A Distilled Markets and Macroeconomic Letter: October 2006

Transparency Snapshot

The Markets

Stocks - Short Term - Negative Outlook

With the recent run up, the market is in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 11.58 (9/27/06), which is very low and can be a contrary indicator. There seems to be little fear in the markets.

Stocks - Medium Term - Negative Outlook
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 - Inverted yields pointing towards recession?
Yields continue to be inverted. In the short run bonds may rise in price with a slowing economy but in the longer term (5 year and longer) longer duration bonds may fall significantly.

Last month gold looked like it would go up or down with some significance. It went down.

Oil - Stays high unless we see a recession or more war(s)
Oil has sold off significantly, which is a nice boost for the consumer. The risk is that a lower oil price is pricing in a coming economic downturn.

The Economy
Fed funds rate is at 5.25%. The Fed paused again at the last meeting. It seems that they will continue to pause or will only raise a .25% or so. This is not really that great of news. The risk is that the economy is slowing much faster than the major media pundits would have you believe.

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. In some areas, housing seems to be in meltdown mode.

The Dollar is still holding up and may well continue to do so near-term. I feel that dollar based assets are at risk in the long-term.

Transparency Detail

Relevance of Dow at New Highs
After six years there might not be much relevance. The Dow components have changed a bit. Adjusted for inflation the Dow is down a fair amount even if you only use the CPI numbers. The S&P 500 is not very close to its record. There is talk around that this rally has been driven by managers seeking to show better returns for the quarter.

On the side of relevance, there has been a fair amount of struggle for the Dow to make a new high. The Dow Transportation index has not been performing as well as the industrials, which according to Dow Theory is not a good thing. Even if there is a firm close at a new high, it might only be a false breakout. My opinion is that valuations are rich and a new high will only make the market that much more expensive.

There has been a lot of talk about a rotation to larger capitalization stocks within the market because they have lower valuations than most of the other stocks. These large cap stocks could still go down, of course. New bull markets tend to start from low P/E ratios and high dividend yields, neither of which are currently present.

Housing Housing Housing
I feel that housing is the key to the current economic and market environment. If housing falls enough that consumers restrict their spending and more lending institutions have problems, the economy should slow and the markets, both domestic and world, should go down. The NY Times published (8/30/06 “Full House”) a chart put together by Robert Shiller and Karl Case, which showed home values back to 1890 adjusted for inflation. This chart shows that from 1997 to 2006 home values, on average, have gone up about 83%. That is an amazing increase and I think everyone should look at this chart.

Richard Russell writes today (9/28/06) that the Fed may be pumping excessive liquidity into the financial system. The M3 broad money supply is no longer being reported, which makes many people wonder what the figures are. If the markets continue to float higher, the Nasdaq starts performing, and housing has a soft landing, then this could be the case. We shall see. If housing and the markets melt down, then I would expect the Fed to cut rates aggressively, which may cause excessive inflation in the future. That is the risk.

The Markets

The market has rallied higher and I don’t trust it. The Dow needs to go above 11,722 for things to get interesting and the Dow Transports would need to go to a new high as well. The Transports where heading sharply lower but they have recovered somewhat. If the Dow closes over the old high we could be in for a further rally on the optimism. If this scenario comes to pass I will not be jumping on the overall optimism train. The chart on the S&P 500 does not look anywhere near as good.

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, two year to medium duration bonds may 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. In other words, if you buy ten year bonds and rates spike higher, you may feel stuck with poor return and a lower bond price.

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 I’m still negative on the Dollar. Near-term strength is certainly possible. 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 $62.93 (9/27/06). The risk is that oil stays high. If oil prices continue downward, they may be pricing in a recession. I’ve heard talk that consumers now have more cash to spend with gas prices lower. What happens when trillions of dollars of mortgages reset?

Much has been written about how the world is currently experiencing peak oil production. If we have a recession, especially a global recession, we might not have to worry about peak oil for a while. When the economy recovers from such a recession, oil could go much higher.
Will new sources of oil come firmly online in the interim?

The Economy

The Fed
The Fed is in pause mode. Near-term rates may go up slightly and if housing and the economy slow enough the Fed should start cutting rates again.

I feel that the housing picture could become much worse.

Barron’s reported (8/21/06) some interesting statistics on housing: 10% of all home owners with mortgages have no equity in their homes and $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.

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. Maybe next the consumer will be squeezed by their mortgage payments being reset.

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.

If you have specific questions, 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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