Sunday, October 7, 2007

News Letter 10/7/2007

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The Economy:

The stock market underwent severe fluctuations during the summer of 2007 as economic data and Fed policy decisions shifted investors’ sentiment form bullish to bearish and then back to bullish again. The largest influential factor was the credit crunch caused by loan defaults due to dropping house values. All across the US and especially in Michigan, house values have dropped and the housing bubble that has been brewing over the last few years is bursting. As a result borrowers are increasingly finding they owe more than their houses are worth and they are defaulting on their loans. Banks in turn are revising their lending practices and tightening lending standards. This credit crunch cycle is leading many economists to predict an economic slow down or a recession. They argue that consumers will run out of easy available credit to spend on goods and services which will ultimately lead to a recession. The Fed stepped in at the right moment in August and reduced the discount rate (rate the Fed charges banks) by a 50 basis points and the Fed funds rate (rate banks charge each other) by 50 basis points later in September. The Fed funds rate reduction unexpectedly shocked the markets and reversed a bearish trend in one day. As a result the markets quickly recovered and went up to all time highs. Click on chart below for Stock Market Index performance to date. The Fed’s intent in easing of the money supply was to reverse the credit crunch and infuse cash into the markets to reverse the slow down and recharge the economy. The side effect of money easing is inflation. While the core inflation rate (minus energy and food) has been contained over the last few quarters, going forward inflation will become a concern and will be watched closely by the Fed. Oil prices are at all time highs at $81/barrel as well as many other commodity prices. Commodity prices are also influenced by the currency exchange rates as well. Low US interest rates over the last few years relative to other countries’ interest rates have pushed the US Dollar to recent lows trading at 0.70 Euros and 1 Canadian Dollar. Imported commodities such as oil are more expensive as a result. The weakening Dollar is not actually bad for the economy as exported US products will gain a currency exchange advantage. Companies that export products such as GE will increase their global sales as a result. Foreign Companies that export products to the US will suffer reduced sales.

Future Outlook:

As usual the outlook is mixed among economists. Some economists are stating that the Fed went too far with the 50 basis points funds rate reduction. They argue that the Fed’s action will increase inflation and will weaken the US Dollar further. They predict that the Fed will ultimately have to increase rates back up to counteract inflation and the currency weakness. As a result the rate increase will lead to a slow down and a recession. Other economists state that the Fed has saved the economy from a recession and there will be a resumption of growth into the future. They state that as long as inflation is contained, the currency weakness is not a bad thing and is good for growth. They state that if future earnings grow modestly at 5%, discounting that future growth into the present leads to a conclusion that the markets are still undervalued by 20% meaning that markets have room to grow by another 20%. It is my opinion that barring any major events such as a terrorist act or a disruption in the oil supply, the markets will continue to grow modestly. Long term investing is the best strategy and any market drops are a dollar cost averaging opportunity.


Previous News Letter stock recommendations such as GM and Google have done well. My favorite stock now is Microsoft (MSFT). MSFT has not appreciated as much as other large cap tech stocks with international markets exposure. MSFT is now trading at $29.84. The 12 months average price target is $35.64 for the 21 analysts that follow MSFT. The PEG ratio is relatively low at 1.5 as well meaning the stock is inexpensive.

Disclosure: I don't have any position in Microsoft. I am a GM employee and own a small number of shares of GM stock.

Mike Katto
Registered Investment Advisor
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