A Distilled Markets and Macroeconomic Letter
January 2008

Transparency Detail
A little Review and Some Things to Watch
The bull market euphoria from early 2003 seems to be almost over. ďAlmostĒ is, of course, the operative word. If you look at the weekly chart of the S&P 500 ($SPX at stockcharts.com), this index has already broken through the August lows. This is considered a negative sign by many, including myself. If you look at the daily charts, however, the index has yet to break the August lows. If the index makes a higher high (~1500 or so) it may stay in the recent range from ~1410 to ~1560 for a while longer. If the August lows break on the daily charts I feel that we could experience substantial weakness.

The fundamental picture is more bleak in my opinion. The housing situation is still bad and I think it could weaken substantially. Economists Shiller and Krugman are both talking about a 30% potential decline nationally. This would not surprise me at all. What may be a real problem is what a decline of this magnitude may do to the derivatives markets because of various products, many of which employed leverage, that have been based off of home mortgages.

Real Estate Investment Trusts (REITs) were quite weak in 2007. Look at IYR, which was down ~21%. There may be more weakness coming and there could also be issues with derivatives tied to loans that were made to REITs.
It seems to me most market participants do not believe that the economy, housing, corporate profits, financial company losses etc. can get much worse. I still feel strongly that things could get much worse.

The S&P 500, in total return terms, gained ~5.5% in 2007, but this small gain is mostly gone at the moment. Gold was up ~31.25%, oil was up 60%. These items have seemed to respond sharply to the recent Fed cuts and weakness in the Dollar. I feel that we could see some relative strength, near term, in the Dollar but more of the same in terms of Fed cuts and the marketís reaction to them.

In my opinion these are some things to watch for in 2008:

1. More credit crunch issues with banks and private investment groups. This could worsen substantially and Iím concerned about the potential that some large institutions could fail.
2. More pain in Housing and mortgage defaults in Prime and Alt-A.
3. Write Downs because of problems with Credit Default Swaps (CDSs).
4. More volatility in the stock markets and potentially a bear market.
5. Dollar weakness, Fed cuts, and the market reaction.
6. Recession.

Please send me email if you are reading this on iTulip.com and would like to read Transparency in its PDF version that I email each month.

The Markets
Fundamentals: In short, I feel that the market is overvalued on a historical basis. If we see higher inflation, the market may move higher in Dollar terms but could well remain challenged in terms of other currencies.

Technical: Today (01/08/08) the markets seem to be stabilizing a bit. We might see a small rally from here (S&P 1410) but I donít think it will hold.

Iím concerned that longer dated bonds (5 years to 30 years) may fall in value at some point.

Gold seems to be reacting to the Fed rate cuts and financial/economic weakness.

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
Long-term Iím still negative on the Dollar. The real story is the Dollar against gold and oil etc., where the Dollar has lost a huge amount of value and may lose much more.

Oil is at $97.16 (Intra-Day 01/08/08). After moving up to $100 (IntraDay) oil has sold off a bit. There seems to have been quite a change in psychology where people feel relieved that oil is back below $100 as if it will just continue to fall. Of course, oil could continue to fall but there is significant risk, in my opinion, that it may stay relatively high indefinitely. If oil prices move downward substantially, this 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
See above.

See above.

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 Snapshot
Stocks - Short Term - High Risk
Very near term, it seems that the market should rally at least a little and then maybe fail before 1500 on the S&P. The market, though, is acting quite week and I would not be surprised to see it drop from here. The VIX (fear gauge) is a little higher this month at 23.49 (Intra-Day:01/08/08).

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. The fundamental picture is bleak in my opinion. The credit/insolvency crisis seems to be getting worse.

Bond yields have moved down and seem to be pricing in fear of recession etc. Iím still concerned about longer dated bonds loosing value.

Gold one month futures are at $881.90 (01/08/08). Iím watching Gold relative to stocks, Fed cuts, the Dollar, and other currencies.

Oil - Staying High
Oil is at $97.16 (01/08/08). If we have a slowdown or recession, oil might have a relatively steep sell-off. I think there is significant risk that with Fed rate cuts we could continue to see high/relatively high oil prices even with a slowdown/recession.

The Economy
The housing/credit/insolvency crisis continues to worsen. Home prices have fallen in many areas, some quite significantly. The Fed is worried and seems poised to cut rates further. I donít think these cuts will have much of an impact.

The USD is at 76.16 (01/07/08) (stockcharts.com ticker: $USD). I feel that dollar based assets may be at risk in general, both near and longer term.

Fed Funds are at 4.25% (01/08/08). I think the Fed will continue to cut rates if more bad news in the financial sector/economy/stocks/housing comes to light. I, of course, expect to see plenty of bad news.

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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