A Distilled Markets and Macroeconomic Letter
April 2008

Transparency Detail
Bear Stearns/JP Morgan Chase
As I have been noting for some time, the potential for problems with derivatives may be quite significant. This was the problem behind the Fed organized, and controlled, sale of Bear Stearns. Today (04/02/08) Fed Chairman Bernanke said:

..."Normally, the market sorts out which companies survive and which fail, and that is as it should be. However, the issues raised here extended well beyond the fate of one company. Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The companyís failure could also have cast doubt on the financial positions of some of Bear Stearnsí thousands of counterparties and perhaps of companies with similar businesses. Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability. To prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed Bearís financial obligations.Ē

What Bernanke is not saying is how big this exposure was. The total notional exposure was/is apparently $13 Trillion (http://bigpicture.typepad.com/commen...tive-expo.html). Notional exposure is not the same as the potential amount at risk in the case of a firmís demise. My interpretation of what Bernanke is saying is that the actual amount at risk, and the potential for placing other firmís positions at risk, was too high to allow Bear Stearns to fail outright.

Itís interesting to note that, if you look at the link above, the notional exposure of JP Morgan Chase is around $90 Trillion and the total market-wide exposure is much more. Even if a small amount, in percentage terms, of this market goes bad it may have serious market and economic consequences.

What to watch for: if the housing situation continues to deteriorate, the pressure on these derivative contracts and financial institutions may increase significantly. I donít think any of the current proposals will prevent further significant declines in home values.

In light of the above, I am starting to report the TED Spread (http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND). Paul Krugmanís explanation is ďThe TED spread is the difference between the interest rate banks charge each other on 3-month loans (3-month LIBOR) and the interest rate on 3-month U.S. Treasury bills. Itís a measure of financial jitters. If banks believe that their peers are solid, they should be willing to lend each other money on almost the same terms as money lent to Uncle Sam. When they start demanding a big interest rate premium, thatís a sign of fear.Ē http://krugman.blogs.nytimes.com/200...my-friend-ted/

April Fools Rally?

I see this April 1st rally as a technical one. In other words, it seems to have been a counter intuitive rally. If we move a little higher from here we are into a higher technical trading area and may see more upside. Put another way, I think additional upside will be less likely but certainly possible. Large percentage moves, like we have seen recently, may be indicative of markets at risk for further downside.

The Markets
Fundamental: 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. (This is still a potential outcome, but I think it is less likely than more market downside).

Technical: The market seems to be in a neutral place in terms of price action. I think it will be very difficult for the S&P to move above 1400.

Iím concerned that longer dated bonds (5 years to 30 years) may fall in value at some point, although this may be a bit further in the future.

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 as measured against gold and oil etc., where the Dollar has lost a huge amount of value and may lose much more. I am watching the Yen for signs of the ďcarry trade unwind.Ē

Oil is at $104.77 (04/02/08). 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 global 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
Markets bounced today on news that the Fed is loaning banks up to $200 billion (More below). The VIX (volatility index or fear gauge) is at 26.36 (03/11/08).

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.

Treasury yields have moved down (again) and seem to be pricing in fear of recession etc. Iím still concerned about longer dated (5 year and longer) bonds loosing value.

Gold one month futures are at $976.00 (03/11/08). Iím watching Gold relative to stocks, Fed cuts, the Dollar, and other currencies.

Oil - Staying High
Oil is at $108.70 (03/11/08). If we have a global 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 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 Dollar (USD) is at 73.25 (03/11/08) (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 3.0%. The 3 month T bill, at 1.46%, often leads Fed rate adjustments. 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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