Market Commentary

Last week the economic news was bleak, and the economy continues to face difficult headwinds. Wholesale inflation in July jumped to a 9.8% annual rate. The July leading economic indicators index declined 0.7% following a 0.1% decrease in June. This index peaked in March 2007 and has been trending lower for more than a year. Speculation about the future of the mortgage giants, Fannie Mae and Freddie Mac, also hit investors’ spirits hard - - until last Friday. And then oil prices dropped sharply and the stock market, after being knocked down most of the week, rallied back up on Friday. For the week, it was a split decision between the bulls and the bears.

Many economic indicators topped out last fall, and our economy probably has been in a recession since December 2007. Despite this, a leading newspaper stated on Sunday that “Now, high energy prices, financial systems crippled by fear, and the decline of trading partners have combined to choke growth in many major economies.” All of this is true, but very old news, and thus has already been a factor in our now 11-month-old bear market. Investors are down, but not out. The final arbitrators of the stock market’s direction are supply and demand for stocks, which is very bullish, and investors’ mood, which is improving.

If you are feeling worn out and frustrated with the stock market, join the crowd. This bottoming market action is no fun, but it does set the ground work for the next bull market. However, be aware that the very light trading volume typical of the month of August can cause very volatile market swings. The next big event will be the Nov. 4 presidential elections. At this time, the stock market acts like it has put the election on the back burner. However, the presidential race will probably heat up again as a stock market factor around mid-October. So how should an investor deal with this do-little, exasperating stock market? We continue to advise investing in stocks and patience as the way to come out of this dull, bottoming market with a portfolio of stocks ready to participate in the next bull market. The market acts tired of the old bleak economic news, but not energized enough to get its blood and enthusiasm flowing.

The long-term record of the stock market has been positive, and most realize this. What is required for one to buy stocks is confidence in the future of our economy, or a global economy. Confidence is slowly growing in the stock market as can be seen in the market’s uptrend since mid-July.

Of course, everyone would like their stocks to go up quickly and in a steady fashion, but that is usually not the case. In fact, when the stock market is one big party and stockholders are all smiles, the market is probably getting into trouble — think early 2000. The value of a stock is determined first by the mood of investors and then by the company’s own fundamentals. When investors are in a good mood, they are willing to pay more for stocks, and thus price/earnings multiples rise. Of course, the opposite is also true. The mood of investors controls how a company’s internal fundamentals are perceived. If folks are in a good mood, even a negative development is often ignored. When the mood is gloomy, even good news will not help a stock. Mood shifts are what cause the market’s ups and downs, and this creates the need for patience.

Stockholders are subject to rather sharp shifts in mood. If a long-term investor is patient, they will live through short-term market declines. If impatient, one tends to get caught up in a mob mentality, and following the herd is usually a mistake. We are not saying that stocks should be held forever as there are times to reduce one’s exposure to the stock market. But after almost 11 months of a bear market and after being hit by myriad problems, it is now time to invest in selected stocks.

For example, this past week oil and most commodity prices dropped sharply and the dollar rose — good stuff for the economy and also inflation depressants. We had the same situation two weeks ago, and the stock market rose sharply. This past week, the market just churned around. We had the same positive environment but different market reaction as the mood cooled down a bit.

As the old saying goes, “We have met the enemy, and he is us”; and that is one of the major problems facing investors. All of us, whether a new or experienced investor, are controlled by fear and greed. We have all been living with a bear market for approximately 10 months and a lot of very serious fundamental problems. In effect, a number of unprecedented problems caused, only naturally, a big spike up in investor fear. But the fundamentals have changed in a positive direction, and so has the stock market. Now here is the problem: Investors, being mere mortals, do not recover from shocks quickly. Instead, a kind of post-traumatic stress syndrome sets in and most investors become paralyzed and are unable to adjust quickly to the changes in the fundamentals. This can be a costly human frailty.

The stock market advanced sharply last week, and for good reason. Oil prices dropped dramatically, the dollar rose sharply and it became increasingly apparent that many foreign economies were beginning to show signs of recessionary conditions. For the dollar, the long five-year slide appears over. Oil prices have broken their year-long uptrend, and for fundamental reasons as global demand is weakening. And the stock market did well despite big quarterly losses at the mortgage finance giants, Fannie Mae and Freddie Mac. Also, there is little reason to believe that bank write-offs are behind us. The message delivered by the positive stock market action is that some big institutional-type investors have begun to look beyond the valley of our current problems to an eventual return to more normal conditions.

It is not easy to overcome post-traumatic stress syndrome after a bear market. If it were easy, everybody would be a buyer of stocks, and thus there could not be a stock market. How can one put normal fears into perspective and let a little greed slip into our emotions? For starters, write a big note to yourself that says, “The best time to buy stocks is when it is extremely uncomfortable buying stocks.” And back it up with some fundamental reasons to buy stocks - - (1) everybody with a pulse knows all of the problems, so they are already substantially baked into stock prices; (2) stocks represent very good value relative to other investable assets; (3) we have a very friendly Federal Reserve, and interest rates are not going up anytime soon; (4) there is a record level of sidelined cash; and (5) there is a level of gloom and doom often seen at important bottoms. The long-term winners in the stock market, and in life, are those folks who overcome the enemy within all of us.

The U.S. economy, and thus the stock market, have been hit by major events — collapse in home prices; subprime mortgage debacle and the subsequent severe credit market problems; and a leap in oil, gasoline and food prices. Any one of these could have caused serious economic problems. All of them coming at the same time was potentially a major shake up to our economy. Many supposed pundits in the media talk as if we are in for an economic Armageddon and advise folks to run, don’t walk, out of the stock market. In our opinion, the critical point is that despite a serious shake up, the economy is not collapsing and the stock market is in a bottoming process. Yes, the United States is probably in a recession that was due anyway after six years of economic expansion. What investors should focus on is why our economy has been able to bend, but not break, and what this says about the future.

Let’s look at the latest economic news in a fair and balanced fashion. Second-quarter inflation-adjusted GDP increased at a 1.9% annual rate. Not bad at all, but it was helped by the tax rebates and continued strong exports. On the negative side, fourth-quarter GDP 2007 was revised to a -0.2% annualized decline. Also, July nonfarm payrolls fell 51,000, the seventh consecutive monthly decrease in jobs. And housing continues to dampen output. Yes, the economy is soft and will probably stay that way for the rest of the year. But how is the overall economic environment as compared with the multiple shocks it has received? The unemployment rate rose to 5.7%, which is not a good thing; but not too many years ago, a 5.5% rate was considered full employment. A number of sectors of the economy - - energy, high-tech, exports - - are doing pretty well. And many economists believe we are not even in a recession. We don’t agree, but it does look like hindsight will show that the recession was not severe despite all of the problems. That says a great deal about the diversity and depth of our economy.

The stock market is doing a good job of wearing out investors’ interest in owning stocks, and that’s one way market bottoms are created. Rallies have been okay, but not strong enough to really excite the record-setting level of cash on the sidelines. Pullbacks have been fairly heavy, but so far not dramatic enough to cause a total capitulation and selling climax. Yes, the stock market is making investors struggle hard to look ahead, beyond today’s shocks, to better times ahead. If you know someone who truly believes the economy will never get better, give them a book about American history. A new bull market will start when confidence in the future returns, as it always has. Meanwhile, one should focus on the positives that most are ignoring: a very friendly Federal Reserve and Treasury; a very high level of gloom and doom; lots of cash on the sidelines available for stock buying when the mood improves; probably a recession, but not a severe one unless oil soars up to and over $150 a barrel and stays there. And remember, shake ups shake out the problems.

Confidence in the future of our great nation and economy is what is lacking in today’s stock market. This trust in the always unpredictable future is what allows investors to look beyond the valley of current problems to peaks, or better times, ahead. The bears believe that rallies of the past several months, and subsequent declines, have been a “confidence game,” or basically a swindle perpetrated on gullible investors. We strongly disagree. Every day the news is full of the same list of problems — bank write-offs of bad assets; home prices; gasoline prices; soft labor market; geopolitical problems; a probable recession. The news reads like an obituary for the U.S.A. Of course the media loves to accentuate the negatives, because bad news sells, and often eliminates any positives because they reduce fear.

The media likes extreme news, either bad or good, as that sells newspapers and increases the viewing audience. In reality, the news more often than not is grey and not that interesting, which makes it tough to fill TV time. Much more important to the stock market is the action of the stock market itself. Nothing attracts stock buyers more than several weeks of a rising market. This bear market started in October 2007 and has had almost 10 months to do what bear markets do — drop stock prices to levels that initially causes a few brave souls to ignore today, have confidence in tomorrow, and buy stocks. Bear markets end in one of two ways. The easiest to identify is a selling climax in which a bear market experiences a day of very large volume and a severe decline, but then a reversal to the upside. We have not, unfortunately, had one of these.

The more common bear market bottom takes many months of volatile action both up and down, some severe declines and yet only modest rallies. This type of bottom eventually wears out most investors who basically lose interest and confidence in ever owning stocks again. That is the current situation in the market. It is not a confidence game. It is a bear slowly transitioning to a bull. Investors have had 10 months of mental and fiscal anguish. They are like a patient who has had major surgery. After a bear market, or after surgery, the investor or patient does not recover overnight — the healing process takes time. This recuperation period isn’t fun, but those investors who use it to accumulate stocks selectively, or those patients who do required rehab, benefit in the long run. The sky is not falling and our economy remains basically sound. Home prices will recover, eventually. Banks will clear up their balance sheets, eventually. The economy will perk up, eventually. Confidence in our nation’s future has been valid since 1776, and it is not a “confidence game.”

Oil prices dropped sharply, and the stock market put on a big rally - -from Tuesday’s lows to Friday’s highs, both the DJIA and S&P 500 leaped up close to 6%. On Sunday, a week ago, Treasury Secretary Paulson proposed a very broad plan to rescue Fannie Mae and Freddie Mac, the giant mortgage finance companies. But wait, the shakin’ didn’t end there. The SEC proclaimed that short sellers in a number of financial stocks would have to play by the rules and not do “naked” or uncovered shorting. This news was partially responsible for dramatic rallies in many financial stocks. After six weeks of decline, the stock market was ready for at least an oversold rally and it had lots of reasons to bring in the buyers. But was the big rally just an aberration or the start of something bigger?

Last week’s market action and the background news look like the start of something bigger. How big and how fast it happens depends on the price of oil. If oil prices continue to drop short term to the $100-$125/barrel range, it would do wonders for a lot of fundamental problems. Gasoline prices would come down, consumers would feel better, inflation fears would be reduced and even the housing market would benefit as confidence improves. If oil leaps back up, it will probably be a long time before the big stock market rally last week is repeated. We are encouraged by the fact that many Americans are totally disgusted by the lack of a constructive energy plan for the past thirty years. We believe the people will be heard and Congress will finally attack our very serious energy problem. Even talk about conservation and increased drilling can push down oil prices. Most likely both presidential candidates should make energy one of their most serious issues.

Economic reports this past week showed increased inflation as the overall June producer price index jumped 1.8%, but rising food and energy prices are not significantly boosting other prices. The core rate of producer prices increased just 0.2%. The June core consumer prices index increased only 0.3%. This puts the 12-month core inflation rate at 2.4%, but this is still above the Fed’s preferred range of 1.0% to 2.0%. Although two regional Federal Reserve measures show manufacturing and business contracting, they did show that output is not contracting as broadly in July as in June. The geopolitical news from the Middle East seemed a bit improved, but not enough to cause any real positive shakin’ to go on. To keep this bear market transitioning to a bull will require continued help from oil and improving investors’ mood. It won’t happen overnight, but eventually investors will change their mood from fear to greed.

“Are we there yet?” is the question my kids used to ask (what seemed like every five minutes) when we would drive from Utah to California to go to Disneyland. It’s the question investors are now asking on our journey to “the bottom” of this decline in the market.

Whether or not we’ve hit the bottom yet, and therefore time to buy stocks, is the question that’s on every investor’s mind. Unlike a trip to Disneyland where we can know for sure when we’ve finally arrived, with the stock market we can’t knows for sure when we’ve arrived at the bottom. We can only know that we’ve been there after the return journey back up has begun. If you are willing to accept that answer, you have taken a big step toward being a successful long-term investor.

So then, what are we supposed to do when attempting to accumulate wealth by investing in the future of our economy? The first question to ask yourself is whether or not you have faith in the long-term growth of our country. Growth that has continued since 1776 based on our democracy and free enterprise system. If you do not, stop reading this report. If you do have faith in our country, ask yourself one major question: Would you rather buy stocks after they have been going up for a long time or after a long decline? Bear markets occur approximately every four to five years and do one very good thing — they create great buying opportunities for the long term.

Sounds simple! The problem is: how does one know whether a bear market is about over, half over or just getting started? Again there is no way to know for sure… but there are some guidelines to follow. This bear market started nine months ago, the popular averages have dropped more than 20%, and many individual stocks have declined much more. The level of fear is great, sidelined cash and shorts are at record levels, and it is very difficult to find a bull. All of these factors are seen in the area of a potential bottom, but they are no guarantee we won’t see the stock market lower. These factors do say that the risk/reward ratio in the long term is much improved from what it was one month or nine months ago.

Almost every American, we believe, has faith in our nation’s long-term outlook. The biggest challenge all investors face in buying stocks after substantial price decline is their own state of mind. After big market declines, most folks are depressed, pessimistic and certainly not in the mood to buy stocks. Successful investors control their emotions and buy when it is uncomfortable to buy. To protect against a possible further market decline, we suggest taking only partial positions. Keep some cash to use if the market goes lower or when market action improves. The failure of IndyMac Bank, the giant mortgage lender, is a dramatic financial event that has often started at least a short-term market rally. The U.S. Treasury and Federal Reserve placed the federal government firmly behind Fannie Mae and Freddie Mac - another possible bottom development. Is it time to buy? We can say with complete confidence that we don’t know for sure. However, market history says it remains time to do selected buying for the long term.

Although the long-term outlook for the stock market should be investors most critical concern, most of us are deeply influenced by short-term market action. It is almost impossible not to be emotionally impacted by daily and weekly market action. Certainly, the poor action of the stock market the past four weeks has many investors worried. So let’s take a look at both the short-term (a month or so) and long-term (six months to several years) market prospects. First, the short term. The DJIA, S&P 500 and Nasdaq Composite have been dropping, and the advance/decline ratio has been negative for most of the past four weeks. Yes, there have been some several-day rallies, but overall market action has been negative. This pullback has created the preconditions for a short-term, oversold rally.

A month-long selloff creates a high level of fear and a very low level of greed — a characteristic of at least a short-term bottom. Also, a decline in stock prices obviously reduces price/earnings multiples thus making stocks more attractive for purchase. The market does not go straight down or straight up, and the current level of gloom indicates a market environment in which, at least for the short-term, the sellers have sold about all they want to sell. We have the preconditions in place for a short-term rally.

The long-term outlook is a different tale. We continue to believe the economy is in a recession that started in either December or January. Investors had begun to look past the subprime mortgage, credit-market and home price problems to better times head. The problem investors are unable to look beyond at this time is the steady increase in oil prices.

If the price of oil continues to rise and stays high for a period of time, the “garden variety” recession we believe the economy is in would turn into something more severe. It is the ability to look beyond the valley of a recession to better times ahead that starts new, long-term bull markets. The price of oil needs to start coming down soon or this bear market will drag on much longer than we had anticipated. Oil, like any commodity, eventually reaches a level where demand is reduced and supply is too abundant. A lot of the oil price increase has been emotional, and moods often change when least expected. Anyway, oil remains the big long-term uncertainty for the market. Economic data last week showed the economy continues to weaken, but not collapse. The June Institute of Supply Management (ISM) manufacturing index actually rose to 50.2, which indicates expansion. June nonfarm payrolls declined 62,000, the sixth month in a row of contraction. The short-term tale of the market is that a reflex bounce is probably close. The longer-term tale is still held captive by the price of oil.

This past weekend, the news media was full of a statement that we are “on the threshold of a bear markets”. Yes, the DJIA has now dropped 20%, the classic definition of a bear market. But the word threshold is very misleading and could cause a lot of investors to panic at the wrong time. Threshold means the “beginning stage” of something. Folks, this bear market started eight months ago, and the damage to stock prices has already been bearish. The market is not at the threshold of a bear. The 20% decline in the DJIA simply confirms what has been going on for eight months. Since February, we have stated that we were probably in a bear market and also in a recession. The threshold of the bear market was October 2007. The threshold for the recession was probably December or January.

OK, now that we hopefully have put this stock market into proper perspective, let’s get to reality. Market action last week was very poor. Thursday’s market collapse showed classic signs of capitulation, but there was no upside reversal and thus no reason to call Thursday a selling climax. Everyone knows the problems: the dollar, concern about inflation, the financial sector and fear that oil prices will turn a probable normal economic recession into something more severe. These are very serious problems, but they too shall pass. Last week in our Market Commentary we added more caution to our near-term market opinion. We also stated that “the wait (for a better market) may be longer than we had believed,” and market action this past week supports this adjustment to our opinion. But it doesn’t change our long-term opinion.

For investors, our advice is to stay cool, hold approximately 20% cash buying power and if underinvested, do some selected buying. Things always look the bleakest and the news is always bad in bottom areas. Where the final bottom is, no one knows, but we are encouraged that the S&P 500 is now selling at approximately 15 times 2008 projected earnings compared with the 10-year average of 18.7. The past 10 years cover both a bull period and a big bear market. The Federal Reserve last week kept interest rates unchanged and stated that the upside risks to inflation have increased. They also stated that they still expect inflation to moderate later this year and that downside risks to the economy still remain but have diminished somewhat. With so much gloom and doom around, let’s look at some good things to dream about: (1) oil prices drop because of reduced world demand, (2) the dollar firms as a result of a global effort, (3) the Fed raises interest rates as they believe the economy can tolerate it (This would help the dollar, hurt oil prices and reduce inflation fears.), and (4) Americans again realize the wonders of our free enterprise system and democracy. Yes, words do count, and out there somewhere will be the threshold of a new bull market and an economic recovery.

Last week we stated that the three main market worries are oil, the Federal Reserve and consumer sentiment. However, the stock market was hanging in there. Unfortunately, all three of the market worries worsened this past week, and the performance of the stock market turned ugly. When the market speaks through how it acts, we must listen and react. We thus are adding a bit more caution to our near-term market opinion. The first of the three main worries, the price of oil, rose again, which caused increased fear of the current “garden variety” recession or sharp slowdown possibly turning into something more severe. If it does, our prediction of a 5% decline in corporate earnings for 2008 is too optimistic. Part of the oil price rise was due to the fear of increased tensions in the Middle East, but the Federal Reserve, one of the market’s three main worries, also contributed to the price rise.

A few weeks ago, Fed Chairman Bernanke signaled that the Fed was going to increase its focus on helping the dollar. The dollar did firm up, and oil prices dropped. The stock market rallied as fears of “stagflation” were reduced. But this past week the press picked up leaks of news that the Fed will not raise interest rates anytime soon, and oil prices shot up again. The Fed knows what it is doing and the implications of its action, but it is a very tough task. Raising interest rates would help the dollar and also push oil and gold prices down - that’s the good part of the equation. The dark side is that our weak economy will weaken further if interest rates are raised before the economy is strong enough to handle higher rates. Do we hear any volunteers for the Fed chairman’s job?

Consumer sentiment is fragile these days with home prices so weak and gasoline prices so high. Nothing last week helped settle folks down. Investor sentiment took another hit as credit ratings for the major bond insurers were lowered, which brought renewed selling pressure on the financial stocks. In our opinion, oil holds the key as to how soon our economy turns back up. Another big and lasting jump in prices would delay the recovery until much lower world demand brings oil prices down. If oil drops or settles in this $135 per barrel range, the economy could be doing better toward the end of 2008. Potentially, the quickest way to lower oil prices would be a strong dollar resulting from either higher interest rates or a global effort to support it. No one knows for sure the what and when of oil prices, but the fundamentals, in our opinion, call for lower prices. Stock market action last week said investors are taking a “wait and see” attitude. The wait may be longer than we had believed, but the good news is that the stock market is already down, and stocks are reasonably priced as the problems are very well known.

A good investment at this time is in patience. Continue doing your searches, adding to your watch list and be ready to take action when the stock and the time are right.