Newsletter
October 2, 2006
To Our Valued Clients and Friends:
- Room for encouragement in the broader market
- Danger in the Dow
- A few changes
Many of you may recall my concerns about the US economy as addressed in our third quarter 2005 letter, under the heading, “A Perfect Storm of Debt”. Because of the break in fuel prices and a pause in increased interest rates the current quarter gives us reason for optimism. I believe we must look below the surface to determine whether the economy has real strength, or are we being tempted to commit to the markets because of temporary conditions that may or may not be misleading investors.
ON THE POSITIVE SIDE what a wonderful fall in gas prices! Locally we have watched gas prices drop from $2.99 a gallon to $2.11, a 29% decline in the price of unleaded gas. If prices continue to fall or at least stabilize, the consumer will undoubtedly feel relief along with having more disposable income entering the last quarter of the year, which is important to the retail sector of the economy.
Interest Rates: While the prime continues to be stuck at 8.25%, a 22% increase from this time last year, it has at least stopped its climb each month as the Fed increased the short-term discount rate. While this is indeed encouraging, it does not relieve the pressure on homeowners who have watched a doubling of their interest cost associated with their home equity lines over the last two years.
Mortgage rates have already fallen from the higher levels achieved last month because of a decrease in the demand for home mortgages during the quarter. Ten-year treasury notes, a base for most adjustable mortgages, has fallen from over 5% back to 4.71% during the quarter and is now only 11.9% higher than this time last year. Nevertheless, even with these historically low interest rates, I do not believe that those areas of the country that shouldered the greatest degree of real estate speculation will avoid very real pain during this real estate price correction. As mentioned last quarter there are areas of Florida that have already observed a 25% decline in Real Estate prices.
Debt continues to be a problem for both the government and consumers. Current numbers reflect that our Nations debt now tops 8.4 trillion dollars, a 6.3% increase over last year, while consumer debt increased by over 9.5% during the same period. Any increase in interest rates, will undoubtedly add to the burden of debt service to the country and individuals.
MY CONCLUSION REGARDING THIS ENCOURAGING INFORMATION; Don’t get too excited about the consumer having a few extra dollars in their pocket for Christmas. The Fed is just one decision away from again raising interest rates. Caution over optimism!
DANGER IN THE DOW: I ask that you pay special attention to this portion of our letter, as this is where the real substance of our message is for the quarter. You may also want to warm up your “reading between the lines” talents as this section addresses a potential trap for investors.
The numbers:
| Index | 12/31/05 | 6/27/06 | 9/30/06 | Quarter %Change | YTD % Change |
|---|---|---|---|---|---|
| Dow | 10,717 | 10,924 | 11,697 | 7 | 9.1 |
| NASDAQ | 2,205 | 2,100 | 2,285 | 8.8 | 3.6 |
| S&P | 1,248 | 1,239 | 1,335 | 7.7 | 7.6 |
| Russell Value | 685 | 703 | 762 | 8.3 | 11.2 |
| Russell Growth | 513 | 494 | 524 | 6.2 | 2.1 |
| Treasury | 91.9 | 83.6 | 89.39 | 6.9 | 2.7 |
| REIT Index | 64.1 | 69.2 | 77.15 | 11.52 | 20 |
The quarter turned in some impressive numbers giving credence to the statement that “You cannot afford to be out of the market during those brief periods of time when performance is generated.” All indexes were positive with both growth and value orientated equities increasing in value to their highest levels in five years.
Take a moment and review the quarter’s performance stated as a percent of the year to date performance.
| DJIA | 76% |
| NASDAQ | 100% |
| S&P | 100% |
| Russell Volume | 74% |
| Russell Growth | 100% |
One hundred percent of the year to date S&P, NASDAQ, and, Russell Growth performance was generated during the third quarter. The Dow Jones Industrial Average had over 76% of its year to date performance generating during the period as well.
Volume: An interesting observation regarding the Dow, focusing on the Exchange Traded Fund (ETF) referred to as diamonds. (Symbol DIA) The average volume for diamonds on any given day is approximately 6.7 million shares. Nevertheless, over the last thirty days the volume for “diamonds” has increased to approximately eight million shares a day, or approximately 20% higher than normal.
A review of the NASDAQ and S&P 500 exchange traded funds, referred to as QQQ and SPY note little, if any, change in volume. Higher volume usually represents an increase in demand for the stocks of that index because of a perception of an increase in the potential for the stocks in that index. Lets look deeper! Below are the price earnings ratios, for select indexes for today and, one year ago.
| PE’s | 9/2005 | 9/2006 | %Change |
|---|---|---|---|
| Barron’s 50 | 16.4 | 16.2 | (1.2) |
| DJIA | 18.7 | 22.5 | 20 |
| S&P 500 | 19.3 | 17.89 | (7.3) |
| Prime Rate | 6.75 | 8.25 | 22 |
| P/E “Fair Value” Ratio | 14.8 | 12.12 | (18) |
Please observe that the Barron’s 50, an un-weighted Capital Index, and the S&P 500 have watched their average price earnings ratios decline over the past year, reflecting the increase in interest rates. This makes the stock cheaper as one is paying fewer dollars for a dollar’s worth of earnings. The Dow Jones Industrial Average, which is outperforming both the NASDAQ and S&P 500 by 152% and 20% respectively, has watched its price earnings ratio increase by approximately 20%. One might think that there must “really be something special” going on with the thirty stocks that make up the Dow Jones Industrial Average, right? The index, along with its increase in volume, is climbing and the stocks in the index are getting more expensive. Don’t you think this would suggest that earnings, or the prospect of earnings, must be improving to drive these stocks higher? Lets take a look!
| Earnings | 9/2005 | 9/2006 | %Change |
|---|---|---|---|
| Barrons 50 | 257.11 | 286.66 | +11.4 |
| DJIA | 581.81 | 518.13 | (10.9) |
| S&P 500 | 63.36 | 74.69 | +17.88 |
All information for investment indexes is provided by Barron’s. (10/21/2006)
Earnings for the stocks contained within the Barron’s 50 are up 11.4% over last year. The S&P 500 earnings are up a full 17.8% for the year. The Dow, the most closely watched investment index worldwide enjoyed an increase in volume while its corporate earnings declined by a full 10.9% during the past year. Furthermore, along with being maybe the most easily manipulated index due to the small number of stocks, the Dow has gotten more expensive during the quarter while the stocks in other indexes have gotten cheaper.
Gas prices are down 29%. The Dow Jones Industrial Average is up 9.1%, even though earnings have been declining. Surely, oh surely, tell me that there is not a piece of cheese I smell here. I hope I am terribly wrong, yet I fear for the performance of the Dow Jones Industrial Average and the price of gasoline after the elections in November.
For investors, I believe that the word here should be both caution and a high degree of skepticism regarding the Dow. While the broader market may enjoy an improving position, based on the increase in earnings and the reduction of P/E ratios, the Dow may suffer a decline.
A Few Changes
We wish Jackie Moon success as she departs our small firm to take a position with a local accounting firm. At
the same time, we are delighted to introduce Mario Humbert and Lauren Hanks who have joined our staff. Please take a moment to visit our website to view their smiling faces and learn more about their background. I am very pleased with our current team, as I believe that we can provide you with a level of service and attention in which you will be delighted.
Until Year End!
M. Brooks Clark
MBC/lh
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.
