The Markets	6/30/07 Close	3/31/07 Close	2nd Qtr.  Change	6/30/06 Close	12 Mo. Change	YTD       Change
Dow	13409	12354	+8.54%	11150	+20.26%	+7.59%
NASDAQ	2603	2422	+7.47%	2172	+19.84%	+7.78%
S&P 500	1503	1421	+5.77%	1270	+18.35%	+6.22%
10-yr Treas. yield	5.03%	4.65%	+0.38%	5.14%	-0.11%	+0.32%
Fed funds rate	5.25%	5.25%	n/a	5.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

For the second quarter in a row, the stock market had a 3% decline and struggled back, although this quarter’s gyrations were not as dramatic as the first quarter. In fact, the US market shook off an 8% drop in the Chinese market in early June; a similar decline in February had precipitated a global market drop. This time is was interest rates and the ongoing fear of inflation which caused market jitters. The European Central Bank raised their rates to 4%, the highest in four years, and continued global growth is now seen as contributing to inflation here in the US, whereas before this growth was seen as keeping a lid on prices through lower prices on imports. The slumping dollar and growth in local economies has largely eliminated that import advantage, so our trade deficits have even less of a silver lining.

The real action was in interest rates. It has been exactly a year since the Fed lifted short-term rates to 5.25%, and the market’s opinion has lately swung wildly between the Fed cutting rates to stimulate growth and actually raising rates further to keep a lid on inflation. In the June FOMC meeting, the Fed abandoned their previous description of inflation as “somewhat elevated”, but they also made it clear that they were not declaring victory on the inflation front. Meanwhile, the job market stayed strong and core inflation measures have dropped to increases of 2% or less, but oil has jumped over $70 a barrel on turmoil in Nigeria, so the signals are decidedly mixed.

The benchmark 10-year Treasury had a huge jump in yield, touching a five-year high at 5.27% before drifting back to its closing 5.03%. This increase restored the yield curve to more of a flat/normal shape, which is significant because the inverted curve of the prior twelve months is often considered to be a predictor of coming recessions. The implications of higher interest rates for the recent buyout boom (higher borrowing costs would be a burden on companies’ cash flow) and potential home buyers (mortgage credit has already tightened and higher rates reduce the buyer pool even further) are not pretty. Alan Greenspan opined that he is not worried that the Chinese will dump their holdings of Treasuries, which would really send rates skyrocketing, because they don’t have anyone to sell to. At the same time, he warned that the liquidity which has fed easy money for borrowers of all types cannot last forever. More borrowing discipline, while painful in the short run, would eventually be positive for the economy.

Parts of the market, particularly homeowners, seem to still be in denial about the depth of the housing slump. Housing inventories are near all-time highs at almost nine months’ worth, mortgage rates have risen and we still have not seen speculators throw in the towel and begin to drastically prices to get rid of their albatross investments. Still, homeowners remain confident in home prices according to a recent poll, and the economy is still taking the slump in stride. Even the near collapse of two Bear Stearns hedge funds due to bad bets on subprime mortgages will be no more than a bump in the road, except for the funds’ investors, and everyone else will see it as just desserts for greedy, opportunistic Wall Street.

Looking Forward

Although the future growth of the economy is always a concern, at this point it may be at a critical crossroads. The slowdown in the first quarter to 0.7% growth involved factors which won’t be going away immediately, namely the housing slump and the trade deficit. As a leading indicator of housing, even the formation of new households has declined precipitously; previously, the demographics underlying new household formation were considered rock solid. This is admittedly a volatile measure, and new household formation could rebound, but it looks like many potential first-time buyers are opting to live with roommates or extended family rather than entering the market.

The driver of resumed growth of over 2% is expected to be a revival of business investment and, surprise, the consumer. Construction spending finished the quarter on a strong note and business inventories have been somewhat drawn down, both promising signs. As for consumers, both spending and incomes showed increases for May, but both were also below expectations. One has to wonder how much longer the consumer can carry the load.

A recent Wall Street Journal survey of economists underscores the balancing act. They expect growth at an annual rate of 2.6% for the remainder of 2007 and 2.9% in 2008, with the probability of a recession in the next 12 months at 23%, down from 27% six months ago. With productivity growth slowing and globalization putting upward pressure on prices, 21% of the economists see renewed inflation pressures as the biggest risk, twice the number from the last survey. As for other risks looming largest, 30% indicated weakness in the housing market, 12% noted a sharp correction in financial markets and 9% are most concerned about weakness in business spending.

Our Portfolios

As advocates of long-term diversified portfolios, we prefer to adjust exposure to a market segment rather than exiting completely. However, we recently decided to liquidate all our positions in high yield bonds, even though most of the high yield funds we owned are less “junky” than others. On a relative basis, the spread, or difference, between the yields for junk bonds and Treasuries are at historic lows, so investors are not being adequately compensated for the added risk of junk bonds. On an absolute basis, investment grade bonds and CD’s are more attractive options as interest rates have ticked up. Finally, as we noted last quarter, our feeling is that the recent private equity binge, which is funded largely through junk bonds, will end badly as more private equity players are chasing ever more risky deals with less certain returns.

Even though interest rates have ticked up, we believe they will creep higher and are not yet ready to commit to longer maturity bonds. We are adding to short-term bond holdings, taking advantage of attractive CD yields for retirement and conservative portfolios and are finding opportunities in intermediate municipal bonds for higher income clients.

For more aggressive portfolios, we have taken some gains from areas of the stock market that have had strong relative performance, such as mid-cap stocks. This is more due to capturing the outperformance, which cannot continue indefinitely, than to any great concerns about the overall stock market. Likewise, we are making selective use of some mutual funds which “tread water” in an up market but which have historically performed well in down markets. These are not funds which have a direct inverse relationship to the market; we believe that if you feel strongly enough that you want to buy a bear fund you should simply exit the market. Rather, these vehicles use a number of investment strategies to hedge market risk while still maintaining exposure to stocks, and this hedge is appropriate for some portfolios.

What Are They Thinking?

Despite all the uproar about subprime and “alternative” mortgages, there are still plenty of outrageous mortgages being offered out there. Consider the solicitation we received recently: interest rate of ¼% (yes, that’s one quarter) fixed for ten years, with a fixed payment of only $71 per month.

The catch is in the fine print, which notes that the APR is 6.75% and that the deferred interest will accrue. A call to the lender confirmed that at the end of ten years, the new loan balance (which would be 87% higher than the original loan if the minimum monthly payment has been made) will be amortized over twenty years at then-current rates. Because of the higher balance and shorter term, a borrower could be looking at payments that would be more than twice the amount if he had taken a 30-year traditional loan now at the same 6.75% rate.

Who would take out such a loan, other than someone who is either totally ignorant of borrowing or is misled by a mortgage salesman? It could only be someone who 1) had a temporary cash crunch and was confident his income would increase dramatically; 2) planned to refinance in the next year or two; 3) thought the house’s value would increase at greater than 6.75% a year; or 4) did not care whether he eventually owed far more than the house was worth. All but the last scenario are risky, to say the least, and the likelihood that the house will increase at greater than 6.75% is less than 50/50.

Besides, who would make such a loan? Sure, the lender gets to record the deferred interest as income, and most loans are packaged and sold to investors, but it’s hard to imagine investors going for this deal either. It is also true that the 6.75% is a higher rate than we would normally qualify for, so there is a bit of a premium to the lender. But unless the lender is willing and able to end up owning a lot of houses when the borrowers ultimately default, this loan makes no sense.

The first words out of the mouth of the “mortgage counselor” that answered my call were that they wanted to make sure we got the loan that was right for our needs, so the answer is that this solicitation was simply a teaser to attract inquiries and the lender really doesn’t want to make these loans; they will probably make a select few just to prove that it is a legitimate offer. A ridiculous loan offer turns into the old bait-and-switch, which will never be eliminated. The sad part is that if this loan is out there, some desperate or unsuspecting borrowers will end up with it, sealing their fate.