remained in the 4.25 – 5.00% range for quite some time. Relatively low and stable interest rates have supported stocks through stock repurchases and the financing of private equity takeovers.

Another economic storm cloud that has concerned us for awhile has been the weak U.S. dollar. A weak dollar can eventually translate into higher inflation as goods coming from overseas cost more and allow U.S. competitors to raise prices. The silver lining has been that the weak dollar has helped our large global companies sell more of their goods and services overseas as those economies grow faster than ours.

You might think with our acknowledgment of all of these silver linings in those dark economic clouds that we might be inclined to change our view and take a more optimistic approach to managing our clients’ portfolios. While we look forward to the day that we can be unabashedly bullish about the stock market we are not there yet.

Our biggest concern is valuation. While many investors see the market as cheap trading at 15- 16 times this year’s expected earnings, we worry that those earnings estimates represent historically high profit margins that will revert back to a more normal level. The price/earnings ratio on “normalized earnings” is over 20 and that ain’t cheap.

Low inflation and interest rates and the shrinking supply of stock from repurchases and the private equity company buyouts have all pushed valuations on stocks and bonds around the world to levels that we think limit their future returns should this ideal environment change.

Although the economy has been able to withstand the headwinds caused by the housing slump and keep growing, we are not confident that will continue. We see the housing market getting worse before it gets better as home sellers find that they have to significantly cut prices to sell their homes. We think the economy and the stock market will suffer.

While those silver linings in our clouds of concern give us enough comfort to keep looking for new investment ideas they are not enough for us to change our defensive strategy.