End of Summer Musings

As the nation’s housing bubble continues to deflate, the general economy remains reasonably robust. U. S. GNP figures for the second quarter showed growth of 3.4%, well above most economic estimates, as consumers and a newly growing export trade (due at least partially to a weaker dollar) pushed growth ahead.

To date, the recent difficulties encountered by home builders, hedge funds, and particularly sub-prime mortgage lenders remain confined to those sectors. Reining in overleveraged borrowers and the institutions that lend to them, and thereby cooling housing prices, should all be viewed as crucial long-term objectives to enable strong, sustainable growth. The Federal Reserve now must work to ensure that these objectives are achieved without putting undue stress on other sectors of the economy.

International markets have largely mirrored the recent volatility in U.S. markets while the dollar seems to have found a short term level at around 1.375 to the Euro. Continued strong international economic growth has increased demand for U.S. exports and keeps commodity prices high.

With crude oil above $70 a barrel, the long-term upward trend of prices continues. Gasoline prices are down as refinery capacity is being more fully utilized in the US.

Short-term trading by hedge funds and others currently gives above average volatility to crude oil prices. For the longer term, however, the upward trend of crude prices continues based on fundamentals. Supply and demand are finely balanced.

U.S. Treasuries have rallied from 5.06% to 4.75% on the ten-year bond. High-yield bonds have sold off sharply – spreads have widened 428 basis points, the highest since May 2005.

We are in a process of re-pricing risk after a number of years of loose lending standards. Thus, we recommend staying in the higher quality bond market with bias to lengthen maturities. The yield curve is exhibiting a more normal upward slope.

Stocks had substantially risen through July 13 reaching 14,000 on the DJIA. From July 13 through early August the market was off approximately 6.5%. To a large extent this represents the systole and diastole of the market, periods of gain and loss alternating, even though the basic trend is still up. Much current market sentiment revolves around sub-prime mortgages and the pressure this has brought on higher-rated loans including private equity loans for corporate takeovers. These credit areas will take possibly a year or two to work out.

Should the economy in the face of credit weakness slow further, the Federal Reserve will likely feel its hand forced and begin rate reductions to revive consumer spending and mortgage lending. Although the resolution of underlying problems will take time to work out, markets will anticipate this and refocus on growing corporate earnings.

In recent years, the market has been through a period of unusually low volatility. We have not had as much as a 10% market correction in almost four years. At the onset of the Iraq war, the market fell 10.5% between 1/20/2003 and 2/7/2003. Within a matter of months the market regained this lost ground. In a more unusual instance, in 1987 the market fell 41% between 8/25/87 and 10/20/87. Within three months a substantial part of the loss was recovered, and by the end of the next year the market had gone on to new highs.

In sum, for the short term there may be additional market volatility, but the prospect of good corporate earnings growth and relatively low inflation will continue to drive well-selected securities upward over the intermediate and longer term.