A Distilled Markets and Macroeconomic Letter
May 2007

Transparency Snapshot

The Markets

Stocks - Short Term - High Risk

On a valuation basis, I believe that the market is expensive. The VIX (the “fear gauge”) is at 13.51 (5/01/07), which is low. There seems to be little fear in the markets.

Stocks - Medium Term - Elevated Risk
The story here is that gold took a beating along with most asset classes rather than moving in the opposite direction. It may eventually return to it’s more negative correlation to stocks. Gold is up modestly vs US stocks this year.

Bonds - Inverted yields pointing towards recession?
Yields are down a bit and the yield curve is still inverted. In the short run bonds may rise in price with a slowing economy but the longer-term bonds (5 year and longer) may eventually fall significantly.

Gold is down a little and gold stocks are down a little more. Gold has been leading the gold stocks in gains.

Oil - Probably Stays High Unless...

Oil is at $64.40 (5/01/07). Factors for increased price near-term: terrorism, war, or other supply disruptions. Factors for a reduced price near-term: an economic slowdown, less terrorism, Middle East Peace.

The Economy
The housing crisis continues to worsen and there are plenty of Adjustable Rate Mortgages that could still reset to higher payments. New car sales are still off. Consumers are loaded with debt.

The USD is at 81.45 (stockcharts.com ticker: $USD). The Dollar may have a rally here soon. I feel that dollar based assets may be at risk in general, both near and longer term.

Fed Funds still at 5.25%. The Fed may not want to cut rates immediately in the face of an economic slowdown, which would probably be unpleasant for the markets.

Transparency Detail

Booking Unrealized Gains vs Risk Management
Something that I seem to witness a lot is the habit of people to mentally “book” unrealized gains on their investments. As markets worldwide march to ever higher levels this will probably become more prevalent. We have seen this, on a large scale, most recently in the housing market and previously in technology stocks. Additional pressure to think this way seems to come from the many years of strong gains starting in the 1980’s.

In my experience, this way of framing the situation clouds one’s thinking. I’m still hearing people make positive comments on housing in bad markets where very few sales are taking place and prices are falling. Many feel that housing will come back strongly “any time now”. When one speaks to someone who is actually following the data one gets exactly the opposite idea. This is, of course, the big risk in housing: it may get a lot worse. I think it will, at least in certain markets. It is hard to predict what will happen to very strong markets such as prime San Francisco/East Bay properties or New York City properties etc.

I think the same type of thinking is prevalent in the stock/bond markets. When investors are told that valuations are quite high historically, they stare blankly and say “but the markets are going up.” They always seem to be looking for one stock that will go to the moon. I prefer to try to manage risk, as best as possible, for the long term.

Recent interesting reading:

iTulip Select’s break-down of Jeremy Grantham’s recent letter to clients ($ subscription).

John Hussman’s last three commentaries.

Barron’s profile of legendary investor Michael Steinhardt ($ subscription).

The Markets


Technicals: The US markets are currently slowing (5/01/07). A key support level on the S&P 500 is 1460 to 1470. Watch to see if this holds.

Fundamentals: You might want to read John Hussman’s commentary on market valuations. In short, the market is overvalued on an historical basis and most people just don’t believe this to be the case. I agree with Hussman.

The yield curve is still inverted. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. This inversion along with other indicators point to a higher likelihood of a coming recession. The yield on the 30 year has moved up to 4.82.

Gold is holding up fairly well for now. If gold now moves lower, I will be concerned that it is pricing in a recession. Gold might move higher if the Fed decides they need to cut rates.

Reminder: fiat currencies are not tied to anything of tangible value. They are only worth whatever the market, and the public, feels they are worth. As more fiat money is created the value of this paper money should go down. In my opinion, the U.S. is creating too much money and so are China, Japan, and Europe.

Dollar | Currencies
The Dollar is below 82 but may now have a rally after its slide. If the USD goes up to 82/82.5 and then heads down this could be a significant negative. Long-term I’m still negative on the Dollar. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value and may lose much more.

Oil is at $64.40 (5/01/07). The risk is that oil stays high. If oil prices move downward substantially, they may be pricing in a recession. A major concern with oil is the potential for a wider conflict in the Middle East, which could crimp supply. There are many other potential geopolitical risks to oil as well.

The Economy

The Fed
The Fed is in pause mode and it seems that they will stay in pause mode for a while. If housing and the economy slow enough the Fed should start cutting rates again. There is risk that the Fed will not cut even in the face of a recession in order to support the Dollar.

I feel that the housing picture could become much worse and now, at least in the Subprime market, it seems to be happening.

~ $1 Trillion in mortgages may reset in 2007.

The key chart to reference on housing via the New York Times.

The Consumer
I believe that many consumers have less home equity now than before because they have taken money out of their homes and spent those funds. Consumer savings rates are very low or negative. I believe that consumers are being gradually squeezed by high oil prices on one side and rising

Transparency Strategy
My concept is to bring you a the most transparent look possible on the economy/markets via a quick read with plain language. This letter is geared toward the busy executive/business owner. If you are really short on time just look at the Snapshot section where I keep everything as brief as possible. In the Detail section I try to give a little more insight into my thinking without delving so deep that I stifle the reader.

When constructing portfolios, I take the client situation into consideration first and then combine that with the current economic/market factors presented in this letter along with well researched asset allocation strategies.

If you have specific questions on where I see things, or would like to discuss your portfolio, please feel free to contact me.

Eric Hodges
Financial Advisor
Stahlschmidt Financial Group


925 906 4600

500 Ygnacio Valley Road
Suite 150
Walnut Creek CA 94596

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