4.15.20082008 1st Quarter Client Newsletter April 2008 Economic Update: The consumer is strapped! Our belief is that we are in a recession, the severity of which is yet to be determined. The economy should continue to slow as the consumer is spending more than ever on the necessities of food and transportation. February unemployment has risen to 5.1%, its highest level since September 2005. We commented a few newsletters ago that as long as unemployment remains low, the economy will be fine. The fear of rising unemployment has become reality. Hopefully, it will not spiral out of control and will moderate. Market Update: The worst quarter in 5 ½ years We aren’t convinced the current stock market correction is complete. In the very least, we expect the market to re-test the January 2008 lows, which are 5.5% lower than the current market. The credit markets (bonds) are flashing warning signs, the consumer doesn’t have any discretionary spending, and corporate earnings estimates are too high. The credit markets continue to be disconnected with the global equity markets. For example, secure bank debt in some cases is priced cheaper than unsecured debt from the same issuer. The riskier asset is more expensive than the less risky asset from the same company. This makes absolutely no sense. In a second example, municipal bonds, with federally tax-free interest, yield more than US treasuries, which are subject to federal income taxes. At one time last quarter, municipal bond interest rates were 17% higher than treasury interest rates. If we factor in federal income taxes, municipal bonds were yielding 80% more than US treasuries. How on earth can one say capital markets are efficient? This makes no sense. Another example of the current market environment is the real rate of return (interest rate minus inflation) offered by US treasury bonds. The annual inflation rate is 4.3% and the 10-year US treasury interest rate is 3.5%. This is a pre-tax real rate of return of -0.8%. Since US treasuries are taxable and assuming a 30% income tax rate, the after-tax interest rate is 3%. The after-tax real rate of return offered by 10-year US treasuries is -1.3% (3% - 4.3%) per year. Admittedly this is a single observation; however, something has to give eventually, because the current yield/inflation relationship is unsustainable. Either inflation has to decrease, or rates have to rise, or a combination of the two. Back to why we think the market will suffer, the consumer can’t increase their discretionary spending with high fuel and food prices. We estimate the average household is spending $2,000 - $3,000 more on food and gasoline than this time last year. In conclusion, the markets are signaling additional problems and the consumer’s financial health isn’t good. As a result, corporate earnings will decrease. Portfolio Update: Continued Caution Given the prevailing economic conditions, we believe this is the time to be cautious and to reduce risk. Toward that end, we ended the quarter with our most conservative position since our inception. We strategically repositioned portfolios by selling our riskier small company international, Asia and the underperforming Schwab Hedge Equity positions. Strategically, we bought large companies when the market was panicking and deeply oversold. We expect the Dow Jones Industrial Average to be the best performing index for the next few years. Its 30 companies are paying high dividends, have low debt, and more predictable earnings. If unemployment rates continue to increase, we will remain conservative. If unemployment rates come down, we will be willing to accept more market risk. Thank you for your continued trust and support. Trevor K. Holsinger, CFP