7/26/07

SUBSCRIBER ALERT

7/26/07

It was another rough day; so we decided to send you much of what would be our end of the week conclusions about the economy/Market. And barring Friday being another day like Thursday, most of our opinions included in this Subscriber Alert will be repeated in this week’s Closing Bell.

This is part of our conclusion as of Thursday night to the Economic section of this week’s Closing Bell:

Bottom line: …….default problems in the sub prime market have spilled over into the higher quality mortgage (Countrywide’s acknowledgement that delinquencies were spreading into higher quality home equity loans) and the private equity funding (Cerberus’ difficulties financing the Chrysler transaction) markets. It seems apparent from the housing statistics that the delinquencies in the sub prime market are having an impact on home construction/sales/financing and as we have previously noted, barring a sudden change in the direction of the July housing statistics, we will likely have to lower our 2007/2008 economic growth forecasts.

On the other hand, the extent of the damage to the quality mortgage/private equity funding segments is unclear; and for the moment, we don’t want to allow a potential problem that has become emotionally charged to stampede us into altering how we interpret the economic data. We will concede that Countrywide/Cerberus are manifestations that credit risks exist beyond the sub prime sector and their consequences could result in an economic growth rate lower than expected (via corporations being unable to finance growth or consumers inability to borrow to buy cars, appliances, etc); but like the erratic behavior in the industrial sector earlier this year and the current sloppiness of consumer spending, we need more information before making that judgment and any additional adjustments to our forecast.

And our conclusion from the Market Fundamental section:

The Market significance of the Countrywide announcement and the sudden loss of liquidity in the private equity financing market is (1) the elimination of one of the sources [private equity buy outs] driving stock prices higher [the others being corporate buy outs and stock buy backs] and (2) the private equity market’s inability to find a clearing price for the newly perceived higher risk debt needed to finance deals may ultimately result in a possible additional impediment to the earnings growth of companies that (a) serve the financial and homebuilding markets, (b) require new financing near term to conduct business or (c) have a substantial majority of their earnings in the US.

Of course, (2) above is by far the more important issue and the question is how will Market psychology adjust to it. Certainly, recent market performance, particularly on Thursday, suggests that the investors are not processing that this adjustment very rationally. And the truth be told, there is probably little chance for any meaningful improvement in Market psychology until the participants in the credit market can agree on the clearing price of newly perceived higher risk debt--meaning that we shouldn’t expect stocks to resume any sustained upward trend until the debt market stabilizes (which it will).

That said, we think it important to keep in mind that (1) corporate profits continue to climb--as an example, as of the close of business Thursday, 40% of the S&P 500 companies have reported second quarter earnings which in total have increased 15% and (2) there is absolutely no evidence, none, zip, nada that there has been even the slightest diminution in global economic strength. So there are some strong economic positives to support equity values.

Our bottom line is that our Price Disciplines continue to suggest that stocks are still mildly over valued and whether they return to Fair Value due to a rapid emotionally charged sell off or an extended period of psychological malaise is largely academic. However, whatever the course, anything more drastic than a simple adjustment to Fair Value will likely create buying opportunities.

Our investment strategy has shifted somewhat:

(1) pay close attention to our Price Disciplines in particular our Buy Value Ranges

(2) as a corollary, use the present heightened volatility to our advantage by taking profits when prices spike to the upside and buying the stocks of great companies when opportunities present themselves,

(3) insure that our Portfolios can ride out any further turmoil brought on by trouble in the credit markets