Another month comes to a quick close, as the markets race the calendar to finish on the plus side after falling for much of July. Confirmed this week is the economic weakness we have discussed for quite some time, as the GDP growth rate came in well below 3%, prompting investors to believe the Fed will actually step aside in August and take a pass after 17 consecutive hikes. The question becomes whether whatever slowing we are beginning to see has got its own momentum and we could see growth sometime before yearend come in below 2%, which would begin discussions around whether the Fed should start cutting rates (our thought by December). Housing should be the key determinant, as growth has ceased and contraction has actually begun with housing prices falling in some markets, while most regions experience sales slowing. The triple threat of higher oil prices, higher interest rates and lower home prices should, after many years, push the consumer to the sidelines, creating a flat economic growth landscape for the next couple of years – until the consumer is able to repair their balance sheets. It won’t be smooth, and sometimes even unpleasant, but medicine will be taken. 

The markets took a liking to a slower economy and a Fed that is likely to step aside for once and put on its best weekly rally in a year. After being oversold mere a few weeks ago, it is now (on a short-term basis) getting to the point of needing a rest. However, our longer-term indicators have finally reached an area from which a rally could actually ensue. While August may provide a bit of a rally after a few sloppy months, we don’t believe that the picture has brightened much. If we do get a respite from the selling, our indicators could move back to the middle ground before getting a typical September-October swoon that would likely set-up a decent yearend rally. Since earnings estimates remain high well into next year, we expect that the markets may get a dose of economic reality that could push the markets back toward their lows of the year by quarter end. The markets may have trouble rising much more than a percent or two, as it has sputtered at the 1300 level on the SP500 on more than a few occasions in the past year. However, on a relative basis, the technology stocks could rally more, as the damage to that market has been greater – but remember, all the markets are on a short leash. 

For only the third time since the end of January, the bond model has flashed a buy signal, indicating that rates actually may fall in the months ahead. We prefer waiting to get a couple of weeks in a row before declaring the bond bear market over for the time being, as the other two buy signals were merely one week wonders. We have been steady buyers of bonds in the 7-10 year range; we are not yet ready to begin pushing out beyond that range until we get confirmation from our model. At that time we may begin purchasing 20+ year bonds, in hoping to capture some appreciation in addition to the income flow. If we are correct, we could see the 10-year bond (currently just a hair under 5%) trade to 4.5% over the next six to nine months, creating some good appreciation on our fixed income investments. 

© 2006 Paul J. Nolte, CFA
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The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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