The much awaited employment report came and went with barely a notice from the financial markets. After the now usual revisions, the employment report showed that the economy was still creating jobs, albeit at a pace that is below the average of the past 12 months. When looking behind the numbers, the report confirmed what other reports were showing, manufacturing continues to suffer, and while the service side remains relatively robust. For the third month in a row jobs were lost in manufacturing, a condition that many believe cannot continue without an economic slowdown (if not an outright recession) occurring sometime soon. This week the Fed will meet for the last time this year and they are expected to leave rates unchanged. Their discussion regarding the economy and inflation will be the key for the markets – an attempt to gauge their next move (which is expected to be a cut sometime in the first half of 2007). Other reports that investors will be watching will be the inflation reports that should come in relatively benign, but will take on added significance with the Fed meeting also this week. With the big reports for the month finishing up this week, investors will likely be “shutting down” for the year.

If the economy is merely doing OK (on its way to not so great), why is the equity market doing so well? We are seeing a huge dichotomy between individuals and corporations. Corporations are very flush with cash and are having a hard time to find places to actually put it to productive use (expanding plant/equipment or hiring). The proliferation of mergers and buyouts is a direct result of too much cash trying to find a productive place to go. The consumer has been on a spending spree, funded by the increased value of their homes (which have stopped rising). Unlike the corporate balance sheet, the personal balance sheets, as a group, are in terrible shape and will require more than a few years to repair, putting a lid on robust economic growth. So corporations are chasing deals and not building capacity while individuals curb spending to rebuild their reserves does not bode well for long-term economic health. The big however in this are the corporate buyouts that could keep the markets chugging higher for longer than many would expect given the economic backdrop that we are facing. While the markets may be short-term bullish, we believe the current situation is long-term bearish for stocks.

The employment report was not received well by the bond market, as it pushed off a likely rate cut by the Fed to May from March. Whether in the first or second quarter, we believe that a rate cut will happen next year and will be the beginning of a rate cutting cycle that will take the 10-year bond below 4% in either 2007 or ’08. Even though rates backed up a bit last week, the bond model remains at a bullish “3”, still pointing to lower rates ahead. The commodity markets remain the prime concern of the bond market, as oil and gold have regained their footing and have begun moving higher. Since we believe the consumer will be sitting on the sidelines, the Fed will need to move rates lower than many expect to get the same bang they got during the last rate cutting cycle.

© 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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