June 29, 2005

To Our Valued Clients and Friends:

I.    The Market is going nowhere—Look again!
II.   The price of oil and Wal-Mart
III.  The U.S. Dollar and international markets
IV.  Real Estate—Is the air finally coming out of the bubble?

I. The market is going nowhere—The Dow Jones Industrial Average is down about 2% during the last 90 days. Almost everywhere I go I keep hearing people say that the market is going sideways, and I am then asked the question, “How do you make money in a ‘sideways’ market?”

Well, I hate to disagree with this general observation, but a more thorough review of the numbers suggests that there is a lot of activity in the market. You just have to look more closely to see the action. Let’s take a look at the numbers for the quarter and for the year:

I find the following items to be of interest as I look over these figures:

1. While the Dow lost about 2% during the quarter, most other indexes were up between 1.4% and 3%.
2. Treasuries and real estate had substantial rebounds in the second quarter, up 9.9% and 12.8% respectively.
3. For the first time in five years, growth in the second quarter is beginning to outperform value.
   1. The Russell Growth index kept pace with value during the second quarter, marking the first time growth has kept pace with value in five years.
   2. When the Dow fell from 10,940 in March to 10,012 on April 25th, growth dropped by 5.7% while value dropped 6.6%. One would think that value would have been more protective than growth during such a period.

The numbers show underlying strength away from the major indexes. We were rewarded by maintaining our strong REIT position during the second quarter, which had fallen under such pressure in the first portion of the year. At the same time we enjoyed an attractive return with the Fidelity Contrafund. This is the first growth-oriented fund we have held in over three years.

You must move away from the larger index holdings to achieve a return in this market. Going back to our “fair value” ratio, which divides the prime rate into one to determine a fair value for the market price earnings ratio, the market appears to be priced fairly. (The prime is now 6%. Dividing 6% into one provides us with a fair value of the price earnings ratio of 16.66. We should be willing to pay $16.66 for $1 of corporate earnings. This compares to last year’s prime rate of 4 that provided us with a fair price earnings ratio of 25.)

The Dow ended the week with an average price earnings ratio of 17.85 and the S&P with a price earnings ratio of 19.74.

[For a more thorough explanation of the fair value for the price earnings ratio visit our website and note our March 28th newsletter.]

The 50% increase in the prime suggests that corporate earnings will have to increase by 33% to keep pace with this evaluation of stocks from last year. Because investment indexes are dominated by large stocks and are capital weighted, large companies are hard pressed to provide you with a 33% increase in earnings. Remember these companies are behemoths and have been around forever. These large companies are not likely to have an explosive growth rate in earnings or sales. Index investing cannot provide you with the performance that selected stocks may provide you during this type of market.

This has truly become a stock picker’s market, not an index driven one. Few managers bested the Standard and Poor’s 500 in the 1990’s, but I do not believe that the index is quite as hard to beat in 2005. (I.E. Marty Whittman’s Third Avenue Value and Real Estate funds are up 6.8% and 8.8% respectively, while Fidelity’s Contrafund is up 3.4% year to date. This compares to the Dow’s (4.5%) and the NASDAQ’s (5.6%) year to date. Perhaps no story makes this case better than the following example of stock selection:

Wal-Mart—You may recall that last year in our third quarter letter I spoke of the high cost of fuel taking an additional $70-$75 a month out of the discretionary income of the consumer for each car that was driven by the family. Oil has once again drifted over $60 a barrel and gas prices have risen from $1.90 for regular gas two weeks ago to over $2.09 today. Gas prices have returned to the level that they were in the third quarter of last year and the consumer is talking about gas prices at the pump again.

1. The “Wal-Mart” view—Wal-Mart sales have decelerated and the stock of Wal-Mart has dropped from $57 to $47 over the last 90 days. This is an 18.35% decline in value. (Remember my earlier comments about large companies and the impact that they have on the investment indexes). This company, and companies that depended on the middle and lower, middle end consumers, are going to be hurt by higher oil prices. Wal-Mart now trades at 19 times earnings, a slight premium to the Dow Jones Industrial Average, and the stock may head lower from these levels.
2. The Target or “Tar-je´ view—Here is a retailer that has a different consumer demographic than Wal-Mart. The stock has actually climbed from $45 to $55 over the last year. While the stock of Wal-Mart declined by approximately 10% and the S&P added a few percentage points during the period, Target increased in value by over 20%. (Note attachment A). The difference is simply the consumer demographics.

The IRS says that it now costs about $.42 a mile to drive an automobile today. If a car gets 20 miles to a gallon and the average fuel cost is $2.00 per gallon the fuel cost is approximately $.10 a mile, or approximately 20%, of the cost of driving an automobile. If gas prices were to go up by an additional 50% to $3 a gallon, the increased cost to operate the car per mile will rise by a nickel, so the cost of driving the car has increased by about 10%. Few in this demographic group are greatly concerned that the cost of driving a car has gone from $.42 per mile to $.47 per mile. As a result, one can see that while gasoline cost may continue to increase, it may not have as great an impact on consumers that have greater discretionary income. The cost of operating a vehicle represents only a small portion of this group’s annual budget.

I am not trying to be cavalier about this issue, but I do want to emphasize that you must be specific in your equity selections and not depend on a “rising tide” of the investment index raising all boats. That is the way investors viewed the market in the 1990’s. The indexes are dominated by large companies, like Wal-Mart, that are not nimble nor creative enough to defend themselves during a period where their primary customers are under spending constraints.

Conclusion: I believe the major indexes will continue to trade narrowly between 10,000 and 10,750 for the Dow for the remainder of the year. Nevertheless this does not suggest that we cannot earn a sound return by carefully selecting sectors that are either undervalued or companies that are nimble or creative enough to prosper during these difficult times.

[Each of our selected mutual funds within our Thoroughbred program are exceeding their comparative Lipper indexes, and our portfolios continue to lean heavily on our balanced funds. Yesterday, while the Dow Jones Industrial Average fell 166 points, or 1.52%, our aggregate asset mix fell by less than 1/2 of 1%, or less than 1/3 of the decline of the overall market. I am very please with the performance of our portfolio in a falling market.]

III. The U.S. dollar and foreign market—I would like to briefly revisit my comments earlier this year when I suggested that, while the U.S. dollar might rebound against foreign currencies in the short run, I felt that international equities will continue to occupy a place in our portfolios. In the past three months the dollar has rebounded 8.2% against the Euro and 6% against the pound sterling. At the same time, the international indexes are powering their way northward compared to our DOW, which has fallen 4.6% year to date.

As a result we will continue to expand our international exposure. This move is based on the long-term belief that America will continue to “suffer” by not addressing balance of payment deficit caused by this ongoing trade deficit, and that the government will also ignore its staggering physical deficit, causing a continued weakening of the U.S. dollar.

IV. Real Estate—Is the air finally coming out of the bubble?— If I had a dollar for every article on real estate that I have read recently, I would be able to take a bunch of us to lunch. There is a growing belief that there is indeed a real estate   bubble, primarily in vacation homes and condos, and the only folks that I can find defending the pricing of these properties are those who either own them or want you to buy one.

While there are a few folks who may be left “holding the bag” on these properties, I am concerned that a drop in the value of these properties will affect   the economy to a greater extent than simply a few people holding properties that have declined in value.

In the year 2000 homeowners owed $492 billion on their home equity lines. That number has grown to $881 billion, or a 79% increase in five years. I do not have any figures to support what portion of this increase in home equity line debt has been used to purchase additional real estate, but you can imagine the impact of declining investment property values and even a slight decline in the value of primary residence may have on bank loan quality and consumer spending habits. This is a potential problem that can snowball its way through the economy and we are watching this situation closely and with more than just a bit of concern.

Higher oil prices + projected higher interest rates + declining real estate values = ouch!
This is the reason we continue to run our portfolios on the defensive, yet selected exposure side.

I look forward to talking with you at the end of the third quarter.

Warmest Regards,

M. Brooks Clark

MBC/alm

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*Clark Financial Advisors is registered with the Securities and Exchange Commission (SEC) as a registered investment advisor and annually files an ADV with the SEC, as required. The ADV II form provides background on the firm and its principals. If you would like to receive a copy of this form please contact Amanda McCollum via email at Mario@clarkfinancialadvisors.com to receive a copy. You may also return this page of the letter with a note signifying your request for a copy of the ADV II filing for Clark Financial Advisors.