October 2007 - From Client Review Letters

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The Federal Reserve has begun cutting interest rates in order to provide liquidity for the economy in light of concerns over sub-prime loans.  Interest only mortgages, adjustable rate mortgages and other financing schemes are catching people in a vise as home prices drop.  Those with a home value lower than the current balance on their mortgage loan are obviously in a difficult situation psychologically and financially.  In some parts of the U.S., home prices had reached premiums well above fair market value.  Through various financial instruments, mortgage loans get interlocked into investment products around the world.  These investment products have lost considerable value as the default rate on sub-prime loans has grown dramatically.  Much of the world blames the U.S. for initiating the problem.  However, it is unlikely the U.S. is the only culprit.

The U.S. dollar is trading at historic lows against the Euro ($1.40 per Euro) and has reached parity with the Canadian dollar for the first time in decades.  The impact of the falling dollar varies depending on the players involved.  Certainly, the dollar decline has made it much more expensive for Americans traveling abroad.  Conversely, foreigners may be attracted to U.S. destinations by the increased purchasing power of their currencies.  U.S. companies with international operations will benefit when translating their foreign earnings back into U.S. dollars.  The falling dollar makes U.S. goods more competitive in world markets resulting in a reduction in the U.S. trade deficit as exports rise and imports fall.  So long as any additional decline in the value of the dollar is moderate and orderly, the economic impact should be minimal.

The flip side of the above discussion is the potential for higher inflation.  The Federal Reserve’s primary focus was, until just recently, keeping inflation under control.  However, the sub-prime loan problem caused the Fed to shift policy focus to easier money.  We believe preventing inflation from getting a serious toehold in the U.S. economy should remain the primary focus.

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Oil prices continued to rally in the third quarter reaching over $80 per barrel.  Current projections are for demand to continue to outstrip supply in the near future.  A warmer than expected winter or slowdown in global economic growth would put downward pressure on oil prices.

In times of economic and market volatility it is important to own high quality securities in well diversified portfolios.  Broad diversification allows a portfolio to participate in the areas of the market that are performing well while at the same time limits the downside from both individual stocks and stock sectors that are underperforming.  Although this dampens some upside in a strong bull market, it also greatly diminishes a portfolio’s downside in a bear market.  Over most of its history, through September 30, 2007, Eads & Heald Investment Counsel’s Equity Composite has only declined approximately 80% as much as the Standard & Poor’s 500 stock index in down markets while participating in virtually all of the upside gains.

Recently, given the economic concerns, larger company stocks have outperformed both mid-size and small-size company stocks.  Also, growth stocks have generally performed better than value stocks in 2007.  The U.S. stock market has continued to climb in spite of a slowing economy.  The stock market has shaken off a slumping housing market, rising oil and commodity prices, a slowdown in consumer spending and a weak financial sector.  It is currently trading near all time highs.

The issue of global warming and the environment takes on a different level of importance in different countries.  Compared to Europe, the U.S. does not share the same degree of concern.  Possibly, much of Europe’s environmental views were tempered by emergence from the ravages of the Second World War.  Gasoline in Europe continues to cost two or more times U.S. pump prices.  European cars are still typically smaller and more fuel efficient than U.S. cars.  Grocery store plastic carry bags must be purchased so most people bring their own reusable bags.  Hotel room lighting must often be activated with the plastic door key placed and left in a slot inside the room.  Hall lighting is often activated by motion detectors or a timed wall push button.  France gets approximately 80% of its electric power from nuclear plants.  People often dry clothes on outside lines and dry/reuse paper towel sheets.  These may be extreme measures but, nonetheless, very different than in the U.S.  On global warming, Europeans generally view the U.S. as out-of-touch with what they consider reality.

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