A Distilled Markets and Macroeconomic Letter
June 2008

Transparency Detail
There is talk that the Fed will start raising rates. I have been noting the fairly tight correlation of 3 month T-Bills and the Fed Funds Rate both of which are at 2%. This implies that there may be no rate increase. If one looks at the slowdown/recession, it certainly seems unlikely that the Fed would want to raise rates.

Additional turmoil in the finance sector could easily lead to more cuts. This is already being seen and many, including myself, expect more to come.

Demand Destruction vs Oil Inflation
Here the question is whether lower demand will have an impact on the rapidly rising cost of oil. This could certainly be the case as I have noted for many months now. The question is, will the Fed devalue, via rate cuts, the Dollar sufficiently that oil stays high or relatively high? I still feel that there is significant risk that the oil stays relatively high in the face of a severely slow or recessionary economy. What is relatively high? Remember when many thought that oil would not sustain above $80? $100? $125?

There is an excellent iTulip article on this subject by Eric Janszen, Inflation in America part II, at ($): http://www.itulip.com/forums/showthr...7396#post37396

Also note that once the economy works through the current crisis, we may see much higher oil prices if demand explodes with global growth.

Credit Default Swap (CDS) Market (Think Bear Stearns)
I am still concerned about the CDS market. This is, essentially, insurance against a specific company becoming bankrupt. Here is a very interesting article on this by an industry insider, Satyajit Das: http://www.wilmott.com/blogs/satyajitdas/index.cfm/General. If Satyajit is concerned, I'm concerned.

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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 failed at S&P 1400. Current support at ~1350 (06/10/08).

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 has moved lower after its huge recent upside push.

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 There is also talk of a Dollar carry trade developing.

Oil is at $131.70 (06/10/08). 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
Very short term, the markets seem to be heading higher. I donít expect this to last very long though. The Ted Spread is still high at 1.11. The VIX (volatility index or fear gauge) is at 18.21 (05/06/08), which is quite low.

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 been moving a bit higher. Iím still concerned about longer dated (5 year and longer) bonds loosing value.

Gold one month futures are at $877.70 (05/06/08). Iím watching Gold relative to stocks, Fed cuts, the Dollar, and other currencies.

Oil - Staying High
Oil is at $121.93 (05/06/08). If we have a global recession, oil might have a relatively steep sell-off. A Goldman analyst thinks oil may go to $150 - $200. 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 is still in force. Home prices have fallen in many areas, some quite significantly. I feel that we could see home values have a total drop from the peak of 20 to 30% nationally in 2008 Dollars. The non-inflation numbers may not look as bad.

The Dollar (USD) is at 73.00 (05/06/08) (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 2%. The 3 month T-bill, at 1.62%, often leads Fed rate adjustments.

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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