Economic Growth
 The current positive US business cycle which started in October 2002 is now 46 months  old. The median bull market has lasted 27 months since 1900. The current bull market started in March 2003.  US GDP growth in Q2 2006 was 2.5%, compared to 3.8% in Q1 2005 and 5.6% in Q1 2006.  The slowdown is here.

In our last investment outlook letter, we wrote that May was the start of a short-term correction, the extent of which we are unable to predict. There is no change in the outlook.

Job Growth
June payrolls rose by 121,000 jobs, up from 92,000 in May. The 1st  quarter of 2006 averaged 185,000 per month. The year 2005 averaged 165,000 per month. In April 2004 payroll rose by 252,000 and in April 2005 payrolls rose by 228,000. What’s happening here? We think the economy is slowing.

The May unemployment rate decreased to 4.6%, down from 4.7% in April 2006,  5.1% for 2005, 5.5% for 2004, and 6.0% for 2003. It got as low as 4.0% in 2000. The economy is approaching full employment, which could lead to higher wage increases.
Now there is consistency between job growth, retail sales,  orders, and the GDP growth rate.  They are all slowing.

The Consumer (Same data as last investment outlook letter except for consumer confidence)
Most economists think the consumer will spend less in 2006 due to higher interest rates, high energy costs, and higher consumer product prices. Consumer confidence was 106.5 in July, up from 105.4 in June, but down from 109.6 in April 2006. That was the highest level since May 2002. Improvements in the labor market are cited as the reason for the high level. The survey is based on only 5,000 households.

Consumer credit as a percentage of personal income was 21.97% in 2003, 21.15% in 2004,  20.77% in 2005, and 20.22% in Q1 2006.  It’s high by historical standards, but it’s decreasing as a percentage of personal income. However, consumer credit does not include mortgages and home equity loans.  

Personal savings was a negative (0.67%) for Q1 2006, (0.17%) for Q4 2005, and (1.72%) for August and September 2005. Consumer spending rose throughout this period.

According to Federal Reserve Board statistics, total household debt as a percentage of disposable personal income has risen from 11.12% in Q1 1980 to 13.86% in Q4 2005. It was 12.04% in Q4 1998. This seems to reflect the increased cost of housing as well as cost of cars, boats, education, etc. We would have expected a much higher percentage in 2005.

The statistics seem to show some strain on consumers even as they continue to increase spending.  One possible logical inference is that the increase in the negative savings rate in Q1 2006 may have been caused by increased energy costs to heat homes. We wonder how the consumer can support the economy during a recession if personal incomes drop significantly due to unemployment.

Inflation
The Consumer Price Index for All Urban Consumers increased .2% in June, before seasonal adjustment. That’s 4.3% higher than June 2005.  The consumer price index unadjusted was 202.9 this June compared with 194.5  a year ago, according to the Bureau of Labor Statistics.  Commodity price increases may be finding their way into manufactured product. We are all too familiar with the effect of crude oil and commodity prices, and their effect lags by at least six months.

The Fed’s favorite inflation gauge, the core PCE deflator, which excludes food and energy, rose 0.2% in June. Year over year, the increase was 2.4%, and that is the most in 4 years.

One of the restraints on the effects of inflation is productivity. In June 2006, the Bureau of Labor Statistics reported that productivity in the business sector during Q1 2006  grew faster than Q4 2005, 3.7% versus 3.2% as revised and ahead by 2.5% year over year (seasonally adjusted annual rates). Productivity is one of the keys to neutralizing the effects of wage inflation. Even so, the Federal Reserve’s primary goal at the moment is fighting inflation before it can gain a foothold on our economy.

Interest Rates
The Federal Reserve is set to raise short-term rates another 25 basis points on August 8th.  They appear to continue to be bothered by commodity prices. We are still betting that they will overshoot in this rate increase cycle, despite their concern about creating a recession. The Fed has overshot tightening in 8 out of the last 9 tightening cycles. We are betting they will do it again.

 As per out last investment report, there seems to be growing consensus that the Fed will stop raising rates this year. We still have the same questions as in May. With current super high debt levels, will they risk plunging the real estate industry, consumer spending, and the general economy into a recession, again?   The long-term rate of increase in the all-urban consumer price index since 1925 is 3.05%, since 1985 3.03% and since 1995 2.89%. Since the Fed funds rate is already above these long-term rates, exactly what long-term inflation rate is being used is a question.

Our last report said that twelve leading investment strategists gave their forecast for the 10-yr T-bond yield as being in a 3.85% to 5.8% range with seven predicting a 5% to 5.5% range (mortgage rates are pegged to the 10-yr T-bond yield).  As I write, the 10-yr T-bond yield is 4.98% and there is a 50% chance that the Fed raises ¼ point or 25 basis points or to a Fed funds rate of 5.25% in August. We still think 5.75% is a real possibility by December 2006, but with the slowdown, the Fed may halt at 5.50%.

For those of you who are thinking about what type of home mortgage to have, adjustable rate mortgages may be a little risky right now. Anyone with an adjustable rate mortgage  might want to think about restructuring their debt.

Investing in domestic bonds and REITS, in general,  for 2006 is a bet that the Fed will stop raising rates soon. That is a bet we are not yet willing to take in any significant way.  Foreign bonds however may offer greater reward for less risk, as foreign interest rates may be closer to their highs, plus the declining dollar offers some protection against loss of principal should foreigners decide to push rates up. In May the European Central Bank left their prime rate unchanged at 2.00% because their economies are very slow and inflation is not a major problem. We now hold Fidelity New Market Income bond mutual fund, Loomis Sayles bond fund,  and PIMCO Emerging Market Bond fund.

Money Supply (unchanged from data in May investment outlook)
There is an old saying: “Just as the party gets going, the Fed takes away the punch bowl.” Just as the economy is showing signs of sustainability, job growth, and earnings growth, the Fed has been quietly reducing the growth of the nation’s money supply since 2001. The Fed buys Treasury notes and bills to increase the money supply and sells notes and bills to take money out of the supply. According to the charts of M1 and M2, the rate of growth of the money supply has been decreasing since June 2001, measured on a year over year basis. M2 growth rates are around 4.6%, from around 10% in June 2001. History shows that, over time, when money growth decreases, the economy and the stock market decrease.

Earnings
Standard & Poor’s Investment Services forecasts earnings for the S&P 500 to be $78.43 for the year, but quarter by quarter it is not rosy. For example, Q2 and Q3 are forecasted to be essentially flat at $20.30 and $20.60 respectively. Q4 is forecasted to be down 11.65% at $18.20. Many companies are lowering their guidance (for future earnings). That’s one reason why we are underweight US securities.

Foreign company earnings growth may also slow, but China, Asia ex-China, Canada, and Latin America may continue to outpace the rest of the world. We hope so, as we are overweight foreign securities.

Energy
Oil closed at $74.40 per barrel on Monday July 31, 2006. This compares with a high of $74.61 per barrel on May 2, 2006. T. Boone Pickens, manager of a commodity hedge fund and former CEO of Mesa Petroleum, thought in 2005 that the trading range would be between $40 to $60.  The price has bounced up from the $40 support level several times in 2004, and from a $50 support level in 2005. The price started January 3, 2006 at $60.23.  Pickens recently appeared on CNBC and said he wouldn’t be surprised if oil reached $80 per barrel before yearend and predicted $100 per barrel prices within twelve months.

Refining capacity is at 84 million barrels a day and demand is something north of 86 million barrels per day. Approximately 22% of production is light sweet crude, which everyone wants for clean gasoline. The rest is heavy, sulfur rich crude, more expensive to process, and is typically used for other purposes. Coal tar sands in Canada hold roughly the equivalent of the Saudi oil fields, but production has not been ramped up, since it has been only recently that it has been profitable to produce it. Depending on which expert is opining, oil reserves are adequate or declining.

During 2005 we added Conoco Phillips to all portfolios and Valero Energy to some portfolios. We added Valero in 2006 to portfolios that didn’t have it.  We still like selected oil securities. Suncor, PetroChina, and CNOOC have been big winners for us.

The research contained in the book “The Oil Factor” by Stephen Leeb published in 2005 makes a convincing and scary case that the supply of oil is declining and prices will top $100 per barrel at some point in the future. His predictions don’t look as impossible now. The energy problem is not going away anytime soon.

US Current Account Deficit
The US bought more from the world than it sold to the world by about $208.1 billion, down from $223.1 billion (revised) in Q4 2005.  The US current account deficit, including other outflows and inflows, totaled $791.5 billion (revised) in 2005 versus $668.1 billion in 2004, or 6.4% of gross domestic product. Economists do not think this high rate is sustainable. Is this a problem? The current situation works fine as long as the world buys US Treasury notes and bills, or the dollar depreciates against the world’s currencies, or their currencies appreciate.However, if foreign countries decide not to recycle the dollars back into US debt instruments, that would cause US interest rates to rise in order to entice foreigners into buying our debt and, if rates continued to rise, a recession in the housing market and other sectors of the economy would occur. During Q1 2006 foreigners bought $157.6 billion of our debt securities versus $242.7 billion in Q4 2005. That’s not a good trend.

In March 2005 Korea said it was thinking about cutting back on US debt purchases because it didn’t like the depreciation of the value of those notes and bills due to the declining dollar. The 10-yr Treasury note yield went from 4.20% to 4.6% in a couple of days, which tells us what might happen or worse if the world suddenly stops buying our debt. In addition, the stock market dipped as well.  Eventually, these debts have to be repaid somehow.

The Fed’s measured pace of rate increases may keep our debt desirable. The value of the dollar has been declining lately, and we are betting it will continue to decline long-term.  Investors tend to want to hold gold as protection against a depreciating currency. That is one of a number of factors contributing to the dollar decline.  We are maintaining positions in the Tocqueville Gold fund, Central Fund of Canada, and, if in a nontaxable account, StreetTrackers Gold.

US Current Account(Budget) Debt
In 2005 the government debt totaled 4.7 trillion versus 3.3 trillion in 2001. Is this why the Treasury is issuing the 30 year bond again, starting in February 2006? Frankly, there is a real question as to when will be the right time for investors to be long on bonds. If the Treasury does go ahead with their plan, will long-term bond rates go up and short-maturities go down? Or will the opposite happen, as holders of short maturities sell those notes to invest in the 30-yr bond?  Will the 3, 5 and 10 year note yields go up? What will the effect be on mortgage rates? Stay tuned.

Stock Market, Long-Term
We think the market will track the economy and S&P earnings growth somewhat, but there will be periods of irrational exuberance followed by irrational despair. Typically, the November 2004 to March 2005 time period has exuberance or rally potential, and the May 2005 to October 2005 period has irrational despair potential.  Historical returns have been 10.3% since 1929, but that could be reduced to a 7% to 8% range in the coming years.

Currently, businesses seem to be either fairly valued or overvalued. We believe a pull back is needed to flush out some bargains from our watch list. The current bull market rally which started in October 2002 is looking old. The median bull market since 1900 has lasted about 27 months, according to Leuthold Weeden Research. However, in recent years, a bull market has tended to last 2 ½ to 3 ½ years, according to State Street Global Markets, a Boston brokerage firm.

We think the 18 year bull market from 1982 to 2000 could be followed by an 18 year secular bear market, with intervening rallies...lower highs and lower lows. Buy-and-hold will be replaced by buy-and-watch. Active portfolio management will be essential to success during the coming years.

Stock Market, Short-Term (No change in outlook)
We have struggled during 2006 to find good businesses at reasonable prices and the right countries to invest in. We look for the correction to either continue or a consolidation pattern to emerge throughout the summer and fall in the US market.  We look for an entry point into Western Europe and to enlarge established positions in Japan. We think at some point bonds, REITs, and other income type securities will become attractive again. The economy should slowdown in the US and that will probably affect foreign economies to some degree.  If the fears about a soft economy in 2007 are quelled,  a small rally before 2006 is a possibility.

Stock Market, Technical Indicators
On July 31 the S&P 500 Index closed at 1276 which was over the 200 day average of 1260 and just over the 1266 38.2% Fibonacci. However, the 38.2% level was penetrated intraday. The 61.8% retracement is only a 7.38% correction. The 1121.26 monthly 38.2% retracement would be a 15.48% correction, and that is within a “normal” 10 to 15% correction range.

Since the index has taken out the daily Fibonacci retracements and has retraced over 100% of the last run, we will focus on the weekly and monthly Fibonacci timeframes.  Those levels are shown in the following table. On the weekly timeframes the S&P 500  made it down to 1266 intraday last week. It will go lower. Fibonacci retracements have proven quite reliable historically, and they work for most markets.

Fibonacci levels for the Russell 2000 Index, representative of the small cap market, are shown below. The index has fallen more than 100% of its daily Fibonacci retracement (which is not shown below). On the weekly timeframe, the index will have to fall to 719.73 in order to complete a 38.2% retracement on the weekly from October 15, 2005 low. The index hit 700 on Monday July 31, 2006. It has fallen to the 50.0 % Fibonacci retracement on a weekly basis. It is more likely to fall to the 61.8% point of 679, which is near the 400 day EMA of 673. The index has not fallen to its 38.2% retracement on a monthly basis, but in a bear market pullback, that is very possible. We have had a bare minimum allocation to small cap mutual funds for some time now.

Other technical indicators forecast further weakness. July 31, 2006,  the indicators say we have an overbought US market. The McClellan Summation Index, a good advance indicator, started the year at 369; rose as high as 772 on February 1st, and has been declining ever since. It got as low as –518 on June 27th and stands at +22 at July 31, 2006.

I don’t have a good answer as to why we don’t track the foreign markets. We should.

The chart below shows the other technical indicators we watch on a daily basis.

These indicators are telling us the market is due for a short-term decline.

Stock Market, Sentiment Indicators
As of July 31, 2006  the AAII Index percentage of bulls was 34.9%, the percentage of bears was 43.0%, and the percentage of neutrals was 22.1%. A high percentage of bears to bulls is a contrary indicator, but given current conditions and technicals, it may not be high enough to signal a near-term rally. 

The Chicago Board of Exchange’s VIX or volatility index was 14.95 at the close of trading July 31, 2006.  The VIX ranged from 11.10% on February 15, 2005 (the height of the market indices) to 19.34% on August 6, 2004 (the low of the market indices).  A VIX over 25 indicates fear, investors paying premiums for puts, a contrary indicator, and a possible buying point. A VIX at 10.00 indicates complacency, investors paying less than normal prices for puts, and possible selling point.  (The VIX is derived from two month of prices of all quoted at-the-money and out-of-the-money S&P 500 Index puts and calls.) 

The correction will probably continue on into October.  The market is overbought at the moment. However, the market could be higher when the year ends on December 31.


Foreign Stock Markets (unchanged)
At a seminar on May 6, 2005,  a representative from Julius Baer Global mutual fund showed correlation between US stocks and foreign stocks to be approximately 90%, meaning that the 90%  of the performance of foreign stocks can be attributed to performance of US stocks. If US stocks fall $1.00, foreign stocks should fall by $ .90 cents. However, he gave other reasons to invest in foreign markets at that time.  Valuations were generally more reasonable. Opportunities for growth were greater than the US then and we believe still are. Foreign consumers do not have as much debt; therefore they have more sustainable consumption patterns. We tend to agree. On the other hand, there are risks.

Last quarter we reduced the Fidelity Latin America Fund to a 1% holding because of concerns over the socialist leanings of the governments of Venezuala and Bolivia. Apparently other investors have similar feelings because the Latin American stock market sold off, mostly after we sold. During this last period we increased the allocation to India to 2%.

Housing Market Bubble (unchanged from previous letter)
Lately, there has been much debate about whether there is a housing bubble. Since 1929 the average annual increase in real estate has been 5.3%. Since 1968 the average annual increase has been 6.2%.  In 2004 the increase was above 10.0% in many areas versus around 5.0% in the 2000 to 2002 timeframe. Properties in coastal areas have risen at a greater rate than 10.0% recently. Prices in certain areas of the country have risen at higher rates. Prices are being driven by low interest rates, low down payments, loss of objectivity on the part of realtors, appraisers, and mortgage brokers, shortages of desirable land, high immigration rates, speculative activity, and lack of supply (of good homes and land). Household or personal incomes are not keeping pace, pushing affordability down.

In our view, anytime prices are rising faster than the historical average, there is the potential for a bubble. The present rates are not sustainable, irrespective of whether there is a bubble in a particular area of the US. A study of historic median house prices to median incomes will show the multiple is much higher than historic multiples. A study of rent to house prices will also show higher ratios.

Yale professor Robert Shiller believes there is a housing bubble, but he is not sure how to measure it or when it will end. He believes that excessive talk about and attention to the problem will be the catalyst. He believes it will end badly, whatever that means to individual sectors and areas of the country. Not everyone agrees with the bad ending.

Why should you care? Because a severe break in housing prices can cause a recession in the US and in turn possibly in foreign countries. Stock markets will follow downward.

For those of you thinking about a real estate purchase now, let us add this little postscript. Martha Stewart has sold her East Hampton NY place for $9 million in 2005 and has her Turkey Hill farmhouse in Westport CN listed for sale at $9 million. Her cost in 1972 was $80,750. As we know, she had pretty good timing in selling Imclone stock, didn’t she? Only kidding.

Commodities Bubble
Since our last letter, we added approximately a 2% allocation to metals by buying BHP Billiton and Phelps Dodge, the two largest miners, drillers, and processors of metals.
We added to gold positions, bringing the allocation of gold and metals together up to around 7%. We still hold Central Fund of Canada and Tocqueville Fund because the world economy is still strong, inflation is still a threat, the US government is still selling bonds to cover the budget deficit, the dollar may continue its decline,  China may increase gold reserves significantly, sucking up most of the world’s gold production temporarily, and last but not least, there is a war in the middle east which could widen.

Valuations
At any one time, the market is either overvalued or undervalued. We believe it is never precisely fairly valued as so many commentators will say from time to time. When Robert J. Shiller published Irrational Exuberance in 2000, he thought the market was clearly overvalued. He still thinks so today. High prices, relative to average, have been followed by lower prices, regardless of fundamental factors. In every market, reversion to the mean takes place.

According to Jeremy J. Seigel in Stocks for the Long Run 3rd edition,  the real return on stocks from 1802 to 2001 was 6.9%. Add inflation of 3 to 4% and you get a total return of somewhere north of 10%. Seigel argues that the price of an investment should equal the present value of the future stream of dividends, including buyback of shares from retained earnings. Whether you get a 10% return depends in part on the the price you pay for the investment and the dividends it pays. This bring us consideration of the price-earnings ratio or PE ratio.

According to Seigel, the historical PE ratio of “the market” from 1871 to 2001 has been 14.45. Divide that into the average value of “the market” and you get a figure called the earnings yield, 6.8%, which nearly matches the 6.9% real return, cited above. Seigel says that “the market” represents the entire market value of all stocks of all companies, both large, medium, and small in size. That makes comparisons difficult with individual indices such as the DOW, the S&P 500, the DJ Utilities, the NASDAQ, and the Russell 2000.

As of July 28, 2006, according to Barron’s,  the PE ratios for certain of these indices are all higher than 14.45, (DOW 21.52, S&P 17.59, DOW utilities 19.71). Seigel argues that a stable economy, low trading costs, low inflation, and lower taxes justifies PE ratios in the low 20’s, for an earnings yield of between 4 and 5%. However, inflation is not low, the economy is not stable, and the 2 yr Treasury note yields 4.96%. Using the historical 14.45 ratio together with the current environment suggests present market overvaluation to us.

For 200 years, the equity premium in the earnings yield of stocks over the rate of “safe” long-term government bonds has been about 3.5%. Since 1926, the equity premium has been about 5.0%. Seigel argues that the future equity premium should be between 2.0% and 3.0%. The earnings yields on the DOW, the DJ Utility average, the S&P 500 Index, and the S&P Industrial Index are all lower than either the 10-yr Treasury note yield of 4.98% plus 2.0% and the 30-yr Treasury bond yield of 5.07% plus 2.0%. Again, this suggests present market overvaluation.

Historical dividend yields have been in the area of 3.0%. Prior to 2004, dividends received by individual taxpayers were taxed at their marginal tax rate. Today, qualified dividends are taxed at a maximum rate of 15.0%. Dividend yields could conceivably be in the area of 2.4% and still be at the historical level. The dividend yield for the S&P 500 Index is presently at 1.92% as of July 28, 2006. Companies aware of the desirability of paying dividends are increasing them, narrowing the gap between historical and present yields. Again, this suggests present market overvaluation.

Historically, the ratio between earnings growth and price to earnings (PEG ratio) has been 1.00. Put another way, over time, the percentage of earnings growth of a company should be the same as the percentage of the price-earnings of the stock. The S&P 500 forecasted earnings for 2006 is $78.43 versus the historical $69.93 for 2005, an implied growth rate of 12.15%. With a PE at 17.45, the PEG ratio of the S&P 500 is presently 1.44. Unfortunately, we do not have recent historical data for the S&P 500.

Bonds
Since our last investment outlook letter we made minor additions to foreign bond mutual fund positions. I could be early because of a heightened risk of inflation and interest rate increases.  But there is also risk of a recession because the Fed has overshot  8 of the last 9 rate hike cycles. In a economic slowdown, rates decline and bond prices rally. We hope the future will validate the decision. So far, the positions have appreciated, slightly.

We do have a 7.80% appreciation in Rising Rate Opportunity Fund as of July 31, 2006, which doesn’t seem significant, but it was as high as 14.0% until the recent pullback in the yield on the 30 year bond upon which the fund is keyed. Further, because the asset allocation was more than 10%, there is significant dollar appreciation, which at the moment is all potential short-term gain. With the prospect of a hawkish Fed, we are still betting on more appreciation in the fund. Our gamble is that the 2 year and the 10 year note yields will not invert, signaling a recession and the end to this short-term bet, plus the 30 year bond prices will decline again, pushing up yields and the gain in Rising Rate Opportunity Fund.

REITS
REITS have outperformed all other asset classes over the last five years, but that trend could be coming to an end. Higher interest rates can be fatal to that trend, as also a slowing economy could be. Yields have come down from 9% to 5%, generally, although there are a few that yield between 6% and 8%. We will be patient with investments in this asset class, although we have added a couple of apartment REITS recently, mainly for potentially increasing dividend income. Since our last investment outlook letter, some REITs increased in value, particularly apartment REITs.

The Iraq War (Unchanged from the last investment letter)
Like or not, the costs of the Iraq war are affecting the economy and the budget deficit. There is some indication the Pentagon is studying troop reductions of up to 30,000 plus before the end of 2006. There are both problems and progress. As we see it, the economy (of Iraq) will greatly assist in stabilizing the country and that depends much on oil production. Through January 2006, oil production has averaged about 1.9 million barrels a day,  somewhere south of 2.03 million barrels a day in 2002. Iraq exports about 1.0 million barrels a day and consumes the difference. The US hopes to get production up to 3.0 million barrels a day by December 2006, of which about 1.0 million more barrels will be exported, it is hoped. If the US imports all of that increase, I wonder what the cost per barrel would be, including all the war costs?  

Bear Market Funds
We sold the Prudent Bear Fund during the period at a small gain. We may come back to it, unless we find better alternatives. We bought ProFunds Ultra Emerging Markets Fund to protect against declines in emerging market mutual funds. We probably bought too much, as we realized significant losses when we reduced the position. However, that has to be weighted against the cost of buying puts to protect against losses. We think emerging markets may correct further before November comes.

We will raise cash, hedge to a degree, and buy the best-in-class mutual funds and great, financially strong businesses on the dips. About one out of every four years, there is a correction. If one develops this year, we believe it will be an opportunity.  The low-term decline in interest rates may have justified passive investment with index ETFs which include weak and marginal companies, but the rise in interest rates and moderating returns on stocks will justify active portfolio management with best-in-class mutual funds and great, financially strong businesses purchased at reasonable prices at the right time.
 
Cash (Unchanged)
We expect to vary cash positions depending on opportunities to invest and hedge.
We believe that healthy cash positions, hedge positions, foreign equities, energy, and defensive-type equities will serve us well during 2006.

We appreciate the trust and confidence you place in us to manage your wealth.

Sources of index information comes from the online website www.finance.yahoo.com.