Newsletter

Saturday, June 28th, 2006

  1. A very confused market
  2. Interest rates and inflation
  3. General Observations
  4. Perspective — A falling bookshelf

I. I don’t think I can remember when so many market professionals have admitted that they have no idea which direction the investment markets are headed. At the end of the first quarter most indexes were headed north with the Dow ahead by over 5% at 11,279. I observed at quarter’s end that I felt the market was overvalued, based on our fair market price earnings ratio, but frankly was enjoying the ride. The Dow and the bulk of the investment indexes provided a great April and in early May peaked at 11,709. This represented a 9.2% rise from the end of 2005.

The new Fed chairman then suggested that the Fed was not through raising short term interest rates and inflation continued to be viewed by the Fed as a problem. The market was caught off guard and the Dow gave back its full 9.2% gain and actually visited negative territory for the year before righting itself and returning to a plus 2% as we near quarter’s end. If anyone questions whether the United States economy sets the stage for the world markets allow me to mention a few of the domestic, world and commodity indexes that reacted to the Fed chairman’s comments between May 11th and June 14th.

The market now appears to be momentarily stabilized, but of course waiting for the Fed’s actions in their June and August meetings to see if there is a signal that the Fed will stop this incredibly long string of increasing short term interest rates.

II. Interest rates and inflation — The Federal Reserve feels that its major tool to control the economy’s growth is the setting of short term interest rates. Keep the interest rates low, which provides an abundant supply of cheap money and the economy tends to expand. Raise interest rates slightly and you begin to slow the expansion. But the question is, will the Fed overshoot the mark on increasing interest rates and slow the economy to a point that the economy begins to decline and actually enter a recession.

I suggest that you visualize a small plane taking off with low interest rates representing the fuel that is being provided to the plane’s engine. As the pilot begins to pull back on the controls and accelerates the throttle forward the plane begins to lift from the runway and the pilot strives to achieve a proper altitude. After the pilot reaches that altitude he beings to pull back on the throttle reducing the fuel to the engine, or our “economy”. (Also interpreted as an increase in interest rates.) What happens if the throttle is pulled back a bit too far and the plane begins to descend? Will the plane begin to descend, or will the pilot be able to accelerate the fuel flow once again and level the plane to that proper altitude?

So now we wait and observe our pilot, the new Fed chairman, trying to “cool” the economy to that perfect altitude by this lengthy march toward higher interest rates. My concern is that it all may be different this time as I believe that the Fed chairman is entering into uncharted waters.

The U.S. economy is growing at a rate of between 2.5% and 4% annually, depending on which set of quarterly numbers you are reviewing. This figure compares to the world economy which recently had its growth rate raised from 4.3% to 4.9% for 2006 by the International Monetary Fund. Forecasts for the world’s economic growth for 2007 is projected to be even higher. And then, there is China!

During the last month China’s industrial production rose by an astonishing 17.9% and in the first quarter of this year the gross national product sprinted ahead of the last year’s by a blazing 10.3%, according to Barron’s. Besides it’s incredible thirst for oil, China has been consuming industrial commodities at a truly awesome pace. According to Morgan Stanley’s Steve Roach, in 2005, China accounted for 50% of the growth in the world aluminum consumption, 84% of the rise in demand for iron ore, 108% of the increase in the consumption of steel and 115%, 120% and 307% in the growth of worldwide demand for cement, zinc and copper respectively. With this much industrial demand from both China and the rest of the world, will the Fed’s raising of domestic interest rates have any real cooling effect on the industrial portion of the U.S. economy, or will the raising of interest rates simply hurt the U.S. housing market and the consumer? This potential scenario results in American industries continuing to be profitable while at the same time the U.S. economy, which has historically been driven by the consumer, begins to decline. (2/3 of the economy is powered by the consumer).

What an awkward scenario! Industry continues to increase its exports to the international market while the domestic consumer is burdened by the increase in interest rates and a decline in the overall housing market. In a recent interview in Business Week George Soros, a brilliant investor, observes that the U.S. consumer is the most vulnerable. He states, “The U.S. consumer has a negative savings rate and while the consumer has been benefiting from the double digit rise in house prices to fuel his consumption, that is coming to an end.”

The consumer has bailed out our economy ever since the market crash that began in 2000. While industry cut it’s spending the consumer kept spending every cent that they had, encouraged by zero interest rate car loans and an array of interest only and adjustable rate mortgages being provided by aggressive mortgage lenders. This combination of creative mortgage packages and low interest rates stimulated a demand for the first and second homes to unprecedented levels and while consumers had little savings to draw from, the ever present lenders were there to eagerly lend the consumer 110% of his or her equity to continue their spending habit. (Allow us to encourage you to visit our website and re-read our comments regarding the consumers “perfect storm of debt” found in our third quarter letter of 2005).

So here we are — falling home, and second home prices, and increasing interest rates. Barron’s reports that condominium and housing prices in Naples, FL have already fallen by a full 25% and they are still not selling. Interest rates on home equity lines have increased from 4% to 8% and thirty year mortgage rates have risen from just above 4% to about 7%, dramatically reducing the number of American’s that qualify for home purchases. In addition there are $1 trillion of adjustable-rate mortgages to be re-set this year and $1.7 trillion next. (That is trillion with a T). Home owners with adjustable-rate mortgages will see their monthly payments increase by 25% to 60%.

I fear that we may be in only the initial stages of this decline in real estate prices. We have had an extraordinary boom in housing development and housing prices. An historic building boom, per the housing analyst at HSBC, lasts approximately five years and the analysts observe an increase in housing permits, prices, and the sale of homes between 100% and 150% during the “boom” period. The current boom, in sharp contrast, has gone on for fifteen years and prices, permits and sales have increased by as much as 300%.

The flip side to this “mother of all housing booms” is the potential size of the downside. HSBC points out that we may be entering only the early days of this correction in regard to real estate prices, as this correction could go on for perhaps five years and price declines could range from 40% to 60%. If you think that is impossible, I watched this very same scenario unfold on the gulf coast between 1985 and 1993.

III. General Observations: So where do we go from here? I believe that we have a good chance that the country will fall into a recession, beginning in 2007, but a different type of recession. The consumer will be the one to move into a recession. Corporate earnings, especially those corporations that are multi-national in nature, will continue to observe an increase in their earnings. I believe that the historical driving forces of the economy, which in the past saw the consumer generating 66% of economic activity while industry picked up the slack, will begin to be more balanced with industry’s share increasing to the point where we will have a more balanced economy between the consumer and industry. I believe that there will be Americans that will be hurt badly by such a recession and that the gap between those who have, and those who have not, will continue to widen.

(We recently increased our cash position in our balanced and moderate growth accounts to react to this possibility of recession.)

In sharp contrast I believe that the rest of the world will begin to reduce both their dependency and their reaction to the U.S.’s problems and economy. I believe the developing countries will continue to find alternative consumers for their products in other international markets. I believe that in twenty years, and please do not be offended by this comment, that the United States will no longer be the world’s dominant economic player and that the world economy will be far more balanced. Our portfolios should reflect such an inevitability.

(We recently redirected a portion of our international emerging market exposure to more mature international markets for long term growth, yet with a greater degree of stability.)

IV. Perspective — A falling bookshelf — In hopes of putting this all into perspective we had something happened at our house the other day that I found to be interesting. As Beth and I sat in our living room we heard a bookshelf collapse in one of our upstairs rooms. A shelf had given way and a number of books were sprawled across the floor. When I opened up one of the books I found a newspaper clipping that had been saved and it was dated November 23rd, 1995. The article was a story about a fire in the Empire State Building and I remembered that this was the date that we had taken the children to New York to watch the Macy’s Parade and we had visited the Empire State Building shortly before this fire. We had saved the article to remind the children of both the fire and their trip to New York.

When I turned the page over I found an article that announced that the Dow Jones Industrial Average had crossed 5,000 for the first time. I stared at the article for the longest time and realized that between November 23rd of 1995 and today’s date the Dow Jones Industrial Average has more than doubled it’s value even though the Dow has experienced one of the largest market declines in history, almost 40%, between 2000 and 2002. The investment results of the stock market during that period had eclipsed most other investment opportunities.

While no one knows what the next ten years will bring I found that this newspaper clipping provided me with a reminder to try to keep things in perspective, think long term and try not to react to short term annoyances.

Have a great quarter!

M. Brooks Clark

MBC/lh

The numbers:

Index
12/31/05
3/25/06
6/27/06
Quarter %Change
YTD % Change
Dow
10,717
11,279
10,924
(3.1)
1.9
NASDAQ
2,205
2,312
2,100
(9.1)
(4.7)
S&P
1,248
1,302
1,239
(4.8)
(.7)
Russell Value
685
727
703
(3.3)
2.6
Russell Growth
513
529
494
(6.6)
(3.7)
Treasury
91.9
89
83.6
(6)
(9.1)
REIT Index
64.1
72.7
69.2
(4.8)
7.9

PLEASE NOTE: All checks to be added to your accounts should be made payable to: Fidelity

*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 Jennifer Gibbs via email at Jennifer@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.

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