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Quarterly Letter to Clients

October, 2007

Indices at quarter-end (September 30, 2007):

Dow Jones Industrials: 13,895.63 3Q'07 +3.63% YTD +11.88%

Standard & Poor's 500: 1,526.75 3Q'07 +1.55% YTD +7.64%

A recent cartoon shows the New York Stock exchange façade with bright yellow “caution” tape in front of it. Caution is indeed the watchword.

The big news of the quarter just ended was the Fed’s action of cutting interest rates by 50 basis points (one-half of one percent). This was a reversal of the Fed’s policy of the last couple of years, and came in response to the sub-prime lending crisis (which has been the big news of the last two quarters). Stocks rallied sharply on the news, in what I would describe as a relief reaction, a psychological kneejerk. It feels to me, at least for the moment, that we are seeing the top in stocks.

That the economy is slowing seems to be a given, and the Fed’s action of lowering rates only serves to confirm that opinion.

Now here’s an interesting thing: a couple of years ago, while the Fed was making all of those consecutive quarter-point boosts to short term rates, the long term rates went down. Skip ahead to today: after the Fed cut short term rates, long term rates have moved up. Perhaps you have to concede that the market is in control, and not the Fed. At least the yield curve is normalizing.

Stocks continue to gyrate wildly. July, August and September saw the Dow hit levels of 14,000 (a record high), then slide under 13,000, and then rally back over 14,000. That last push was the reaction to the Fed, but two one-thousand-point swings—around seven percent in each direction—in the course of two or three months do not make for a settled stomach on the part of this writer.

I mentioned that the Fed cut rates because the economy is slowing. We also have oil prices climbing to new highs, and the dollar going to new lows. Government spending has not slowed, and our Federal debt is poised to rise above 9 trillion dollars.

Given that demand for housing has dramatically slowed, it is probably a non-issue that money for mortgages has dried up. It remains to be seen if lower rates will ease that situation. We are even beginning to see cracks in the leveraged-buyout business. As the easy money disappears, deals fall through and buyer’s remorse is a more common emotion at some buyout shops. Just desserts if you ask me.

So why are stocks still at this level? I confess that I don’t know. Perhaps it’s because investors don’t want to put their money into real estate. Or perhaps they see that while corporate profit growth is slowing, it’s still growing. Maybe, with interest rates so low, there’s just no other place to put your money. Or maybe it’s all of that excess cash that I have talked about previously. But overall, my gut tells me that prices should be lower, for stocks and for bonds.

Bond redemptions are accelerating as corporations rush to refinance at lower rates. My sense is that this is their last chance to do so, and that rates will be higher, significantly so, within a couple of years. Bond investors will be well served by keeping maturities short and quality high.

As for stock investors, buying high quality companies at reasonable prices is always in fashion. We will doubtless continue to see dramatic swings in both directions, and I hope to be able to use downdrafts as buying points. Volatility notwithstanding, if we stick to a long-term philosophy I believe we will be rewarded.

Jim Pappas