2nd Quarter Letter to Clients.

Note. This is the complete text copy of the investment letter that is going to clients this week with their mid-year portfolio summaries.

Frustrating is perhaps the best way to describe the markets through June of 2005. Stocks have spent most of the last 18 months endeavoring to go nowhere and continued their sideways consolidation of 2003’s gains which we have previously documented. We have included a chart of the S&P 500 {SPX} which shows it’s choppy performance this year. Please note that the red horizontal line shows where the SPX began 2005. Through June all of the major averages had posted negative returns. The technology heavy Nasdaq posted the worst results being down a bit over 5%. The Dow Jones Industrial Average lost about 4% and the SPX 500 lost just a shade over 1%. Only smaller companies have out performed during this time. Analyst estimate that the average stock lost 5.5% through June 30th .

The choppy nature of the market has placed us in a more defensive position these past 18 months. Among other things we have carried larger cash positions commensurate with client risk during this time in order to minimize some of the downside and some of the market’s volatility. Yet at this time our thinking on stocks is undergoing a sea change. Our work is telling us that based on current information the market is undergoing a subtle yet profound change in character. It is our belief that we are entering a period of market transformation that will bring equities back into vogue. We feel that the pieces are in place for a sea change which has the possibility of giving us above average appreciation over the next 6-18 months.

Please remember that what follows is not our thesis about today or tomorrow but for the next 6-18 months. We are simply stating our current investment thinking and deriving certain probabilities based on the facts as we see them at this time. Something could happen tomorrow that would make us rethink this whole process. It is not written in stone. If such a change comes about we are prepared to turn on a dime and adjust portfolios accordingly.


The corrective phase that we have recently witnessed is long by modern standards. Stocks in the main correct in one of two ways, time and price. Most larger stocks have stagnated during this time period. Any corrections that they have seen have tended to be shallow. At the same time corporate earnings have been strong and corporate balance sheets are in good condition. Each day that passes when stocks trend is a day in which their valuations contract.

The economy is in much better shape than most economists would have thought a year ago. As evidence note that the budget deficit is actually contracting versus estimates given at the beginning of the year. Lower growth in Europe & Asia could slow the US economy next year to around the historic GDP growth rate of 3%. If this occurs it should lead to a deceleration of inflation. There have also been the twin headwinds of rising interest rates and rising oil prices. Any indications that oil prices have peaked or that the Federal Reserve might stop raising of rates would be viewed as extremely positive by stocks. Irregardless, interest rates are likely to remain relatively low by historical standards.

However we believe that the issues most holding back stocks at this time is the extreme pessimism exhibited by investors towards equities. Let’s face the facts on stocks. Year 2000 up to now has been rough going with only 2003 showing strong positive results. Even last year’s fourth quarter rally was a chimera which proved to be little more than window dressing as stocks promptly gave back most of these gains between January and April. Otherwise, a 2 1/2 year equity meltdown, terrorism, wars in Iraq and Afghanistan, a Presidential election decided by the US Supreme Court plus corporate scandals are not an environment conducive to long term stock performance or investors perception that stocks are a good place for their money.

But a benign slow growth environment with some help next year from oil and the Federal Reserve should allow for market expansion. While investors have turned a general thumbs down towards equities, Corporate America has been buying back either their own stock or the shares of other companies. CNBC recently stated that corporations are buying back shares to the tune of 1.5 Billion dollars a day while corporate mergers and acquisitions have substantially accelerated, the most prominent example of this is Procter & Gamble's pending purchase of Gillette.

Now a caveat: Our more positive attitude comes with these cautions. While the market has experienced a fairly substantial rally since early April, we are entering a seasonally weak period for stocks. July through September are typically months where the market has traditionally been weak. Therefore it would not surprise us to see stocks slightly lower or flat from these levels by early fall. Again this may not happen this year but that is the seasonal pattern. The 2nd thing is that there are events that could derail this thesis. A major terrorist attack or some unexpected glitch in the economy would render these thoughts suspect. Investors are always worried about the consumer (we usually are not) but any evidence in consumer spending slow down could have a dampening effect on stock prices. Finally an unexpected price move in oil (i.e. oil at 100 dollars a barrel) could finally pose a substantial risk to economic growth.

All that being said, we are now more positive on equities than we have been since the spring of 2003. It is not clear if this will happen in a short violent upward thrust or whether it will be something that occurs gently over a period of months but the conditions are more favorable now for growth than they have been in quite a long time. We are therefore in the process of becoming more aggressive for accounts based on their investment parameters and risk profiles. Areas of concentration at this time should be technology, biotech, medical, retail and financial shares once evidence shows up that the Federal Reserve is done raising interest rates. Much of this exposure can and will be bought in accounts using exchange traded funds.

The sea change we are talking about is mostly in psychology. Since early 2000 investors have grown accustomed to selling stock market rallies. If we are correct in our analysis, investors will soon prefer to “buy the dips”.

Reports

Clients:
We have finally received all of our copies of your statements from your brokerage firms. Your first half reports will start going out over the weekend.

Lumen Capital Mangement, LLC

Bastille Day

Happy Bastille Day to all our friends at the Hotel California & Divisions 1 & 6!

A Sea Change.

This is an almost 5 year chart of a large company that everybody knows. Because I'm not in the business of on line stock recommendation, it's name has been omitted to protect the innocent. This company's share price has done nothing for these past 5 years. I have inserted it today to illustrate several points. For one thing the price tracks of this chart indicate that some resolution to its base should be forth coming soon. More importantly there are a lot of really big companies with similar looking charts. I'm using this illustration as a backdrop to give you my current thinking on the state of the markets.

Please remember that what follows is not a recommendation. I am simply stating a thesis and deriving certain probabilities based on the facts as I see them at this time. Something could happen tomorrow that would make me rethink this whole process. If such a change comes about I am prepared to turn on a dime and adjust portfolios accordingly. I write this blog to give my clients an insight into how I analyze and invest the money that they have entrusted to me. All others act on these thoughts at their own risk.

My clients are no doubt aware that I have developed a relatively cautious stance on equities since early 2004. My thinking has lately turned more positive. I think that the market is on the verge of a sea change that could finally move us out of this long trading range and has the possibility of giving us significant or above average returns over the next 6-18 months. I think this is a possibility because in the main the broader averages have done nothing since early in 2004. I think they have been digesting the big gains that they achieved in the last 9 months of 2003. Stocks in the main correct in one of two ways, time and price. Most larger stocks have stagnated during this time period. Any corrections that they have seen have tended to be shallow. At the same time corporate earnings have been strong and corporate balance sheets are in good condition. Each day that passes when stocks trend is a day in which their valuations contract.

The economy is in much better shape than most economists would have thought a year ago. As evidence note that the budget deficit is actually contracting versus estimates given at the beginning of the year. There have also been the twin head winds of rising interest rates and rising oil prices. Any indications that oil prices have peaked or that the Federal Reserve is close to finishing its raising of rates would in my opinion be viewed as extremely positive by stocks.

While investors have turned a general thumbs down towards equities, corporations have been buyers of their own stock and the shares of other companies. CNBC recently stated that corporations are buying back shares to the tune of 1.5 Billion dollars a day while corporate mergers and acquisitions have substantially accelerated, the most prominent example of this is Procter & Gamble's pending purchase of Gillette.

Now a caveat: My more positive attitude & approach comes with several cautious remarks. While the market has experienced a fairly substantial rally since early April, we are entering a seasonally weak period for stocks. July, August & September are typically months where the market is apt to underperform. Therefore it would not surprise me to see stocks slightly lower or flat from these levels by early fall. Again this may not happen this year but that is the seasonal pattern. The 2nd thing is that there are events that could derail this thesis. A major terrorist attack or some unexpected glitch in the economy would render these thoughts suspect. Investors are always worried about the consumer (I usually am not, see some of my earlier posts) but any evidence in consumer spending slow down could have a dampening effect on stock prices. An unexpected price move in oil (i.e. oil at 100 dollars a barrel) could pose a substantial risk to economic growth. Finally it is the nature of investors to become more optimistic as stock prices advance. Stocks, particularly smaller capitalized securities have had nice rallies off of their spring lows. This thought process has little to do with this current rally (although I did find it very positive that world stock prices shook off the tragic events in London last week). In the short term as I stated above, it would not surprise me to see stocks experience some sort of pullback. This might occur for no other reason than stocks have experienced some nice short term gains in anticipation of the earnings corporations are going to report during the rest of the month. Investor complacency is also relatively high at the moment and that is often a short term negative. The nature of that pullback (should it occur) will determine how I will structure portfolios for the fall.

One final caveat: If I am correct this will not be a move to higher prices that occurs in one day, week or even a month. This is not a call that says we need to invest everything all in the market today. Indeed I believe that there will be many opportunities to become further invested as stocks trend generally higher but experience normal backing and filling over the coming months.

All that being said, I am more positive on equities than I have been since the spring of 2003. I do not know if this will happen in a short violent upward thrust or whether it will be something that occurs over a period of months but I am in the process of becoming more aggressive for accounts based on their investment parameters and risk profiles.

I will add detail to this post in my mid-year letter to clients. All other interested persons will be able to have a copy of this letter by e-mailing me after August 1st.

*Mr. English and/or clients of Lumen Capital Management, LLC hold or have held positions in the above pictured chart. Although said positions are subject to change at any time. NOTE:You can see a bigger picture of any included charts by placing your cursor over the chart and double clicking on it. If you then wait a few seconds a little box should appear typically in the bottom right hand corner. Clicking on that box should give you a full screen version of the chart.

Party Like It's 1999.

A monthly Chart of the S&P 500 ETF {Symbol SPY}. The Index has made it back to where it last traded in the Summer of 2001. {Red Line}. If you look further to the left you can see that the S&P has actually made it back to price levels it first passed in early 1999! The SPYs have traded within a range for about 18 months. An advance above these levels is likely to be viewed as long term positive by the markets.

*Mr. English and/or clients of Lumen Capital Management, LLC hold or have held positions in SPY. Although said positions are subject to change at any time.
NOTE:You can see a bigger picture of the included charts by placing your curser over the chart and double clicking on it. If you then wait a few seconds a little box should appear typically in the bottom right hand corner. Clicking on that box should give you a full screen version of the chart.

This Is London Calling.

This is London calling. Above is a chart of the S&P 500 ETF {SPY}. Notice the steep sell off prior to the markets open on July 7, how it rebounded during the day and how it has since kept right on going higher. We are now 3 days into a rally off of the bottom from this event and the SPY has appreciated over 3% from these lows. More importantly the SPY is within shouting distance of its early March highs. I think the market is indicating a possible change in character here. One of the changes for the positive is that terrorism is not having the extreme negative effect that it's had since 9/11/01. That is not to say that the markets are out of the woods when it comes to this type of event risk or that we are trying to minimize the horror & loss from these actions. But London seems to be signaling that it will take an event larger than the this latest massacre to notably affect world financial markets at this time.
*Mr. English and/or clients of Lumen Capital Management, LLC hold or have held positions in SPY. Although said positions are subject to change at any time.
NOTE:You can see a bigger picture of the included charts by placing your curser over the chart and double clicking on it. If you then wait a few seconds a little box should appear typically in the bottom right hand corner. Clicking on that box should give you a full screen version of the chart.

NBBT!

Today we had an NBBT {Next Big Bad Thing}. This one was a bit different because the markets have long factored in that we would have more terrorist attacks in either the US or in most of the nations alligned with us in the War on Terror. Even if we have accepted the fact that there will be more terrorist attack in the future, we never know when they might occur. In the cold calculus of market analysis, the total events of London were measured against both Madrid and New York and the economic impact was deemed to be minimal. I have attached a 5 minute chart of the S&P 500's etf {symbol SPY} to illustrate how American equities processed the information from London during the day. After an initial decline, the US markets staged a rally & the major averages actually managed to finish close to positive by day's end. It is likely that terrorism has by now been factored into the return that investors are now expecting from stocks and it is therefore also likely that it will take an event equal to or larger than the 9-11 events to have a significant negative effect on stock valuations.

The terrorists made a big mistake today because they attacked the wrong city. As horrific as these events are (and any such loss of life is tragic whether it is in London, the United States or Iraq), the Germans dished out worse and the IRA regularly bombed London between the 1970's-the 1990's. The political realities of this event have yet to be played out. Stay tuned.

The Dow Jones Industrial Average

A year Chart on the Dow Jones Industrial Average as represented by the Dow Jones ETF-the Diamonds-(Symbol DIA). A resolution of this wedge is likely to determine our next direction in this average. Since 12/31/03-that is the last 18 months-the Dow is down about 2% {not including Dividends}. Click on the Chart to enlarge it.

June Scorecard.

All of the major averages posted mixed results for June. The S&P 500 {SPX} ended the month essentially unchanged. It is down 1.7% on the year. The Dow Jones Industrials {DJIA} lost 1.8%* for the month and is negative 4.7%* for the year. The Nasdaq Composite was down .56% and has lost 5.4% in 2005. All three of these indexes have cumulatively posted flatish returns since their highs in the 1st quarter of 2004. Stocks basically have chopped around for almost 18 months, essentially going nowhere while consolidating their large 2003 gains. Only the energy heavy SPX is higher than it was in 2004. The average stock according to CNBC has lost 5.5% in 2005^.

I will try to post pictures next week to illustrate the state of the markets. Only the SPX managed to get near my forecast of break even by midyear. I did flag on June 8th that rising investor confidence could signal near term weakness for stocks. All three averages have struggled since then. These numbers are still signaling high levels of investor complacency.

I will also be posting an important series on what I think is likely to happen to the markets for the rest of the year and what we are going to do to try and take advantage of that so stay tuned. As a teaser, I think we are on the verge of some sort of market change.

In the meantime Happy 4th of July!

*Source: Investor's Business Daily, July 1, 2005. Worden Software. Returns are not calculated with dividends.
^Source CNBC: Closing Bell, June 30, 2005.