Ramblings From 30,000 Feet

This edition was written while flying to and from San Diego, CA. I hope you find it thought provoking.

Be Prepared
Every couple of years I go through the process of updating my will and checking to make sure all of my beneficiary information is up to date. To complete the ritual, I write a detailed "just in case" letter to my wife telling her everything she needs to know.

As much as I hate the process I'm very happy when it's done. In the first place, it forces me to make sure my ducks are in a row. It also affords me the opportunity to see where I may need to do more. But the ultimate reward is the calm I experience whether I'm stepping on a plane or conducting my day to day affairs. I know that no matter what, my family will be okay. So do yourself and your loved ones a favor -- take the time to assess your status. Make sure your
papers are in order. View the time as an opportunity to see where you're at, where you want to be and how you are going to get there.

Outlook 2007 - Follow-up
Housing. In re-reading my Outlook 2007 Letter, I realized that I may have left you with an incorrect impression of my views on home sales. The fact is, home sales account for approximately 6% of GDP. Compare that to consumer spending - approximately 70% of GDP - and you will begin to appreciate why I'm not all that worried about the decline in home sales.

Some of my research this week pointed to sub-prime lenders that are scaling back and sub-prime mortgages that are either late or in default. But, let's keep this in perspective – shall we? These are high credit risk mortgages to begin with. It stands to reason that the default rates would be higher and come early in the cycle.

I did discover a very interesting perspective while in San Diego...the housing market is flat, home values are declining and people are truly distressed over it. There's actually a radio station that has 24/7 programming on how to make money in stocks and how to bail out of bad mortgage situations.

One program was based on the theme, "How bad the Fed is for raising interest rates knowing that there are a lot of homeowners in distress because their adjustable rate mortgages are out of control!" That pushed me over the edge. But this radio station has a following; there are a lot of callers into these shows! Unlike infomercials, these are real people with real situations!

There are lessons here for all of us...

• Economics are cyclical.
• Adjustable rate mortgages adjust. Interest rates go up.
• If you want to make money buy low and sell high and,
• Never buy more then you can afford.

Sarbanes-Oxley
Further evidence that Sarb-Ox rules will be scaled back came last week when Mayor Bloomberg (R-NYC) and Senator Chuck Schumer (D-NY) unveiled a study showing that Sarb-Ox rules are hurting the NY financial sector. According to this political duo Sarb-Ox, left in its current form, will cause NYC to lose its place as the "financial capital of the world" within a decade.

In my estimation any legislation that revises Sarbanes-Oxley will likely come with a tax increase of some kind (think capital gains or estate taxes). It will be interesting to see how it plays out.

The Stock Market
Is the correction that I've so often written about finally at hand? I don't think so...not yet. Traditionally there is a large inflow of capital into mutual funds at this time of year. They stem from bonuses and IRA contributions. Fund managers must invest this money as fund rules dictate that only a small portion of capital be left in cash. So, while I am still committed to the idea of a 10-15% market correction, I don't think it's here just yet.

By the way...I don't know if I was specific enough in my Outlook 2007 Letter. I believe the market will end the year up 6-8% but the road there will be a bumpy one.

Now it's time for some other ramblings...

Delusions of Retirement Solvency by Nancy Miller
Think you're confused on retirement savings? Think that it's impossible to do? Do you think that you'll be working for ever? Evidently you're not alone! According to a Barron's article (title above), "Boomers deemed saving for retirement and quitting smoking as the most difficult things to do - harder than losing weight or working out."

I understand all too well how hard it is to quit smoking but when I thought about the analogy, I realized there were some valuable lessons to be had. Here are my top five...

1. Set a start date. If you're not already saving, set a target date to start.
2. Offset the loss. What we should do is figure our budget after we deduct savings yet we rarely do that. As a result it's hard to cut back on many of our fixed expenses. Look closely and try to find an expense that you can eliminate to pay for your savings.
3. Reward yourself. For some of us, seeing that money grow is reward enough. But, if you don't fall into that camp pick a dollar target at which to reward yourself. Keep the prize reasonably priced. The idea here isn't to bust the bank, it's to remind yourself of how great it is to hit a goal.
4. Assess your progress. Particularly during the first year it is important to look at your savings often - i.e. every payday.
5. Focus on the rewards. Whether you're just waking up, driving to work or on vacation, you're making money -- only you're not working for it. Think about that...your savings is working for you.

And finally...

The New Third Rail of Public Discourse...
I am on the final leg of my return flight from San Diego. The views from 30,000 feet have been breathtaking. The landscape is filled with deserts, snow capped mountain ranges and farm land. From this height it is so clean and serene. I can see how small all of us really are. It is against this backdrop that I consider the United Nation's report on global warming.

Scientists are attributing it to the burning of fossil fuels and noting that, in the 150 years that we have recorded climate information, the last five have been the warmest. I know it's heresy to write this but I'm skeptical.

Let's think back on those 150 years for a moment. The birth of the industrial revolution with all manner of factory. Two world wars (not to mention the lesser wars) where all sort of armament - including two atomic bombs - were detonated. Rocket launches and moonshots by the score. Space shuttle after space shuttle. Coal fired furnaces ultimately yielding to oil fired furnaces. The oil well fires during Desert Storm. There was the dust bowl of the '30s and the smog of the 70s. Not only Global Warming but Global Dimming too. Bad winters, easy winters. Bad hurricane seasons and seasons with virtually none. All manner of volcano eruption, increases in sun spot activity and countless other events attributable to man and Mother Nature. Yet, the answer lies at the doorstep of man's use of fossil fuels.

It also appears that disbelievers are portrayed as uncaring custodians of this earth. They are (we are) the very cause of the problem. I don't know about you but I tend to bristle when my questions are answered with stereotypes instead of facts. And, I do have a few questions. My first question is to former VP Al Gore and the very scientists that craft these reports: tell me please, have you stopped driving cars? Are you chopping down trees and splitting the firewood that keeps you warm? Doubtful. Above all, when will we be able to see genuine
debates based on theories and hypotheses from both sides of the issue?

At the end of the day, in this space, it's about investing and as an investor there's good and cautionary news in all of this...

First, the good news: follow the money! We are beginning to see new energy companies come into play. In fact, just this month three energy related IPOs came out. Some of these companies will offer short term opportunities for positive investment returns.

An old Wall Street adage does provide my cautionary note: Buy the rumor, sell the news. That certainly will be the case for many of these new, alternative energy companies. We will use the tools we are familiar with to assess these companies and invest in the solid contenders.

A Final Note
So, San Diego is different. The roads are cut, like valleys through mountainsides. Rain tends to pool in various spots but with three quarters of an inch of rain, cars end up on their sides or doing somersaults. Here's what has me a bit troubled... I'm on a plane full of folks from San Diego that are heading for the Northeast! These people are going to get in cars and drive! If they can't handle rain soaked roads how are they going to handle snow and ice? LOL

Coming Up in The Fund Informer Letter...

Investor tools for your success.

Outlook 2007

Well, the holidays are over. Having had a sufficient rest, I'm now refreshed and ready to jump into the fray. But, before I get started here's a sampling of Christmas Eve in Mazzaccaville. An exchange with my youngest son...

So, it's mid-morning. My wife has just finished hard-boiling eggs for an egg salad lunch and we're relaxing, watching a movie. It was great...everything was done except for the wine and soda shopping. All of a sudden we hear the hiss of an aerosol can coming from the entry hall...

"Who is that?", I shout. My son Christopher, "It's me!" I reply, "What are you doin'?"Christopher, "Spraying air spray! This whole house smells terrible! Who went to the bathroom in here?" Through howls of laughter I reply, "Mommy just finished making egg salad. Would you like a sandwich?"

God I love Christmas! Let's begin...

Outlook 2007

I've had a difficult time writing this letter. In fact, on two occasions I got about half way through only to scrap my work entirely. The problem had been two-fold.

To begin with, I was looking at conflicting data. That led to a second problem...too much data. Too many charts, too many datasets. If I was overwhelmed, how could I make sense of it for you? What a mess! Sometimes the best thing to do is stop, wait and listen. Order is eventually restored and progress can begin again. The alternative - to rush to meet some self imposed deadline - is pointless and results in rubbish. That, perhaps, is what we will need to keep in mind as we attempt to invest in 2007.

Mergers and Acquisitions

To me 2006 was more about the movement of wealth rather then the creation of it. No place was this more apparent then in the Mergers & Acquisitions (M&A) arena. In mid-December MarketWatch wrote that M&A announcements hit $3.5 trillion topping the previous record of $3.38 trillion in 2000. Some of the largest deals, for instance the $18.75 billion purchase of Clear Channel Communications, were carried out by private equity firms. Yet, the record for 2006 remains AT&Ts purchase of Bell South for $67 Billion. All of this activity helped the major indexes shake off a summer slump in each case rising more then 10%.

This idea of wealth movement was confirmed to me in an e-zine I read this morning. In the past I've quoted John Mauldin and his Thoughts From The Frontline letter. This week, Mr. Mauldin talks about the flow of global assets: "The Savings Glut has permitted deficit countries (and their citizens) a startlingly benign combination of spending much more than their income, rapid gains in real and nominal asset values, and low inflation."

Home Sales

Apparently, the movement of wealth did not extend to the housing market. Although CNN Money reported, "Housing starts jumped to an annual pace of 1.64 million last month from a revised 1.57 million rate in November...", the article failed to disclose the fact that Lennar Builders and KB Homes reported cancellations rates on home sales of 30% and 43% respectively. Or, for that matter, the fact that 53,000 construction jobs have been lost in the last two months despite a warm winter.

Guerite Advisors reports that, "In the previous seven [housing] cycles since 1959, housing starts have fallen, on average, 50.7%. They continue, " Housing starts have dropped 34% so far since their peak in January 2006. Just to get to the average drop we have another 20% or so drop in starts to go." Guerite also indicates that such falls in housing starts take an average of 27 months to complete. "As of November 2006, we are roughly 11 months or roughly halfway to bottom."

The Yield Curve

The Yield Curve has been - and continues to be - of concern to me. The Yield Curve is basically a plot of interest rates of various durations for government issued treasuries beginning with overnight rates and progressing to 30 years. As you might expect, the longer the duration, the higher the interest rate. When shorter term rates are higher then lower term rates, the curve is said to be inverted.

Perhaps a little history would be helpful here. In June of 1996, Arturo Estrella and Frederic S. Mishkin of the Federal Reserve Bank of NY wrote a paper on inverted yield curves - specifically the difference between the 90 day and 10 year note - as a predictor of economic slowdowns and recessions four to six quarters forward. They included a chart comparing the rates of inversion with the odds (percentage) of recession.

Each month since August 2006 the curve has been inverted. According to Estrella and Mishkin's scale, the rate of inversion indicates a 25-35% chance of recession. In my estimation, the inversion isn't significant enough to warn of recession but certainly an economic slowdown. This warning sign tells me that we should be taking a defensive position in our investments.

The VIX

I also follow the shorter term Volatility Index (VIX) indicator. Trader's Notebook explains this technical indicator thus, "Many traders use the Volatility Index (VIX) to measure the volatility of the U.S. stock market. It is their contention that if the VIX moves above (or below) a certain point, it signals a bottom (or top) to the current stock market trend. When used properly, it is a good measuring device to determine if the market might be overvalued or undervalued."

As you can see from this chart the VIX is at historic lows. Last year's rise from 12 to 20 coincided with the market's decline. And, its decline in the second half of the year matched the market rebound to its current levels. I went back and looked at the VIX's historic charts. The last time it was near these levels was 1996. Then, it's rise to 36 - in 1998 - coincided with dips in the broad market indexes.

P/E Ratios

Last is the P/E ratios for the broad market indices - the S&P 500 at 19 and the Dow Jones Industrial Avg at 24. As I've been writing, these are the P/Es of a mature market. Not one poised for a bull rally. Yet, despite all of this negative news there are reasons to look for positive growth in 2007.

2007

Historically, the third year of a presidential term is a good year for the markets. The Executive branch may get help from the Democratically controlled Congress as both sides are anxious to make a good impression going into 2008's Presidential election season.

Although it didn't get a lot of press, last year small business complained that Sarbanes-Oxley (SarbOx) compliance was too costly. As a result, some business were privatizing. I tend to believe that we'll see some legislation easing SarbOx.

However, the picture is mixed. As mentioned, the rate of Yield Curve inversion does bode some level of economic slowdown. I expect to see evidence of that sometime during the second or third quarter. The curve must return to the norm but, I think that bond market action will be a predecessor of rather then a result of the impending slowdown.

Everybody's looking at the Fed to reduce the overnight rate. But this, by itself, will not solve the problem. I believe the Fed's reduction will spook longer term bond holders to sell because they will be concerned about an increase in inflation. That will increase long term rates.

Again quoting from Mr. Mauldin's letter this week, "Normally, market internals deteriorate in a way that provides more time to establish a defensive position - market breadth lags, divergences develop across various industries and security types, price/volume action shows signs of distribution and so forth." Continuing, "The overvalued, overbought, overbullish syndrome may present none of those warnings, particularly when there is even modest upward movement in Treasury yields."

Bonds are somewhat counter-intuitive. As rates go up, bond value - and your investment - goes down. This year that means that long term bonds are likely to lose value. I'm not really bullish on bonds but, if you feel you need to be invested in them, stick to shorter duration bonds and bond funds.

I think M&A will give us a shot in the arm in two ways. I expect first (and maybe even second) quarter earnings to surprise to the upside as the benefits of M&A are reflected in balance sheets. I also think that, despite the lofty prices of some stocks, we may see some additional M&A deals. While they'll grab headlines, I don't believe records will be broken. One thing has been bothering me though...thus far we haven't really seen any labor reductions resulting from M&A activity. Any rise in unemployment numbers will spook the market.

I am also not at all convinced that we are done with the downturn in housing. By the same token, I'm not sure that I agree with all the doom and gloom hype that we're hearing and reading about. It is evident that houses are staying on the market longer and prices are being squeezed somewhat. So, if you need to sell you may have a problem.

Yet, higher inventory and longer turnover times mean that if you're buying, you can cut a better deal. That's what they call a buyers market.

Since I'm looking for longer term gains I tend to be biased in the sense that I favor value over momentum or growth funds. That is especially true when the markets appear poised for some corrective event. Certainly, with the warning signs that are out there now, I believe that the best place for investment dollars is in value funds such as the iShares Russell 1K Large Value.

Finally, China has indicated that they expected economic growth to slow to 9.5%. I think it's fair to say that investment in global funds that include China stocks in their portfolio continues to be a good investment vehicle. However, I would avoid emerging markets stocks/funds. Based on present value, their rate of return is almost on par with U.S. Treasuries. Why take on the added risk unnecessarily?

Coming Up in The Fund Informer Letter...

In upcoming issues I'll provide additional information on The Federal Reserve Board (the Fed), the VIX, and Bonds. Perhaps you've heard of the first two and probably even invested in Bonds. Still, I think it would be beneficial if I dedicate some time to each of these topics.