Newsletter

December 29, 2006

To Our Valued Clients and Friends:

1. Confessions
2. The International Markets
3. 2007

I. Confessions—I guess I just do not get it!

Today is Sunday, the 26th of November, the Sunday following Thanksgiving. We came to the beach here in Perdido Key for the holiday, and because I am visiting with clients in Destin and Apalachicola tomorrow, I have remained behind while Beth, Haley and Brooklyn have returned to the “Real World.” Because I was alone for the afternoon, I took the opportunity to take a long walk on this familiar beach we have been visiting for more than 20 years. In the solitude of a beautiful afternoon, not a cloud in the sky and 75 degrees, I find myself in front of an abandoned beach house about a mile down the beach. Although the property is abandoned, it is not old. As a matter of fact, I remember the house being built about 1992. I remember also that Beth and I commented on its architectural significance to the beach, as the property’s wonderful art deco design looks as if it was lifted from the mid-1940s. The home now stands deserted between two bland and enormous condominium projects like so many that have made their way to Perdido Key. What I found at least a little bit ironic is that each of the new condo buildings, each with well more than 100 units, is just as deserted as the abandoned beach house this afternoon. At least the beach house is awaiting relocation to a quieter portion of the beach, but the condo behemoths are here to stay.

In sharp contrast to a year ago, this afternoon, there are open house signs in front of every condominium building here on The Key, with as many as a third of the buildings’ finished units for sale by “investors” who never intended to occupy the property. The condo “flip” has now become the condo “flop.”

This is what I just don’t get: Whether it was the Tulip Investment craze of the 1630s, the NASDAQ Bubble of 2000, or the current deflating of the resort housing bubble, why do investors always think that they are smart enough not to be the last one holding the “over-inflated ball”?

These investment bubbles are all based purely on “The Greater Fool Theory.” With this theory, you throw logic out the window in the hopes that there is a “greater fool” who will bail you out of your investment position by paying you an even higher price than you have just paid. Now, at this point, many of you may be saying, “Oh, Brooks, get off your soapbox; we have heard you tell this story so many times before.” And, you’re right. Nevertheless, I wanted to stress just how deeply this speculative foolishness has driven the resort condo market. In turn, the resort condominium market’s current decline will add to the effects of a slowing economy and the decline in broader housing, which combined with the decline in the United States’ international stature and weakening dollar, may lead to our investors seeking additional international exposure beyond current levels.

II. The International Markets

On Friday morning, the 24th of November, the U.S. dollar fell to a multi-year low against the euro, British pound and Japanese yen. Perhaps the logic for the dollar’s decline on Friday was that the U.S. economy is now viewed as one that is beginning to slow, causing international investors to seek greener pastures where the “grass” is denominated in euros and yen.

Beyond this perception of a slowing U.S. economy is the balance of trade payment problem that the United States has due to its purchase of $700 billion more in goods and services from foreign suppliers than foreign suppliers purchase from the United States. This imbalance of trade results in foreign suppliers having to convert $700 billion a year in surplus dollars back into their home currencies. This results in enormous downside pressure on the dollar because there are so many folks selling dollars while buyers are becoming more reluctant to absorb and hold the dollars created by this ongoing trade imbalance. Over the last 30 years, many foreign suppliers have chosen to leave their surplus dollars invested in U.S. equities and United States Treasuries. This is why more than 45% of issued 10-year treasury bonds are now owned by foreign investors. But what will happen if the decision is made to no longer hold those bulging surpluses in U.S. dollars? Deputy Governor Wu Xiaoling of the People’s Bank of China recently addressed countries accumulating massive foreign-exchange reserves: “Firstly, long term interest rates are falling, reducing returns on bond investments. Secondly, the exchange rate of the dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for East Asian reserve assets.” (China recently cut its U.S. dollar dominated foreign currency surplus from an 85% position to slightly under 70%— a 15% drop in its dollar holdings.)

The “lightening up” of U.S. dollar positions held by foreign suppliers, combined with the U.S. federal budget deficit, continues to place downward pressure on the U.S. dollar. And herein lies the dilemma for the Federal Reserve—how do we support the dollar on the international stage while attempting to keep the U.S. economy from slipping into a recession?

III. 2007—The Tale of Two Markets (written December 12, 2006)

We are observing two investment markets, the equity market and the bond market, and I believe they are sending two very different messages. The bond market, usually the wiser of the two, is telling us that the economy may be entering a recession as interest rates decline and investors move to treasuries for safety. In early December, the yield on 10-year treasuries dropped to 4.43%, the lowest rate all year, and down from 5.25% mid-year when people were a bit more optimistic. The bond market is clearly sending us a warning to “fear a recession.” Yesterday, the Philadelphia Fed reported that the countrys gross domestic product fell to an annualized rate of only 2%, with part of the slow down being attributed to a 25% decline in housing starts for the year, along with a 33% drop in the request for construction permits. We might also consider the effect that a 68% nationwide increase in housing foreclosure will have on the economy. In previous letters I have mentioned the large number of adjustable rate mortgages that are “resetting” in 2006 and 2007. I believe we are seeing only the “tip of the iceberg” with regard to foreclosures and the effect that these foreclosures will have on the economy. For those of you in Jefferson County, in September there were 354 houses in some stage of foreclosure, a 669% increase above the previous year.

It would appear that the bond market is sending a more intelligent message than that of the Dow. The Dow, higher until this week, has gone merrily along, up almost 16% year-to-date. A deeper look at the strength of the Dow suggests some concern. The price earnings ratio, the ratio used to determine what investors are willing to pay for $1 in corporate earnings, has climbed to $21.81 compared to $19 a year ago. The Dow is hoping for a growth in corporate earnings, while the bond market is signaling the exact opposite.

The broader S&P500 index is a bit more reasonable with its price earnings ratio sitting at 18, or 16% “cheaper” than the Dow. I feel that this index is slightly overpriced, yet it does provide some comfort in the suggestion that a decline in stock prices might not be as severe in the broader market than in the Dow. (Our “fair value, price earnings ratio, determined by dividing the prime rate into the number one, stands at 12. For the Dow’s current price earnings ratio to be justified, earnings must improve and interest rates must decline.)

Just about all of the year-end financial publications appear to be optimistic about the year 2007. Many of the quoted analysts are suggesting a greater allocation toward U.S. stocks. I find myself going in the opposite direction. I believe that the Federal Reserve will be placed in a position where they will not cut rates in early spring, because of the need to support the dollar. One way to encourage foreign investors to hold or purchase U.S. dollars will be to increase interest rates. The lack of an interest rate cut in the spring by the Fed, or heaven forbid, a rate increase, could cause a correction in the market that I do not believe is being properly considered. I believe the best position to be in, with this possibility on the horizon, will be to increase our allocation in balanced funds, international securities, and international real estate exposure. Each of these allocations will be inserted into your portfolio in early January.

In closing, I would like you to consider a few longer-term concerns that I have for our economy. I believe that our economy will always be one of the world’s strongest, but I believe that our economy, and our country, have seen the peak of their economic prowess and international stature. While many have rejoiced that the Dow Industrial average has hit new highs recently, I remind you that both the S&P and NASDAQ indexes have yet to reach the levels that they achieved in early 2000. In March of 2000, as we all recall, the market began a painful correction. This correction began when economic conditions were actually quite sound. Consider this:

• In 2000, the unemployment rate was 4%; it is 4.4% today.
• In 2000, the gross national product was growing at a rate of 7.3%, compared to 1.6% today. (Forbes, Nov. 7, 2006)
• In 2000, Light Sweep Crude was selling for $26/barrel; now it is $62/barrel.
• In 2000, the country’s national debt was $5.7 trillion. Now, that debt is $8.5 trillion, a 49% increase in just six years.

While there has been much attention paid to the Dow Jones Industrial average, which contains 30 stocks, please note that 20 of those 30 stocks have not achieved a level equal to their price on Jan. 14, 2000. The entire rebound in the Dow Jones Industrial average is found in 10 of the 30 stocks.

Here is a sobering statistic. In the year 2012, for every one person entering the workforce in this country there will be two leaving—the Baby Boom is retiring!

It is the combination of these observations that suggest that we must be willing to look beyond our own shores for investment opportunities in the future.

The numbers:

Index	12/31/05	6/27/06	9/30/06	12/29/06	Quarter %Change	YTD % Change
Dow	10,717	10,924	11,697	12,436	6.5	16.2
NASDAQ	2,205	2,100	2,285	2415	5.6	9.5
S&P	1,248	1,239	1,335	1418	6.2	13.6
Russell Value	685	703	762	818	7.3	19.4
Russell Growth	513	494	524	554	5.7	7.9
Treasury	91.9	83.6	89.39	88.47	(1.0)	(3.7)
REIT Index	64.1	69.2	77.15	83.82	8.6	30.7

We have had a very good year, and we appreciate your faith and support in our firm. Thank you from all of us.

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 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.