A Distilled Markets and Macroeconomic Letter
July 2007

Transparency Snapshot

The Markets

Stocks - Short Term - High Risk, but Positive Mode
The large commercial investors seem to still be buying this market, which may continue to push prices higher. This could change at any time. Margin debt is at record levels, the VIX has been a little elevated.

Stocks - Medium Term - Elevated Risk
I believe that the risk is the market averages may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.

Bonds - Yields Increasing
Yields are pushing higher. This should put additional pressure on housing if these rates stay at higher levels. Bond yields look as though they may stay in a new higher range. There is risk that, even if the Fed ends up cutting rates, bond yields could move higher.

Gold one month futures are at $655.70 (7/06/07).

Oil - Staying High
Oil is at $72.44 (7/06/07). Factors for increased price near-term: high demand, 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 seem to be loaded with debt.The USD is at 81.54 (7/05/07) (stockcharts.com ticker: $USD). The Dollar has dropped back down and bounced off of support at 81.25. 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 is holding firm with rates and is still cautioning about inflation risk.

Transparency Detail

Bear Stearns and Mortgage Products
In case you have not heard, Bear Stearns had severe problems with two of its private investment pools. Investments were made in products that are based on subprime mortgages. As more and more subprime mortgage holders fail to make payments, this ripples through to investors. Itís interesting to note that many of these products were given high ratings but were based on risky loans to home buyers. Bear Stearns raised around $3 Billion to try and fix the problem in their investment pools. You might take a look at their stock chart, ticker: BSC.This is significant because I believe that there will be more problems of this kind as not only subprime mortgages go bad but many near prime and prime go bad as well. My impression is that many people at higher income levels stretched to buy their homes. As home values go down it can be difficult to get a fixed rate loan to replace an adjustable loan. The conventional wisdom is that the subprime problem will not spill over to other markets. I feel that the problems at Bear Stearns are a sign that this is not the case.

The real question is how bad will things get. I think that there could be some severe problems for lot of people. It is amazing how slowly this process is taking place. Only in the most overbought markets, such as Florida condos, had prices move down very quickly. I believe many other areas will have problems but that it will take time for this to transpire.

The stock market continues to plod higher. Iíve heard that a large percentage, ~32%, of financial advisors have become negative on the market. This may just be more fuel for the market to move higher. I also feel that the public may start to chase the stock market, which might then finally be the beginning of the top. I feel that the Fed will be less effective in a steep market downturn than in 2001-2003. Steep rate cuts may not bring down longer term interest rates and could have a negative effect on the Dollar. In other words, I believe that the markets could have deep and longer lasting declines than in 2001-2003.

The Markets

Fundamentals: You might want to read John Hussmanís commentary on market valuations at: In short, the market is overvalued on an historical basis and most people just donít believe this to be the case. I agree with Hussman.

Longer dated bond yields have been moving higher, such as the 10 year and the 30 year bonds. Higher yields put more pressure on adjustable rate mortgages and make it more difficult for businesses to borrow.

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 has been weak again but has not broken down. Long-term Iím 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 $72.44 (7/06/07). 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 interest rates on another.

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

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