The Roller Coaster Ride
From 10/13/05-10/9/07 the S&P500 “dumb” index enjoyed a 33% gain with a few sharp declines along the way. (Investors cannot directly invest in indices.)

From 10/9/07- 3/10/08 the index tumbled 18.6%. From 3/10/08-5/19/08 the index soared 12% in a short time after the Fed’s action to avoid a worldwide credit collapse by arranging the Bear Stearns takeover.

From 5/19/08 – 7/7/08 the index quickly tumbled 13.1% as the housing and financial sectors sold off more, and energy prices skyrocketed, sending airlines and auto companies into even larger losses.

We have now had a 20%+ decline in both the Dow and S&P500 indexes since the peak of 10/9/07 which is a “bear market” definition.

The concerns over energy, inflation and tight credit are also affecting many foreign markets. The London FTSE100 index is down over 20% from its peak in November 2005. Many other European and Asian markets are also down 20%-30% or more.

Instead of “dumb” index funds with no brains behind stock selection, we have always sought investment opportunities with consistent market-beating performance relative to risk. Therefore, I and most clients are doing substantially better than the indexes, but still have painful losses.

Advice for Those Fully Invested, Like Myself
Over the long-term, equity investments have provided good returns, beating bonds, inflation and money markets. Historically down markets have always recovered to new highs – it’s just a matter of patience.

If your goal is long-term growth, your portfolio value is only important when you need to take money out, which for most is still many years away.

In a volatile market many investors choose to move more to a cash position, which in their thinking may reduce short term losses.

On the other hand no one can really time the market, and usually some of the biggest market gains come at inflection points such as March 10th when we enjoyed the rapid 12% gain in the S&P500 Index. We are waiting for another inflection point that will hopefully prove sustainable. We do not know when that will be. We will not know that it has happened until after the fact – too late for cash on the side to benefit from the often higher initial gains like in March.

Buying and holding for the long term usually results in better returns than trying to time the market. Having cash on the side may in the short term reduce losses, but it usually misses some of the biggest gains at the inflection point.

If you bail out and sell existing holdings you lock in your losses and will not participate in the next recovery. For those that need to take distributions to meet cash needs, you have no choice, but to the extent you can it is best to ride out the decline, in order to participate in the next upturn.

Consider Portfolio Fine Tuning
You are invited to call to set up a meeting either in person or phone to review your portfolio. We often recommend some adjustments or various options to stay invested but reduce risk in various ways.

Advice for those with Cash
Yes, it is scary to invest when the market has had a large decline. It is more fun to invest when the market is soaring. But of course that is the opposite of what results in the best long term returns.

As of 7/9/08 the S&P500 index is back to its level of 7/21/06. It is not often you get to invest at market values of almost 2 years ago!

Is there hope for near-term recovery?
While no one can predict timing of the next inflection point that starts a market recovery, there are positive signs among the gloom. The market has already taken into account some of the worst of the potential bad news. While unexpected future shocks could make the bad news even worse, for the most part the current market decline is more based on emotional fear than on market fundamentals.

Good Times Follow after Bear Markets – “One good thing about bear markets is that they end. … A rally is coming; the only question is when…We could also be in for a quick recovery, such as the one in 1987; where the downturn only lasted about three months…Bull markets tend to last longer – an average of three years – and have greater gains than were lost in bad times.” says CBS MarketWatch 6/28/08

Big bounces often happened after bear markets. In 1980, 1987 and 1990, the S&P 500 was up at least 20% six months later.

Market Valuations – Traditional price/earnings ratios are relatively low. Stock values as measured by the price to sales ratio may be a better indicator of stock values, since earnings are easier to fudge than sales. An Investopedia article 6/24/08 says, “Since the tech bubble burst, the price to sales ratio has become the value investor's favorite stock screen because it does a better job of identifying stocks to buy on the cheap.” On a price/sales basis stocks overall are as cheap as the 2002-2003 lows before the big recovery. Source CNBC

Market is Extremely Oversold - The Standard & Poor's Oscillator, which traders watch closely, measured -9.4 on June 30th; a reading of -4 suggests a market that's oversold and ready to bounce. A reading below -8 is “extremely oversold” It was the lowest reading for the oscillator since July 2002 just before the tech crash recovery. The oscillator is based on changes in highs and lows for stocks and moving averages. Source: MSN Money and CNBC July 1, 2008.

Another analyst said on 7/1/08, “We are simply too oversold to go down much further in the near future unless there is going to be a huge crash, which I don’t expect on such low volume in the middle of the summer. The S&P Oscillator showed a -9 earlier today which is extreme and indicates that shorts must be covered and stocks bought.”

Continued Strong Corporate Earnings – If you exclude the troubled financial and housing sectors, it is expected that 2nd quarter 2008 earnings will again show about a 10% gain. This continues the long streak of higher earnings. Corporations have a record high level of cash, yet their stock prices are mostly declining. Productivity continues to increase.

Lots of cash available to invest – money market fund assets are at a record high of about $3.2 trillion.

Exports and Job Losses – With the weak dollar, exports continue strong, offsetting the housing crisis. GDP growth is projected to remain at about 1%. This is the slowest growth in five years but at least is positive. June employment declined for the sixth month but is mostly limited to certain sectors, and not nearly as bad as in times of recession.

Credit Markets hint of a thaw – The Kiplinger Letter reports, “Credit markets are finally showing some hint of a thaw. Banks are repairing their balance sheets, raising $212 billion this year. But the crisis isn’t over yet. Big banks are still tightening, adopting stricter lending standards as they wait for the U.S. economy to stabilize before easing up.”

The Fed has made money easily available at the “discount window” for banks to borrow. However, banks must still meet regulator capital requirements and are hesitant to loosen credit requirements, even though the Fed has made funds available at a very low interest rate.

Housing ARM Resets are slowing dramatically
There are two kinds of adjustable rate mortgage (ARM) resets:

1) ARMS that reset periodically to the current market rate. With mortgage rates near 40-year lows these mortgages are not the main concern.

2) ARMS based on an artificially low “teaser” rate, typically for the first two years. Monthly payments for the first two years may be based on a teaser rate of 1%. After the initial teaser period rates may jump to the current market rate of about 6% resulting in a huge increase in payments. Borrowers were told they could simply refinance when higher rates kicked in. Even worse, rates can reset to a large premium above current market rates for borrowers with poor credit.

The teaser rate ARMS are the big concern since payments can double or more on some of those mortgages. Some borrowers could have qualified for better mortgages, but since the lender and mortgage broker made more money on these mortgages many owners were sold them by less- than-honest brokers.

As home values started to decline and foreclosures rose, these teaser rate mortgages became less common. Most of the teaser rate resets occurred in 2007 and in the first half of 2008. Only a small number remain to reset in the last half of 2008, and almost none in 2009 and later years.

However, foreclosures are still rising with about 2.75 million mortgages now in default. Refinancing is almost impossible even for many folks with great credit because of what has been called the “death spiral” of home values. With values plummeting in many neighborhoods, there are now more than 9 million mortgages in a negative equity position. More foreclosures drive down home values more. Mortgage investors have to take huge losses at foreclosure sales. Increasing unemployment is contributing to mortgage defaults. In some parts of Michigan, for example, there is a 10 year supply of homes on the market!

The Dodd /Frank Plan in Congress – a start at helping the “death spiral” victim. But Republicans have blocked its passage and Bush has said he will veto, using the excuse it bails out irresponsible homeowners and speculators. The plan only applies to owner-occupants not speculators or rental owners. It expands the FHA program if the lender is willing to take a large loss and the homeowner qualifies for a reduced mortgage at a reasonable interest rate. In the base proposal in the House there is no government cost. It is hardly a bailout. The lender has to agree to lower the mortgage to 85% of the current appraised value. The FHA will insure the loan to a qualified borrower. The FHA gets an extra 1.5% for FHA risk insurance and if the home is sold at a profit the government gets a share of the profit. It is hoped that enough Republicans will cross over in order to override the promised Bush veto.

The proposal is so narrow it is only a very small life raft, given the numbers on the sinking boat. But it’s a start to address the prime cause of the current economic downturn that affects far more than just the homeowner facing foreclosure.

Many are warning that more dramatic measures will ultimately be required. “The depth of pain is not being registered in D.C.,” reports Businessweek 7/7/08

In a speech on 7/8/08 Treasury Secretary Henry Paulson presented many ideas to provide more mortgages financing including Covered Bonds which have been widely used to finance mortgages in Europe.

Homes more Affordable -- as prices plummet more renters can afford a home. The affordability index is back to 2004 levels. Qualified buyers can get fixed-rate financing at near 40-year low interest rates.

Energy costs hurt but may have peaked
Demand for energy is slowing, with more conservation both in Europe and the U.S. However Asian demand is growing due to rapid economic expansion. Europe has had $8/gallon gas prices for years. They have adjusted and conserved. It is a serious issue but not as much of a crisis as the housing industry. It hurts lower-income folks the most.

A tax cut for low and middle incomes would help offset higher energy costs. Those who prosper from high incomes enjoy some of the lowest individual tax rates in the world. Rolling back the Bush tax cuts for those with incomes over $250,000 seems reasonable, if it is spent to help the housing crisis that is affecting many economic sectors, or helps reduce the huge deficit. It is only an increase in the top rate from 35% to 38.6%. The economy did very well at those rates, never mind pre-1986 when the top rate was 70% with a maximum tax of 50% on earned income over $52,000. The Bush tax cuts have been shown as a redistribution of wealth from the middle income to the wealthy. Reducing Iraq military spending is also a source of funds to help Americans at home or reduce the deficits.

A Not-So-Widespread Downturn – “So far, the weakness has been largely confined to the financial, housing and automobile sectors – suggesting the economy may be more resilient than it appears,” says Business Week 6/16/08. The article points out that without housing and auto industries the GDP grew 2.8% and 2.5% in the last two quarters. The service sector - which accounts for nearly 60% of GDP - grew at 3.1% and 3.5% the last two quarters.

Consumer Spending and Income Up- May consumer spending rose 8% although it was helped temporarily by rebate checks. Disposable income, which excludes taxes, rose 5.7% in May, the largest single month gain since May 1975, reports Forbes 6/27/08

Tough markets contain lots of opportunities – “Investors may be seeing the peak of negativity in the market these days, and that’s exactly why buy-and-hold types should be on the lookout for opportunities. Sentiment is so negative right now that you can’t help but make money in some companies if you take a three-year, buy-and-hold horizon.” Quotes Marketwatch 6/28/08 reporting on the Morningstar Investment Conference.

Good Time to Invest?
The market historically has had gains ahead of positive news of an economic rebound once it sees early signs of a recovery potential, as it did in March.

Is the stock market cheap enough? Relative to bond yields, the stock market has declined more in the current revaluation cycle than it has in 14 of the 15 major declines since 1950!

In a world where bond yields are near four-decade lows as is the core inflation rate, where liquidity growth has been far faster than economic activity, where the vast majority of corporations (excluding financials) are still producing double-digit earnings gains, where there is more growth coming from more parts of the world than ever before, where policy officials are working to speed up economic activity, and when most are pessimistic and scared about the future, sounds like a great time to BUY!

For those fully invested we have recommended staying invested, since we can’t time the market and as the market turns you have to be in it to participate in what are often large early gains.

Yet protect as Much as You Can
While the outlook for equities is good, you still need protection from unexpected turmoil.

Traditional protection of bonds is risky with yields near 40-year lows. This makes them very risky unless held to maturity, in the likely event of

interest rates eventually returning to more historical norms. Or worse, a credit crisis if foreigners are not willing to continue to fund much of our $9 trillion-and-growing national debt. This could cause interest rates to soar and bond prices to plummet.

We are encouraging the use of bond alternatives and other types of investments to diversify from equity market risk. We make recommendations based on your investment objectives.

We are very pleased with the results of most of our recommendations and believe they continue to offer good risk/reward fundamentals for those with a long-term growth objective. But some increased downside protection in the event of another crisis is prudent using alternatives.

Our Recommendations
Instead of “dumb” index funds with no brains behind stock selection, we have always sought investment opportunities with consistent market-beating performance relative to risk as measured by “alpha.”

We believe Investment managers are best judged by the alpha that they have historically generated. Alpha measures the excess return for the risk taken. While past performance does not assure future results, we recommend opportunities with a long history of outperformance vs. risk, not just blind index investing.

"Participate yet Protect"- Most of our clients need reasonable growth to fund 20-30 years of active, healthy retirement and need some protection strategies from large market losses. A 65-year old American husband and wife couple has a 50% chance that one of them will live at least 27 years to age 92 (Source: On Wall Street, SOA).

The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be construed as investment advice, since recommendations will vary based on a client’s goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy. All economic and performance information is historical and not indicative of future results. Please consult one of our financial advisors for more information. Hutchison Investment Advisors, Inc. is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given to advisory clients and is available upon request.