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Wall of Worry October 9, 2007 By Mat Johnson "The key to making money in stocks is not to get scared out of them." — Peter Lynch From June to September 2007, the U.S. dollar continued its "freefall," oil prices "skyrocketed" to record highs; financial stocks were "pummeled" by subprime mortgage defaults and a financial liquidity "crunch," the housing market was "cratering," and companies "shed" workers in August as "odds of a recession increased." Pretty ominous stuff. In fact, it's so ominous that cutting and running from the stock market might even have seemed justified. After all, even the Federal Reserve was concerned enough to not only cut short-term interest rates recently, but cut them by a lot. So what happened? Why did the stock market rise yet again in the face of all this doom and gloom? For the just completed quarter, the Dow Jones Industrial Average (DJIA) was up +3.6%, while NASDAQ advanced +3.8%. Even the S&P 500 rose +1.6%, despite more than 20% of the index being in financial stocks (financial stocks were down nearly -6% for the quarter, and -10% since June 1st.) It certainly wasn't lost on most investors that this past quarter wasn't a bed of roses. Six weeks into the quarter, the major market indices had given up all of their impressive year-to-date gains. On August 16th, the DJIA fell by more than 300 points, though recovered by the end of the day. On August 17th the Fed acted, cutting the interest rate that they lend at, as the lender of last resort; more aggressively on September 18th by cutting the bank-to-bank lending rate by half a percentage point. The market has reacted positively ever since and has impressively climbed the "wall of worry" through the quarter-end. The concern that subprime mortgage defaults and credit "crunch" conditions were spreading into the real economy, as evidenced by the surprise decline in August payroll figures (-4,000), appears to be responsible for the Fed's call to action. While the conventional view is that Fed rate cuts tend to promote future economic strength, and consequently rising equity prices, another is that they merely turn the tide of sentiment - from excessive fear to measured anxiety. The truth is anxiety is a permanent feature of the stock market, while fear is fleeting. To the extent the Fed was responsible for improved sentiment then they have done well. While the Fed's attempt to forestall economic weakness is admirable, history shows that the intended target of the Fed's aid generally continues to experience problems, while new credit winds up elsewhere. (See Technology Bubble Begets Housing Bubble) The point being the Fed is no elixir. It is businesses that determine the broader fundamentals of the markets and as go businesses so goes the market. As we take a review of the economic fundamentals, it is clear that the growth of the economy has slowed throughout 2007. However, the principal cause driving the slowdown has been in place for quite some time — a weak housing market. The softer housing market has reduced consumer spending for large ticket purchases, particularly those that may have been financed from equity appreciation. All told, this is not such a bad thing. The objective of owning a home is to own the home, not to rely upon the credit available from appreciation as ultimately credit equals debt. Looking forward, we continue to see solid underpinnings for the equity market. Earnings growth continues, though has moderated during 2007. Third quarter earnings growth is expected to slow to just 1.9%, year-over-year, down from 9.6% in the second quarter. Much of the third quarter slowdown is the result of all that has gone wrong recently, particularly with the financial and consumer sectors bearing the brunt of the weakness. As we have noted earlier this year however, the housing market impact has been occurring for quite some time, and going forward it will take little more than a moderation of the recent trends for the fundamental outlook to improve. About the time you receive this commentary, corporate America will be reporting their earnings. The key to the market outlook won't be the backward looking numbers that they report, but rather their assessment of the outlook. Judging by the recent employment data, which largely flew in the face of the originally reported August weakness, companies are confident enough to not only hold on to employees, but continue to add at the same healthy rate prior the bogus August report. Add to this that the Federal Reserve in effect flinched on the originally reported decline in August payrolls (since revised to a gain of +89,000), improved company fundamentals (fourth quarter earnings are expected to rise 11%) combined with improved investor sentiment should be well reflected in the stock market in the periods ahead. Unfortunately, volatility isn't likely to go away overnight, though volatility alone doesn't derail the fundamentals of the equity market; it merely focuses attention on those companies with durable growth prospects at reasonable prices. Given that growth investing is our focus, and wealth management is our discipline, we feel well positioned to continue helping our clients achieve their long-term objectives.

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