The Markets	9/30/07 Close	6/30/07 Close	3rd Qtr.  Change	9/30/06 Close	12 Mo. Change	YTD       Change
Dow	13896	13409	+3.63%	11679	+18.98%	+11.50%
NASDAQ	2701	2603	+3.76%	2258	+19.62%	+11.84%
S&P 500	1527	1503	+1.60%	1336	+14.30%	+7.92%
10-yr Treas. yield	4.58%	5.03%	-0.45%	4.64%	-0.06%	-0.13%
Fed funds rate	4.75%	5.25%	-0.50%	5.25%	-0.50%	-0.50%

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

For the third quarter in a row, the market had a scare and a quick downturn, but this time it looked like it could be “the big one” – fallout from subprime mortgages and related securities caused the credit market to seize up almost overnight. Problems spread quickly, as institutions around the world were suddenly faced with investments for which there were no buyers, and others which relied on short-term borrowing folded. Volatility was dramatic, with 34 straight days of 200-point intraday swings on the Dow. Huge updrafts or declines developed within minutes as the market reacted to each piece of news and hedge funds and quantitative investment managers often traded in synch.

Central banks around the world quickly moved to increase the liquidity in the system by adding money to try to contain the damage. (The notable exception was the Bank of England, which steadfastly resolved to allow the market to mete out its punishment. Even the BOE had to take action eventually to bail out a major savings bank that was faced with an old-fashioned run after suffering mortgage losses.) The Fed did not initially take the lead, adding liquidity but not taking other action. Finally, on August 17 the Fed cut the discount rate, the rate at which banks can borrow from the Fed by ½%. This move was intended to restore confidence more than anything else, since banks can borrow more cheaply from each other at the Fed funds rate. The Fed then cut the Fed funds rate by ½% at their September 18 meeting, which boosted the market recovery that had already started.

One result of the interest rate cut is that the yield curve has taken on a bit more slope than it has had in the year and a half that the Fed funds rate had been at 5.25%. Short-term Treasury instruments now have yields below 4%, while longer interest rates declined at a slower rate. This has eased the pressure on longer rates to increase, as they did early in the quarter when they flirted with 5-year highs, but there could be still be some pressure for rates to increase once the credit squeeze subsides.

The other big move has been the continuing decline of the dollar, which reached 15 year lows against a basket of currencies and a record low against the euro (the euro started trading in 1999). The Canadian dollar even reached parity with the US dollar, the first time since 1976 and a remarkable recovery from a rate of around .62 only five years ago.

The rest of the economic data points to a slowing economy. Each report on home sales brings further declines, and oil reached levels above $80 a barrel (although the price at the pump has come down as refining bottlenecks have been resolved). Durable goods orders and manufacturing growth have slowed but are still positive. Solid jobs reports have been the lynchpin of the economy, and the consumer has continued spending despite housing woes, but the August jobs report unexpectedly showed payrolls declining for the first time in four years.

Looking Forward

The big questions for the economy are now plain as day – will the housing and credit slumps drag the entire economy into a recession, or will the consumer and a revival in exports and business spending keep things growing, albeit at a slower pace? The number of adjustable rate mortgages that will “reset” to higher rates should peak in early 2008, but there will still be some “overhang” as it takes a while for homeowners to feel the full pain and slide into foreclosure. Clearly, between the possibility of increased foreclosures, the current inventory of unsold homes (hovering around 10 months, an 18-year high) and the many homeowners who are reluctant to even try to sell their homes in a sluggish market, the recovery in residential real estate is barely on the horizon.

A leading indicator of the economy’s future status will be any further interest rate action by the Fed. After the Fed cut the discount rate in what could be called an emergency intervention, the markets were howling for a cut in the Fed funds target rate. In fact, Fed chairman Bernanke was noncommittal as long as possible, saying that the Fed would “act as needed” and that a rate cut was not imminent, although acknowledging that a cut was expected. The size of the eventual cut fueled the market’s recovery, even though the cut had far more to do with restoring confidence than with truly easing the burden of financing. As of this writing the likelihood of further cuts in the Fed funds rate are 50/50, leaving the market to react strongly to every new piece of economic news.

Aside from the danger of “moral hazard”, in which actions to provide relief to market participants who have possibly been reckless or irresponsible simply postpone the day of reckoning to a more drastic upheaval, the interest rate cuts have also raised the fear of returning inflation. Costs of raw materials continue to rise, slowing productivity has contributed to increased labor costs and, as discussed below, the ability to import lower prices has largely subsided. The years of “easy money” that fueled the overall economy as well as the housing boom were not without risk, and the return of inflation is one of those risks.

Our Portfolios

Having made some portfolio changes in the prior quarter (we prefer to be early in making changes, rather than late), this quarter was one for “fine-tuning”. REIT’s and value stocks were reduced in favor of large cap stocks, which should fare better as the economy slows, and growth stocks, which are recovering from a fairly long period of underperformance compared to mid and small cap stocks. Overall we are maintaining a neutral position with stock allocations, with some overweight in international stocks. We also consider the fact that many large companies derive much of their revenues from overseas, so their earnings will benefit on conversion back to the weakening dollar.

The new interest rate environment has only made the fixed income portion of the portfolios more challenging. Our commitment to using primarily high-quality vehicles, and avoiding complex bond structures regardless of their rating, has certainly helped. (If any investment is too complicated for us to understand its underlying risks and potential returns, we simply avoid it.) Granted, bond index funds do contain mortgage securities, but these are more traditional mortgage securities. With the rate cut, yields on cash and short-term bonds will trend down, but they retain their critical role in managing the risk of the overall portfolio.

The Next “Correction”?

Discussions of “corrections” usually refer to inflated asset values that abruptly and painfully return to more reasonable levels, like tech stocks in 2000 or residential real estate this year. But any type of capital flow that becomes exaggerated will eventually have to slow down; no trees grow to the sky. Take, for example, the trade deficit, which has grown almost uninterrupted since the early 1990’s and seemed to show no signs of slowing down.

The current-account deficit, the broadest measure of the trade deficit, hit an all-time record of 6.8% of gross domestic product at the end of 2005. This was the result of years of an insatiable consumer appetite for all types of goods, a generally strong dollar which made those imported goods cheaper and a willingness of the rest of the world to sell their products to meet that demand. Foreign governments and investors supported our debt binge by buying Treasury securities; foreigners now own nearly 50% of Treasury notes and bonds. Until recently the US economy was growing at faster rates than other developed economies and the housing boom gave consumers an even greater sense of confidence. The net effect was low prices and relatively low interest rates, accompanied by a huge debt that would eventually have to be repaid.

Now, foreign growth rates surpass ours, some oil producers are settling their oil trades in currencies other than dollars, growth of US imports is declining despite high oil prices, foreign investors are willing to look elsewhere for “safe” investments and the dollar is sliding. At the same time, the weak dollar makes US exports more attractive, and they have been increasing at an even greater rate than imports. All this means that the trade deficit declined to 5.5% of GDP in the second quarter of this year.

While a reduction in the trade deficit is generally viewed as a positive development, the rate of change could have a big impact. If things move gradually, we will continue to enjoy the benefits of imports, attractive jobs will be created in export-oriented industries and foreign investors will support the dollar at least enough to prevent a freefall. If those investors abandon the dollar, the trade deficit will narrow more rapidly but the dollar will weaken faster and our interest rates will soar, leading to economic downturn. That in turn would hurt Europe and Asia if their own consumers don’t make up the lost demand from the US.

Currency fluctuations are notoriously complex and unpredictable and are influenced by many factors other than economic growth rates. It is in the self-interest of most foreign economies to support the dollar and the US economy, and as the dollar weakens foreign investors will also be able to buy US real estate and companies. Our national pride should not get in the way, and as the Japanese learned in the 1980’s, using a strong currency can cause a buyer to overpay (remember the purchase of Pebble Beach for nearly $1 billion, which led to huge losses for its Japanese buyers). Let’s hope there is no unforeseen catalyst that upsets the balance.