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Third Quarter, 2007


A few days into the third quarter the stock market climbed to a new high in the face of a gradual decline in domestic economic activity and growing fears of a recession.  As new negative economic reports were released the market turned down with a vengeance, and many leveraged investment funds were forced to sell assets to generate cash for nervous investors and margin calls.  The Russell 3000 Index declined by 10% in 27 days and then the Fed came to the rescue.  Thereafter, the stock market turned on a dime, and by the end of the quarter had almost fully recovered to the high point achieved during the early days of the quarter.  Investors who looked at their portfolios every day had to endure stomach churning market declines on 43% of the days the market was open for business during the third quarter.  Those who, in the fashion of Rip Van Winkle, looked at the level of the stock market at the end of the second quarter and then were oblivious to the goings-on until the end of the third quarter, calmly observed that the broad domestic market gained 1.5% for the period.

Surging mortgage defaults, collapsing big buyout deals, a plunging dollar, rapidly declining home sales and growing fears of recession greeted the beginning of the fourth quarter, but in the face of this drumbeat of negative news, US stock markets remain generally upbeat.

The Federal Reserve has now cut interest rates a second time in the past 60 days confirming its opinion that the economy is gradually slowing down but not (yet) heading into a recession.  The sub prime mortgage debacle continues to spread its malaise throughout the financial sector of the economy.  Most recently, sub prime losses have brought down the heads of Merrill Lynch and Citicorp.  It is very likely that more financial institutions will be announcing massive writedowns of their mortgage securities portfolios in the coming months.  It’s hard to have much pity for these financial titans who are now stuck holding the high risk mortgage securities they created.  Until the securities markets believe that all the bad news is “out there”, the uncertainty felt by investors may very well keep our domestic stock market in a “skittish” frame of mind, adrift without a rudder.

Many economist and other market analysts have commented that the damage remains contained to the financial sector and that the rest of the economy is experiencing just a mild slowdown.  The constant flow of new economic statistics doesn’t support this optimistic point of view.  It’s true that the nature and causes of the subprime problem are well understood.  We know how many subprime loans have been made, when the “teaser” interest rate periods are over, and the number of homes where the mortgage balance is greater than the homes’ value, etc.  However, the bigger problem for the economy seems to be shifting to the increasing difficulty people are experiencing when they seek to obtain bank financing.  Because home mortgages are now being held instead of repackaged and sold, (there are virtually no buyers) banks may have less money to lend to others – call it a credit contraction – which is not good for the economy.

Thus we are beginning to see various signs of spending declines.  Some recent clues of what lies ahead for the economy include:

  1. business inventories are rising;
  2. freight shipments by truck are declining;
  3. railroad freight car loadings are down;
  4. vehicle production cuts (and a new round of auto employee layoffs) have been announced;
  5. temporary employment agencies are reporting rapidly declining activity and their publicly traded stocks have plummeted;
  6. businesses are announcing capital spending cuts.

Ultimately, job losses will start to mount and consumer spending will begin to show meaningful declines.  Mortgage defaults over the next twelve months will continue to fan the flames of broader economic discontent.  If credit conditions continue to tighten and the consumer clamps down on spending, then the U.S. stock market may enter a bearish phase.

Taking all the above into consideration, the Fed has decided to act preemptively and decisively to head off what it now perceives to be the increased chance of a broader economic downturn.  Given that recent home auctions by major builders in various parts of the country have resulted in selling prices 25-35% below original asking prices, we expect that the housing situation will continue to worsen over the next 6-12 months.  Trends for 2007 may result in home auction price discounts of 40-50% below retail in various over-built parts of the country.  Fed officials have stated that their future actions will be governed by the continuing flow of economic data.  We found it interesting to observe that the Fed’s September 18th interest rate cut resulted in an increase in longer-term interest rates and coincided with a jump in the price of gold to a 27-year high as well as an all-time high for crude oil (82.51 per barrel) on September 19th.  One explanation of these market reactions is fear of rising inflation by the investment community causing a growing desire to get out of our fiat paper currency and into almost any type of tangible asset or commodity.

It’s an axiom of investing that the markets of today reflect tomorrow’s expectations of millions of investors around the world, who place their bets with real money.  Presently, markets are telling us that, given the Fed’s change of focus to fighting a potential recession, global future growth opportunities continue to outweigh domestic concerns.  Market expectations are that the home mortgage default rates will be increasing over the next 6 to 12 months, and that many consumers will be hurting for a while, maybe longer.  The market also expects that banks will eventually move through their current period of tightening credit standards and the investors will eventually loosen their purse strings.  In short, the market is telling us it expects that the economy will eventually “muddle through” our current domestic financial crises.  The “muddle through economy” is a term coined by well-known financial writer John Mauldin.

Speaking (briefly) about the dollar, it is under increasing attack around the world as other nations seek to elbow it aside as the world’s reserve currency for global trade.  Iran and Venezuela, for example, want their oil paid for in Euros.  Other petroleum producing countries are not happy selling their oil through the medium of a rapidly depreciating currency.  Rather than continuing to hold dollar denominated investments in the form of treasury securities, the trend is changing to one of acquiring US and other nations’ businesses and assets as a means of reducing dollar denominated short-term reserves.  Such actions are expected to have a long-term positive effect on investment markets here and abroad.

As has been the case pretty much throughout the year, foreign stock markets have continued to outperform our domestic market.  The reason is clear, as most other regions around the world are experiencing stronger economic growth compared to the U.S.   Interest rates on investment quality bonds, while experiencing volatility throughout the first three quarters, were relatively unchanged as of September 30, when compared to their starting point on January 2, 2020.  REITS have continued to underperform most other areas of investment during the third quarter and for the year-to date.  Part of the reason for the poor performance of the broad REIT index stems from the extraordinary declines which mortgage REITS have thus far experienced.

Finally, gold (the commodity) and gold mining stocks have experienced extraordinary gains this year with particularly sharp increases occurring during the third quarter.  It’s interesting to note that gold has moved sharply higher against every major currency illustrating a global desire to reduce exposure to intrinsically worthless fiat paper currencies.

We would like to express our pleasure at bringing on board Paul Whitaker, CFA, who has joined our firm as a portfolio manager and principal.  Prior to joining SIMI, Paul was a senior portfolio manager at Wachovia Bank and Deutsche Bank.  The fit is a smooth one, as Paul’s philosophy for managing client accounts is very similar to our own.  We are all looking forward to a three-party give-and-take process in analyzing new investment ideas, portfolio strategies and wealth management techniques.  You, as a SIMI client, should reap the long-term benefits of our growing firm.


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