Newsletter

June 5, 2007

Our daughter, Haley, has returned from college for the summer so we have “escaped” to Perdido Key as a “party of four”. As I mentioned last fall I have a keen appreciation for those moments when the family is momentarily reassembled during the holidays. While Haley will be returning to Tuscaloosa for summer school early in July, we are taking the opportunity to make June a special month with all of us together again.

I always enjoy our retreats to the Florida Panhandle. This is an area we have been visiting for almost 20 years, and it represents the “backyard” for many of our clients who are keeping a sharp eye on the falling real estate prices in the area, wondering when to consider a purchase or repurchase of “beach” property. The issues we will discuss in this letter are:

1. The Surprising Stamina of the Consumer and the Stock market
2. Fair value of the market (Revisited)
3. The Florida Panhandle and Real Estate

I. The Surprising Stamina of the Consumer and the Stock market
There was a wonderful article in last month’s edition of Barron’s that suggested there are many similarities between October of 2002 and today. In October of 2002, the Dow reached the bottom of its two-year correction, interests rates were low, (the Fed cut rates so many times that everyone had lost count) corporate earnings were beginning to show signs of improvement; yet you could not get anyone to put money into the market short of putting a gun to their head.

Today interest rates have doubled, (at least the prime rate has), foreclosures and bankruptcies are at record levels, gas prices are hovering around the $3 per gallon level, home values are predicted to continue their current decline for a number of years, and corporate earnings have slowed. Nevertheless, a senior Merrill Lynch economist suggests corporate earnings will rebound in the fall. A recent Wall Street Journal poll, suggests that there are two bulls on Wall Street for every bear.

It would seem these two time periods are polar opposites. So what exactly makes October 2002 and today so similar? It’s the fact that no one appears to be paying attention to the signs and signals that are apparent all around them.

These observations do not lead to a prediction of gloom and doom (note my “Fair Value” comments in Section II below), but look folks if gas prices drift above $3 a gallon for a prolonged period of time and home prices, sometimes referred to as the consumer’s piggy bank, continue their decline in value, the consumer, who drives 70% of the economy, may begin to limit those trips to Wal-Mart and Target.

A point of interest:
Since 1990, average household income has risen 11%, while average household spending has risen 30%. The home equity loan has replaced the company raise as the way family’s pay for the consumption that remains the backbone of the economy.

At the end of 2006, I suggested that interest rates would be the deciding factor for the coming year. While the prime has not risen, it was already artificially inflated at 8%‚ the ten-year Treasury rate has drifted up to 5.2% from the lower 4% range, which is a 25% increase. This increase has affected mortgage rates on homes for both new home purchases and for resetting adjustable rate mortgages. Homes are now less affordable to the new buyer and it is harder to maintain ownership for the owner who has seen his mortgage “reset.” There are $515 billion in adjustable rate mortgages resetting this year and $680 billion in the year 2008. Bank of America reports that 75% of these loans are to borrowers with poor credit histories. Twenty six percent of all of these reset mortgages are occurring in the state of California.

Forty-two percent of new home mortgages made in 2006 were made to borrowers who put less than 5% down for the home purchase. A very large percent of these folks are now “under water,” meaning they now owe more on their mortgages than the house is worth. As I have said in recent e-mails, I believe that the U.S. economy may be heading for some rough sailing ahead. I do not believe the slowdown in home building has affected the economy yet because there was a great deal of home building already in the construction pipeline. This kept many folks employed. Nevertheless, in the first quarter, housing starts were down 30.6 %. Sales of new single-family homes were down 23%. I believe as the end of this underway construction “falls” out of the pipeline and construction workers find their employment terminated, the economy will “feel their pain.”

II. Fair Value of The Market (Revisited)
The prime interest rate divided into the number 1 suggests a fair multiple level that the investment market should pay for a dollar’s worth of earnings. This is referred to as a “price earnings ratio”. Today’s prime interest rate, which is 8% (or .08), divided into one, equals 12.5. As a result the market should trade comfortably at a P/E of $12. I have suggested in the past that I believe the current prime interest rate is artificially high. Following this line of thinking, let’s consider the 10-year Treasury bill rate and combine it with the prime rate. The current 10-year Treasury bill rate is 5%. So let’s add the prime rate of 8 plus 5 to get 13 then divide by 2 to get an average. This gives us a rate of 6.5%. The number 1 divided by 6.5% (or .065) suggests a fair P/E of 15.4. Therefore, we should not object to paying $15.40 for $1 worth of earnings.

The current P/E for the S&P 500 is 18.05. If the P/E is based on projected earnings for the next year it is predicted to be 16.8. It would appear that if interest rates remain constant and corporate earnings follow their projected rebound, the current evaluation of the market is close to being appropriate. If the Fed begins to fight inflation by increasing interest rates or maintaining those rates at the current level while the economy slows, we will possibly need to lower the current evaluation.

During the past three days, the market has faltered by approximately 400 points with the concern focusing on the Fed announcing that it will continue to fight inflation; by not lowering interest rates. At this time, corporate earnings continue to be sound; therefore, only one of our two concerns is complicating our current evaluation. Nevertheless, we will continue to monitor this very closely. I view this 400-point decline as a warning shot by the Fed that they are going to protect the dollar and fight inflation by keeping interest rates at current levels. I do not believe anyone is concerned about investors experiencing “irrational exuberance” at this point. The bottom line is that I do not view the market as dangerously over valued, but a decline of as much as five to eight percent might not only be due, but possibly healthy.

June 27th Update:
In last quarter’s letter, I mentioned my concern about sub prime lending problems with borrowers and lenders. This week Bear Stearns announced that they will lend two of their “packaged” hedge funds $3.2 billion to starve off the collapse of the funds. The problem is with sub-prime packaged mortgages, packaged as bonds and purchased by the hedge funds have lost value and investors want out. Without the infusion of the $3.2 billion in cash, the hedge funds would have collapsed under the pressure to raise funds for redemptions. As I have said before I believe that this may only be the tip of the iceberg in regard to the problems of the sub prime lenders and hedge funds that have used package collateralized mortgages as an investment.

III. The Florida Panhandle and Real Estate
I spent approximately an hour today with a trusted Perdido Key broker. We spent the time reviewing recent sales. There were not many, and we explored the enormous number of new listings in the area. During the past weeks, our clients have purchased property in Pensacola at a 32% discount to the asking price and properties in Apalachicola at a 40% discount. As a result, of these transactions and many others like them, it seems to be appropriate to evaluate the status of properties in the Perdido Key area and the Panhandle in general.

Perdido Key has seen a general sales price reduction of 20%. As I drove around the area I viewed hundreds of new “For Sale” signs compared to my visit two months ago. I believe that we are a very long way from committing new funds to the area. One example of the trend in the area is Lyplaya, a beautiful new building built in 2002. The condominiums, before Hurricane Ivan, were selling in the $1 million range. In the past six months, two units have sold for $800,000 and $865,000 respectively. The agent suggested that foreclosures in the area are appearing with a higher frequency, and I believe prices for most beachfront property could fall an additional 15% to 20% before stabilization occurs.

Speak with any real estate agent in the area, and he or she will try to convince you that real estate prices have reached the bottom. Agents in the area report an increase in activity from the buyer’s side. These agents remind me of stockbrokers in August of 2000 when the NASDAQ climbed back to 4,000 after falling from 5,000 in March of that year to the mid-3,000’s before returning to the 4,000 level in August. Stockbrokers ignored historic evaluations and tried to justify the prices of the NASDAQ only to watch the NASDAQ fall from 4,000 to 1,300 by October of 2002. I do not believe that real estate prices will fall as far as the NASDAQ did during that period, but I strongly believe it is far too early to consider a purchase.

A major concern, as we watch the Panhandle real estate decline, by 15, 30 or even 35%, is that we must not focus only on price. We should be focusing on the cost of operation and the possible lack of any potential real estate appreciation for a period of time. An example, the previously mentioned Lyplaya property that traded at $800,000: The association dues for ownership of that unit have doubled to $9,250/year. This is a result of insurance premiums exploding; these costs are being passed on to the owners through association dues. While the unit, selling at $800,000, certainly looks to be a “bargain” compared to the price two years ago, one is faced with having approximately $9,000 per year in association dues and a like amount in property taxes. That is $18,000 per year for association dues and property taxes and you have not made the first dollar payment toward debt service or considered the opportunity cost of the purchase.

Not many investors are willing to shoulder almost $20,000 a year for the right to own a condominium that may not appreciate for years to come. I believe when investors with a “travel budget” of $20,000 a year consider the option of taking some time to travel to major resorts around the country, they may opt for travel and “renting” locations versus purchasing real estate that may have limited upside appreciation for a few years and have high occupancy cost.

I look forward to speaking with you soon.

Warmest Regards,

M. Brooks Clark

The numbers:

Index	12/29/06	3/30/07	YTD % Change
Dow	12,436	(.6)	7.8
NASDAQ	2415	.2	7.8
S&P	1418	.1	6
Russell Value	818	.6	4.8
Russell Growth	554	.7	7.4
Treasury	88.47	(.1)	(3.7)
REIT Index	83.82	1.7	(7.8)

We have enjoyed an excellent quarter with the major indexes providing between 6 and 7.8% performance for the year. You will notice that growth is beginning to out perform value, for the first time in years, and with less volatility. The interest sensitive treasury and Real Estate investment index reacted to higher interest rates falling 3.7% and 7.8% respectively.

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 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.