7.15.20082008 2nd Quarter Client Newsletter Economic Update: What’s going on? Whether or not we are “officially” in a recession, it sure feels like one. Food and energy costs are consuming an increasing percentage of disposable income. The US rate of inflation including food and energy is up 4.9% through May versus 2.6% one year ago. The energy component is up 28.2%, transportation is up 8.7%, and food is up 6.2%. The inflation fears are overblown and we feel inflation will moderate because weak employment and wealth destruction are both deflationary. Unemployment increased to 5.5% in the 2nd quarter, the highest rate since October 2004. Over the past 4 quarters, wages have increased a mere 0.7%, versus 4.3% the previous twelve months. Over the past year, total wealth loss in our economy was $5.2 trillion comprised of $2.1T in stock market losses and $3.1T in housing value losses. The housing market continues to decline with home values down an average of 17.8% from their peak. Foreclosure rates are up 53% year over year. Over the past 3 months, commercial bank credit contracted at a 7.2% annual rate – a record decline since 1970. Bank lending standards are as high as they have ever been and credit availability is severely constrained. The economy cannot grow without an expansion of credit. Market Update: Do you like roller-coasters? As we forecasted in our April newsletter, we expected the market to retest its lows. It has. By the end of June, US stock markets were officially in bear-market (-20% from the October 2007 highs). June 2008 was the worst June (-8.6%) for the S&P 500 index since the Great Depression! The stock market, even after the recent correction, is still expensive on an earnings basis. Historically, the P/E ratio of the S&P 500 index is 15. After the June decline, the P/E ratio is 20.56. Historically, all markets overpriced to bubble status will, over time, revert back to their mean value. This process typically results in markets falling significantly below their mean. The primary issue is profit margins are too high. In other words, companies are making too much money. The economic slowdown will reduce profit margins, corporate profits, and stock prices. We believe that some sectors in the market are oversold and will lead a “bear-market rally” as investors buy the temporarily depressed prices. However, due to the current economic climate, stock valuations that are historically too high and consumer challenges, we believe that the markets are likely to return to a downward trend following a near-term rally. Portfolio Update: Challenging Times Year-to-date, the markets have been a challenging place to invest. Although our investment portfolios have significantly outperformed the equity markets, in hindsight we should have been even more conservative and maintained a higher level of cash. Fixed income investments, to which we increased allocations earlier this year, have been pressured by the continuing credit crisis and the resulting flight to the safety of US treasuries. We believe these fixed income investments will rebound as the credit crisis eases. We plan to increase our fixed income holdings in an effort to build portfolios with lower volatility and more predictability of returns. With the exception of Latin America, even international markets have been hard-hit and are negative year-to-date. The Chinese market is down more than 50% from its high. Near term we plan to take advantage of these depressed prices and capture short-term market rallies. Longer term, we plan to take advantage of market trends, dislocations and deep value buying opportunities. Thank you for your continued trust and support. Trevor K. Holsinger, CFP