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    Default TRANSPARENCY - August 2006 - Eric Hodges

    TRANSPARENCY
    A Distilled Markets and Macroeconomic Letter: August 2006

    Transparency Snapshot


    The Markets

    Stocks - Short Term - Negative Outlook
    The potential for a wider Middle East conflict looms. The Dow Transportation average has taken a beating. UPS sees a slowdown coming in the U.S. The VIX is at 14.85 (7/25/06), there seems to be little fear in the markets.

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

    Bonds - Inverted yields pointing towards recession?
    Yields continue to be inverted. I feel that the risk is on the side of higher rates and lower bond prices longer term, but in the near term I feel that bonds will rise in price if the economy slows enough and/or stocks fall.

    Gold - Consolidating?
    Gold seems to be consolidating. I believe that gold is pricing in the risk that there will be too much money in the financial system in the future, which should increase inflation.

    Oil - Oil stays high unless we see a global recession
    Oil has stayed high and I believe that it will continue to do so unless we have a recession. Various risks to supply continue to cause concern. The world may be at the beginning of Peak Oil Production. This means that we may be starting to run out of oil just as China and India are greatly increasing the demand for oil.

    The Economy
    Fed funds rate is at 5.25%. The Fed tends to overshoot as they raise rates. The markets are pricing in even odds that we will see another boost in August. I tend to agree. If the Fed pauses donít look for the market to outperform.

    Consumers seem to be in a lot of debt and not saving. In my opinion the economy is largely running on consumer spending, which has been partially funded through the housing boom/bubble. It is my belief that this is unsustainable and will end badly.

    The Dollar is still holding up for now, but I feel that we will see the Dollar fall further vs gold.

    Transparency Detail

    Risk of a Wider Middle East Conflict?
    It does not seem that the stock market has fully priced in the recent conflict between Hezbollah and Israel. I believe that the market was already going to go down before the conflict erupted.

    If the market is fundamentally overvalued and there is a negative technical outlook, a wider conflict would probably have a nasty effect on stock prices. As I have said in past months, regarding oil prices, do you think that the situation in Iraq and the Middle East is improving? Do you think the situation will improve any time soon? I donít. I think there is significant risk that this situation will deteriorate enough to cause the markets to fall further than they might otherwise.

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    Mr. Bernanke
    Have you seen Fed Chief Bernanke speak to Congress on television? He seems nervous to me and I think his voice quivers when he speaks. Is he just the shy type or is he worried about something that he sees on the economic horizon? I donít know about you but I would rather not have the leader of the Federal Reserve sounding nervous as he tells Congress the slowdown in housing seems orderly.

    I believe that housing is very key to the economy and to the markets. I hope that housing slows in an orderly fashion but the risk is that it will not. I believe that this risk is at least relatively high if not very high.

    Overall Outlook
    So we have a war going on in Iraq that does not seem to be improving and we are still in Afghanistan. Thereís a new conflict in the Middle East that threatens to widen. Oil is staying stubbornly high. Housing is slowing. Many very astute people feel that the market is overvalued. I feel that the U.S. government debt and private debt is very high. I also feel that deflation is the main trend and that the Fed will have to inflate our currency to counteract this trend, which could eventually lead to an inflationary environment. As the Dollar inflates it should go down in value vs other currencies. Other countries may then devalue their currencies in order to continue to trade with the U.S. I believe that in this situation many investors will eventually allocate a portion of their assets into gold and other hard assets to retain value and provide additional diversification.

    The Markets

    Stocks

    The Nasdaq is not doing well and tech often leads the market. The Dow Transportation average has been hit hard recently leading me to believe that consumer spending is falling. UPS reported bad earnings and reduced expectations for the economy. UPS ended down 15% on the day that they reported.. There are very deep discounts being offered at some high-end retailers.

    Bonds
    The yield curve is 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 recession.

    Not that much action in the bonds as of late, except that the curve is a little more negative than before. I feel that, near term, medium duration bonds should perform well. The risk here is that with any slowdown or recession the Fed will probably be aggressive in cutting rates, which may lead to a sustained inflationary trend and lower bond prices.

    Gold
    Gold has been off again as of late but is holding above $600. It could move to the mid $500 range and still be in a positive mode.

    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 not moved too much in the last few weeks. Long term Iím still negative on the Dollar. I do think that the Dollar has now entered a new period of at least relative weakness vs other currencies. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value.

    Oil
    Oil is over $73 (7/25/06). The risk here is that oil stays high. Much is being written about how the world is currently experiencing peak oil production. I find it interesting that the media gets very excited each time oil moves below $70, as if it will just keep going down. Each month I laugh at the people on TV who are so surprised that oil is still high. I wonder what they will say if it pops over $100?

    There is continued instability in the Middle East. Do you think the Iraq situation is getting better? I donít. Iran is still a problem as well, not to mention Nigeria and Venezuela. All of these situations help to keep oil high along with the lack of new deposits being found and high demand. Oil will probably stay high unless the situations above improve or demand eases because of a broad global economic slowdown.

    The Economy

    The Fed
    There is much speculation over a potential rate increase in August or a pause in this trend. Whatís the risk? The risk is that the Fed will go too far in raising rates, housing will come down harder than many expect and that will reduce consumer spending.

    Housing
    The home builder stocks are taking a beating. Housing looks weak in general. Condo projects are being canceled in some areas.

    When adjustable mortgages reset to the higher current interest rates some people may have trouble making the higher payments. The NY Times reported recently that some people are refinancing with new adjustable loans instead of fixed loans. This should only postpone the inevitable.

    Consumers tend to spend less when their homes are falling in value. I think consumer spending is keeping the economy going at the moment. If housing drops enough we could see a recession and a much cheaper stock market. Of course, this could happen even if housing just slows enough from the current high pace of sales and appreciation.

    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 situation.

    Please note that I only change wording that needs to be changed from month to month, so the frequent reader needs to scan the detail section for changes. If you have specific questions on where I see things, please email me or call me if itís urgent.

    Eric Hodges
    Financial Advisor
    Stahlschmidt Financial Group

    925 906 4600

    500 Ygnacio Valley Road
    Suite 150
    Walnut Creek CA 94596

    Disclaimer: The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Investing involves risks including potential loss of principal.

    The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredictable international monetary and political policies.

    Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors. In General the bond market is volatile, bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

    The price of commodities is subject to substantial price fluctuations in short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

    Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness of reliability cannot be guaranteed. Registered Representative offering securities and advisory services through FSC Securities Corporation, a registered broker-dealer member NASD, SIPC & a SEC-registered investment advisor.

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    Last edited by FRED; 08-09-06 at 07:45 AM.
    Ed.

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