The growing and contracting economy seems to be growing again, after it was brink of collapse just last week. China and sub-prime lending were going to be the ruin of our economy; today they are contained and are an issue for merely a few. The employment report was better than expected (housing hasn’t hurt job gains) and trade has improved some (although not with China). Interest rates went from forecasting cuts fairly soon, to once again flattening out, and discussions about rate increases are back in vogue. Starting with employment – although the gains were better and revisions to historical data were higher, the fact is the average payroll gains this year is substantially behind the average gains of last year, so they are definitely slowing. As housing continues to contract, employment gains will be harder to come by in the future as well – maybe actually a contraction sometime later this year. Trade figures have changed little over the last year and a half and actually rising over the past year. All the while, the dollar trades sideways as well – unchanged since November 2004. The gradual slowing of the economy will continue through this year and depending upon housing – into 2008, eventually taking equities and interest rates lower.

If volume is supposed to show the real attitudes of investors, we might be seeing lower prices in the next few weeks. Friday marked the fourth consecutive day that volume was lower than the prior day, an event that has happened roughly 1% of the time since 1989. A couple of comments: the longest stretch was 7 days was seven days that ended 1999 (and as the markets rallied nearly 300 points). Second, less than half of one percent of the time (like this week) the markets rallied more than 1.5% on lower volume and the markets usually reversed the direction of the market during the volume decline, so with a rally this week of 200 points, we could see lower prices ahead (and likely on heavier volume). On the OTC market, the stretch has run six trading days, which has only happened a couple of times in eight years. With many of our indicators still working their way lower, we expect that the ongoing correction has yet fully played out. We have targeted a couple of large cap funds that we will remove from portfolios if the above expectations actually begin to unfold, with the proceeds going to cash temporarily. Our expectations for the decline should not extend much beyond the lows established last week. 

Although the economic data points to a rejuvenated economy, the lower short rates actually strengthened our bond model a notch to “4”, pointing to lower rates ahead. The yield curve flattened back to where it was two weeks ago and moved it out of the “recession danger” zone for now. The inversion during ’00-’01 was just short of 18 months, this go round it has been only six months, so if the past is going to be prologue, we should expect current conditions to last throughout 2007, pointing to an actually recession in ’08. If the bumpy economic landing continues, we may that scheduled arrival.

© 2007 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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