Mid-Year Letter To Our Clients.

Enclosed is a copy of our mid-year update to clients of Lumen Capital Management, LLC.
The stock market as measured by the S&P 500 was up slightly more than 2% during the 1st half of the year. Other major indices turned in similar performances. However, the more growth oriented NASDAQ composite was actually down over 1% during this time. Due in part to inflation, rising interest rates, and geopolitical concerns - the market has recently struggled. As of this writing, the S&P 500 (shown above represented by its ETF proxy) is down almost 7.0% since its May highs and the NASDAQ has similarly lost about 14%.
Our interpretation of these events is that stocks are still locked into trading ranges that were initially set at the end of 2003 and in most cases adjusted higher at the beginning of 2005. Within these ranges stocks have followed a fairly consistent cyclical pattern of weakness in the spring-early fall period {corresponding roughly to a period between early March and mid-September} followed by a stronger equity environment over the next 5 months. During this weaker period, peak to trough declines in the S&P 500 approximated -8.5% in 2004, -7% and -5% during two declines last year and so far in 2006 the above mentioned -7%. Similarly the market has experienced almost all of its gains basically during the last 60 trading days of each year. In 2004 the S&P 500 advanced almost 11% in that year’s last two months. Similarly in the same period of 2005 stocks advanced slightly over 10%.
If this pattern holds true to form then we can expect a market that in all likelihood should be moribund until early fall. Stocks are caught in a tug of war scenario where each piece of good news is offset by some market negative. Thus rising interest rates over the past two years have cancelled out the excellent shape of corporate balance sheets. The higher price of oil and the fears of a slowing consumer have trumped accelerated corporate earnings growth. The war in Iraq continues to fester and geopolitical concerns continuously weigh on an economy that has posted above trend line GDP growth.
While earnings reports for the 2nd quarter are not final, Corporate America is on track to produce double digit earnings gains. Companies have announced large buybacks of their own shares, well over $100 billion dollars worth which is currently an increase of 23% over last year. But Wall Street currently looks at this witch’s brew of higher interest rates finally braking the economy, some less than stellar earnings reports at high profile technology firms and the mounting tensions in the Mid-East & on the Korean peninsula and has factored in some period of slowdown ranging between a recession and a depression.
We are of the view that while the economy is indeed slowing down, it is headed back to something closer to trend line economic growth in the 2.5-3% area. This would likely mean that inflation should be contained. Indeed inflationary expectations may be subsiding already as gold copper and other major metals are well off of their recent highs. We also think that odds favor a scenario where the Federal Reserve will signal in August that it is done raising interest rates. Further signs of economic weakness could mean that interest rates might actually start to decline by the end of the year.
Stocks behaved in a similar pattern in the 25 months between December 1992 and late January of 1995. Like now the monetary environment was not seen as favorable during most of that period and stocks were consolidating large gains which occurred after the 1st Gulf War. At the end of 1994 the Federal Reserve indicated that its tighter period of monetary policy was finished and stocks began the great bull market of the 1990’s. Coincidentally, stocks are now trading at a cheaper Price to Earnings (P/E) ratio than they were in 1995 and the current forward P/E has compressed to about 14x next years earnings.* While we do not envision a reoccurrence of that era, we do think that an end to current monetary tightening plus sustained but moderate economic growth could equal more normal equity returns later this year and in 2007.
In such an environment some areas we favor are securities in financial sectors and in the medical sectors of the markets. As well we would note that the largest companies by market capitalization are statistically as cheap as in that mid 90’s period and could begin to outperform the market. We also think that certain technology names may warrant a second more serious look if they continue their present declines. Many of these securities are pricing in some of the direst economic circumstances they have seen in many years. While technology may not be the growth driver it was in the 1990’s there are many companies in these spaces that are becoming statistically too cheap to ignore. For most of our investors we believe at the current time the best way to participate in these areas are through exchange traded funds. We would also note that for our investors who purchase fixed income securities, if the Federal Reserve is indeed close to being done raising rates that we will be looking to become more aggressive in purchasing these securities for your accounts as their value increases in a benign to falling interest rate environment.

*Source: “Ticker Sense”, Birinyi & Associates, Birinyi, Lazlo June 134 & 14, 2006.