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Quarterly Letter to Clients

July, 2006

Indices at quarter-end (June 30, 2006):

Dow Jones Industrials: 11,150.22 2Q'06 +0.37% YTD +4.05%

Standard & Poor's 500: 1,270.20 2Q'06 -1.90% YTD +1.76%

A recent political cartoon shows a huge wall being built: it is labeled “U. S. Border”. In the middle of the wall is a sizeable door, bright red, wide open, labeled “Service Entrance”.

But enough of levity. Let’s get down to business.

It all started out pretty good. The markets were nicely higher going into the second quarter, with the Dow Industrials even approaching the all-time high made back in 2000. But then, one week in June, everything changed. There was a widespread tumble, with indices around the world registering a sharp markdown. Japan, India and Russia saw single-day declines that ranged from 5% to 10%; some "emerging" markets showed losses for a one-week period of 30%. While here at home we had a little bounce back, the last few weeks of the quarter were marked by extreme volatility, and all of the gains that U. S. stocks had made from January to May were wiped out, leaving the principal averages only slightly positive by quarter’s end.

The financial press laid it to “interest rate fears”, as if such concerns have not been with us through the prior sixteen consecutive rate hikes. More likely the fear is of the unknown character of the new Fed chief, Ben Bernanke. The Fed did lift rates (number 17), but hinted that its policy of raising may be near an end. That posture was the immediate cause of the market's sharp rise in the last few days of the period.

Various commodities, which had been on a tremendous tear, also hit the wall, with gold at one point falling nearly $200 from its peak, and silver and copper coming smartly off their highs. Oil, bucking the trend, remained stubbornly near $70.

What was so different in June versus May? I would posit that it was nothing more than psychology. The markets, especially the commodity markets, had simply run too far too fast. They needed a break, and they got one. Perhaps we’re just setting up for a nice summer rally. Let’s hope.

The seventeen consecutive quarter-point raises the Fed has imposed have brought the Fed Funds target from a low of 1% to its current level of 5.25%. And still the effect on the bond market has been minimal. Rates on Treasuries and top-quality corporates remain stubbornly low and the yield curve frustratingly flat.

Liquidity is high in the U.S. and in the rest of the world as well, and will remain so as long as we continue to spend money that we don’t have. Our nation’s chronic budget and trade deficits, have, in my opinion, financed a worldwide economic expansion. At the same time they threaten the value of our dollar (here you can read: inflation).

I believe it is just this fear of inflation that has pressured the markets. For quite some time now the investment community has been cavalier about inflation. In private conversation it has been hard to find anyone who believes the government’s inflation figures, but as far as investment activity, the declining dollar has simply not been a factor. Now we have added it to the litany of economic problems. Perhaps it will turn out to be just one more problem that we can continue to ignore.

A slowing economy is widely expected, and while we may now be seeing signs of it beginning, it does not appear to be more than a normal, moderate, cyclical shift. After six years of lackluster performance in the stock market, one cannot have expectations of a roaring bull market cropping up anytime soon. Single digit gains are what we should look for, and be satisfied that they are on the positive side of the ledger. Eventually this malaise will pass and we will be rewarded with higher prices.

I remain somewhat positive about the remainder of the year. As always, caution and patience will be valuable assets. As cash accumulates in your accounts, I will employ it with my characteristic, conservative methods.

Jim Pappas