Newsletter

October 4 , 2005

To Our Valued Clients and Friends:

1. A perfect storm of debt
2. The triple play
3. Real estate at the Gulf
4. Let’s take a look at the markets
5. On a closing and perhaps more optimistic note

My good friend, Mike Tennant, tells me that I “worry too much about too many things”. Mike is probably right. But this last quarter, with its hurricanes, higher gas prices, and massive government spending programs, has contributed a lot to be concerned about.

With so much being thrown at us each day—from the gulf coast, Iraq, and the politicians, I believe we need to look beyond all of the pictures and “noise” and try to make sense of what effect the combination of these events may have on our economy and our investments.

Here are a few thoughts:

I. A perfect storm of debt: I believe that we may be on the verge of an economic slow down that could result in a 10% to 15% pullback in the investment markets. The consumer, who drives two thirds of the American economy, effectively carried the economy through the business recession of 2000 through 2004. I am afraid that consumers have pushed the economy as far as they can with their purchase of goods and services, and I believe that recent events will bring this buying spree to an end.

You may recall my concerns regarding how much debt individuals have shouldered since the year 2000. It is not hard to see how all this new debt occurred. Just look at the closest parking lot or drive to any vacation spot to view the combination of new SUVs and condos.  A 79% increase in the amount of debt reported on home equity lines has resulted in many consumers having only modest equity in their homes, even though property values have accelerated dramatically during the past three years. Now the recent increase in energy costs is about to cause heartburn in many households. While many of you who read this letter find higher fuel costs to be only a minor hindrance, most Americans are now finding their disposable income being pinched, or they may find that to be the case very soon.

Let me explain this “very soon” statement. My friend, Fred Higgins, owns a number of convenience stores in southern Kentucky. He stated that during the recent Katrina-induced gasoline price spike, gas sales in his stores charged to credit cards jumped from 50% to 75%—a 50% increase. Some consumers may have “pushed” the effects of higher cost prices back a few months, but a “perfect storm” of debt is about to hit the consumer.

The new bankruptcy laws now allow banks that issue credit cards to require that the credit card debt be paid at a rate of one twenty-fifth of the principal each month as compared to one fiftieth before. That means credit card debt will now need to be repaid in just over two years, compared to over four years before. The required payment for the principal portion will double in November.

Interest rates: Let’s talk about the prime rate. The prime rate has risen from 4% last year to 6.75% today, a 68% increase. Most home equity lines, which are tied to the prime rate, now require higher monthly payments. The monthly interest payment on a $100,000 home equity line has jumped from $333 to $562 a month due to the increase in the prime rate over the last year.

Heating oil costs, because of the recent hurricanes and demand, are scheduled to increase by 71% this winter, and natural gas prices are projected to increase by 40%.

The combination of higher interest rates, a new acceleration of debt repayment, and higher fuel costs, may be the straw that finally breaks the consumer’s back.

Let me emphasize how higher oil prices really hurt the economy. Once again I’ll cite my friend, Fred Higgins. Fred’s stores, which are located in southern Kentucky, sell about 800,000 gallons of fuel each month. Last month Fred’s customers paid approximately $1 million more for the same amount of fuel that they purchased one year earlier. While the gross retail sales of the area might be reported as being even or even higher than before, the sales data is misleading. This example shows how $1 million was virtually “sucked” out of the local economy in southern Kentucky and, while retail sales reports may not reflect the “damage”, there is a $1 million reduction in discretionary spending suffered by the county. That was $1 million that was not spent at Wal-Mart, the grocery store, local car dealerships or given to charities. 

I am concerned that many may discount the effect of this upward pressure on energy costs and the increase payment demands on old debt. I fear for the effect that this combination may have on the economy and, eventually, the pricing of investments.

Now here’s a real curve ball! The current administration is preparing a $200 billion rebuilding program for the gulf area. Will this enormous spending spree be enough to keep the economy moving? I don’t know, but it may be the stimulus to cause an inflation problem. (Stick with me here)

Last year the United States ran a $471 billion deficit, the largest in the country’s history. This year we were projected to have a deficit of approximately $300 billion, but this was before considering the $200 billion rebuilding package or any additional funds being spent in Iraq. We may run a deficit this year of approximately $400 billion, and one might suggest that next year may be about the same. If you consider the aggregate debt that is caused by these four years of running deficits, you will find that the total equals an increase in the national debt by 50%. This is an interesting position to which we have arrived when one considers that six years ago the country was generating a $185 billion surplus.

The current trade deficit is a bit north of $700 billion. We are buying $700 billion more in goods and services from international suppliers than they are purchasing from us. A good portion of this $700 billion surplus actually remains in the United States; it is represented by U.S. dollars that are now owned by international investors. These foreign dollars are referred to as Euro dollars. The reason that international holders of Euro dollars do not immediately convert their Euro dollar holdings back into their own currencies is that to do so would cause substantial upward pricing pressures on their currency. If this were to happen, their products would immediately become more expensive and would result in a decline in sales, which could endanger their economy’s exports.

International investors are content to hold U.S. Treasuries as long as the U.S. economy continues to be run in a sound financial manner and inflation does not become a problem, thus undermining the value of the U.S. dollar compared to foreign currencies. The only reason that ten year Treasuries, the investment of choice for foreign investors, are still yielding less than 4.5% is the enormous international investment in our U.S. securities. If the United States does not keep its financial house in order, it may lead to a scenario unfolding which could result in international investors selling their U.S. dollar investments in U.S. Treasuries. This could create upward pressure on Treasury yields that would also contribute substantially to higher interest rates, thus further slowing the economy.

II. The triple play: Here is an interesting quote from the chief economist of Merrill Lynch, as published in an interview in this weeks Barron’s. “We’re witnessing an event that has happened barely more than 15% of the time in the five decades: A year that sees the Fed tighten (liquidity pinch), oil prices rise (margin and personal income squeeze), and the equity market head lower (wealth effect, discount mechanism)—a triple play.”

“Such a triple play has occurred only eight times in the past fifty years and on seven such occasions, gross domestic product growth either slowed, or stopped dead in the water. The odds, then, of a slow down in 2006 are 88%, which the Merrill Lynch economist says without fear of contradiction, is not “a track record worth betting against”. The decline in growth, in the wake of triple play years, has averaged 2.5%.”

To paraphrase the closing comments of the Merrill Lynch economist, he suggests that this 2.5% average decline in growth could result in the economy growing at 1% or less in the year 2006. His final comment, “Something tells us that equity evaluation, credit spreads and the dollar are not presently priced for such an outcome.”

I apologize for drawing such a gloomy picture as we head into the holiday season. Nevertheless, I believe that it is the combination of these concerns that that will contribute to a disappointing holiday season. I believe it is important for us to anticipate this possibility, because if one waits until the first portion of 2006 to have confirmation of a slowdown in retail sales it will be too late to make adjustments to the portfolio. As a result, the conservative and defensive nature of our portfolios is being increased slightly in the coming month.

III. Real estate at the gulf: This would not be one of our newsletters if I did not comment on real estate values on the gulf coast. You are aware that over the last year I have been mentioning my concerns about the height of housing prices on the gulf coast. While the bubble may have been extended a bit by the combination of Ivan and Dennis last year, taking approximately 50% of the region’s condominiums “off line”, I believe that the market may finally have reached a point where it is about to take a breather. Please consider the following:

1. In this week’s Wall Street Journal an article focused on Destin, Florida, 250 miles east of New Orleans, where agents say that second home buyers are “backing out of contracts and making offers as much as 30% below asking prices.” Sellers are now lowering their prices, with the multiple listings service reporting 200 price changes from September 6th to September 13th, mostly reductions. “Katrina has brought this market to a screeching halt.”—Destin real estate broker, Jane Araguel.
2. In Baldwin County, Gulf Shores, 400 condominiums were listed in the multiple listings this time last year. Now there are over 2,000—a four-fold increase in one year. In the past sixty days a local real estate firm reports several buyers backing out of contracts and leaving six figure deposits “on the table”.
3. An interesting thought: There are 35,000 planned condominiums units in the pipe line to be built between Panama City and Mobile over the next several years. Now that Katrina and Rita have cleaned out much of the Mississippi coast I am sure that there will be an increase in the development in that area, as well.

IV. Let’s take a look at the markets:

	12/31	3/18	6/26	10/31	Quarter Change	YTD Change
Dow	10,783	10,485	10,297	10,568	+2.6	(1.9)
NASDAQ	2,175	1,992	2,053	2,151	+4.7	(1.1)
S&P	1,211	1,174	1,191	1,228	+3.1	+1.4
Russell Value	656	647	660	681	+3.2	+3.8
Russell Growth	493	471	480	500	+3.2	+1.4
Treasury	88.5	87.7	96.39	92.2	(4.3)	+4.1
Real Estate Index	123.4	111.3	125.6	128.3	+2.1	+3.9

Market Observations:

1. The third quarter was a positive quarter for virtually all of the indexes. The Dow was up 2.6%, NASDAQ 4.7% and the S&P 3.1%.
2. Growth, for the second quarter in a row, exceeded the performance of value by approximately 30%. The Russell Growth index was up 4.1% for the quarter while the Russell Value index was up 3.2%.
3. The Treasury index took quite a hit, dropping 4.3% but continues to be up 4.1% for the year. The Real Estate index added to its rally, which began at the end of the first quarter of the year, adding 2.1% to the index and bringing its year to date performance to 3.1%.
4. With the exception of the S&P, which is up 1.4% year to date, both the Dow and the NASDAQ continue to be down 1.9% and 1.1% respectively for the year. Nevertheless, looking at the broader indexes you will note that the Russell Value index is up 3.8% for the year, Russell Growth 1.4%, Treasury 4.1% and as mentioned before the Real Estate index 3.9%. It is these broader indexes that have contributed to our positive performance for the year.

V. On a closing and perhaps more optimistic note: This country is at one of the many crossroads that life offers. I find a gleam of hope in the fact that this week gas consumption was down to 8.8 million barrels a day from 9.1 million barrels a year ago (A 3.3% drop). The sale of small, fuel efficient cars was up 1.7% to 15.7% of new car sales last month. Some soccer moms have parked their SUVs and are now driving VWs (USA Today). Some individual areas of the country report a drop in the demand for gasoline of between 6% and 10%. Is this temporary, or are we finally coming to our senses? Roughly 65% of oil consumption in this country is supported by foreign oil. Can we turn the corner and drive down gasoline demand by our purchase choices and driving habits? Can we make use of public transportation, where it is available, or are we just experiencing a temporary shock caused by this 46% increase in oil prices during the last year?

Any change will not be easy. Over 60% of automobiles purchased in 2004 and 2005 are now upside down, meaning that their owners owe more than the vehicles are worth. As a result the movement away from large SUVs to more fuel efficient cars will take time, but a change in attitude regarding transportation can reduce our dependence on foreign oil and allow us to regain some degree of control over this portion of the economy.

The government reports this morning that the forecast for the recovery period for Katrina may not be as dire as originally predicted. This is good news for the long term, but does little to remove my concerns about the average consumer in the coming months. If the market does not dip too severely, perhaps “stronger” consumers can lessen the impact of our concerns.

A final bit of wisdom: I got a kick out of a recent article that suggested, “When people talk stocks, buy real estate, when people talk real estate, buy stocks.” If you look back over the last twenty years this suggestion seems to be on target, and while the short term might be a bit bumpy—it may be about time to “step up” to the plate if stocks dip a bit.

Warmest Regards,

M. Brooks Clark

MBC/alm

*Please remember that Clark Financial Advisors’ office is now located at 4128 Crosshaven Drive in Cahaba Heights. Please visit our website for pictures of our new office, as well as photos and an introduction to our staff. Our phone numbers are the same, but our mailing address is now P.O. Box 43828, Birmingham, AL 35243. For directions to our office visit our website or give us a call.

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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 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.