After three quarters of grinding lower, it’s not clear the ultimate loss of wealth at the bottom of this market cycle will be the most painful aspect for investors.  Instead it could very well be the time it takes to get there.

We all expect the market to go up and the market to go down.  We’re conditioned to follow the well-worn mantra - “Investing isn’t about timing the market, but time in the market”.  That’s a great catch phrase for a logical philosophy but perhaps better suited to boom, rather than bust, times.  After all, how much time are we talking about - 5 years, 10 years, 50 years, or 100 years?  Here we are 75% of the way through the decade with a stock market that has delivered 14.3% cumulatively (as defined by the Russell 3000 index); or 1.8% annually – before taxes and before fees.  Perhaps we should have invested in Twinkies, canned apricots, frozen vegetables or cases of motor oil as the consumer price index (even arguably under-reported) has advanced 24.5% over the same time period.

What we’re not conditioned for, as families or as a country, is the prospect of reducing our long-term dreams based on diminished expectations.  Rethinking what it means to “retire”, or live a convertible life in old age as individuals and recalibrating our role in the world economy as a nation. Yet before this downturn’s run its agonizingly slow course, that’s what many citizens, and the United States as a nation, will have to face. 

Unfortunately this realization doesn’t come quickly for our leaders who are more apt to provide short-term props ad hoc to keep the inevitable at bay.  Ultimately, what purpose do the taxpayer rebates in the president’s “Economic Stimulus Plan” really serve?  Or accounting rules and guidelines that allow investment banks to defer financial losses on instruments that can’t be sold by terming them “tier 3” assets?  Far better to take our lumps and clean our closets today, even if it means stock prices decline a further 20-30% from today’s levels.  Over the long-term the end result may remain the same, but perhaps by taking our punishments now, opportunities for the long-term investor would be enhanced and increasing optimism for a prosperous future would instill confidence - resulting in higher stock market valuations.

Just a thought – but hey, what do we know anyways? 

In the meantime all eyes remain glued to this slow motion train wreck we call the U.S. economy and to the marvelous feats of frivolity administered by those in control.

This quarter we’re removing nine funds from our recommended list and adding six.. In our opinion the best opportunities are likely to be found in the U.S. small and mid-cap growth sectors, natural resources/energy, Africa/Middle East region of the emerging markets – each of which has shown resiliency in the market turbulence to date.  We suggest remaining overweight “growth” funds relative to “value” at this juncture as well.

For those who believe the bear market has further to run, we continue to recommend modest positions in the Grizzly Short and Prudent Bear funds - maybe 15-30% stakes in aggregate. Even without “alpha”, or risk-adjusted excess return, the reduced day-to-day portfolio volatility afforded by these funds make them prudent investments.   We continue to advise against owning real estate investment trusts (REITs), high yield bonds, and other instruments heavily dependent on issuing securities to fund their operations – typically financial service companies.

Opportunities are developing in the preferred stock and fixed income arenas as credit conditions continue to deteriorate.  Municipal bonds look extremely timely from a strategic perspective, especially for investors nearing retirement in higher-tax states such as California. Though it wouldn’t surprise us to see spreads widen out further (relative to treasuries) over coming months, the combination of historically wide tax-adjusted yield spreads and the high probability of tax rate increases after the election really shift the decision from “if” to “when” investors should make purchases.

Over the next quarter we will also be looking at opportunities in the convertible preferred, trust preferred, exchange-traded debt, convertible debt and closed-end fund spaces.  While often illiquid, these securities trade on the major stock exchanges and can be purchased through most brokers for commissions similar to those paid for common stock.  As is often the case when markets collapse, these less liquid sectors have been abandoned by underwriters, market-makers and investors alike, leaving solid long-term potential for those willing to conduct the research, step in to buy and hold for years to come. 

For those interested in researching indenture provisions and company capital structures themselves, we recommend a great free resource – QuantumOnline.com.

Changes in Fund Recommendations

We’re not going to elaborate on every change we made this quarter but will provide a bit of color for what we consider to be the more interesting edits to the list.

Hennessy Focus 30 (HFTFX): this is a “swing for the fences type fund”; it’ll likely leave you either jumping for joy (homerun), or crying in yourself to sleep (strike out).  The fund’s extremely concentrated with investments in just 30 companies and a handful of industries so it’s likely to see some drastic moves from time-to-time.  Yet the long-term performance is pretty impressive, assets haven’t ballooned to levels that hinder manager Neil Hennessy’s ability to be nimble, the expense ratio is fair and it’s available as a no-transaction fee fund through Fidelity, Schwab and TD Waterhouse.  Only buy in small amounts (maybe 5-10% of your portfolio value) with a plan to hold it for years to come and you’ll likely be well rewarded.

Loomis Sayles Mid Cap Growth (LAGRX):  Momentum investments have been working since late last year and this fund has capitalized.  With investments like MasterCard and First Solar it’s easy to see that the main risk to performance is a change in investor bias from growth, back to value.  Like Hennessy, this is a reasonably priced offering in sector being favored by the market presently but vulnerable – don’t load up too heavily on it.

PIMCO Commodity Real Return (PCRAX) - A: Returns have been stellar in 2008 after a trying first four years in which the fund trailed the natural resource sector by nearly 60% cumulatively.  Unlike most natural resource funds, the PIMCO offering uses a derivative-based strategy for implementing its views.  Specifically it buys and sells contracts tied to commodity prices which could expose fund shareholders to counter-party credit risk that we would vet prior to investing.

Janus Contrarian (JSVAX):  Fund’s value-oriented style is now out of favor – time to move on.

An interesting article published about a week ago by James Montier of Societe Generale in London made its way to my inbox via the weekly John Mauldin’s “Outside the Box” e-Letter.  I thought I’d share it with you and provide a few thoughts of my own.

Before we get started though, John Mauldin’s free pieces – “Outside the Box” (published Monday) and “Thoughts from the Frontline” (on Friday) are really worthwhile readings for those wishing to stay up on non-traditional thinking and analysis as it applies to the financial markets.  Very focused, opinionated, and to the point. You may not agree with everything written, but I assure you it will make you think.  I encourage you to sign up if you have an interest.

In Mr. Montier’s commentary, he makes a strong case that Wall Street stock analysts are behind the curve with regards to earnings revisions for corporate America in this downturn.  It’s not the first time – in fact Wall Street analysts have routinely lagged reality.

“They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly.”

Mr. Montier goes on to make two additional points.   Most fundamental stock analysts base their assessments, at least in part, on corporate guidance.  Unfortunately companies themselves have a hard time recognizing reality. Instead they’re consistently more optimistic about their own companies than the overall economy.

Finally, in all likelihood the market hasn’t gotten anywhere close to pricing in the severity of this unfolding recession – we’ve likely a good deal further to go, and a good deal more pain to endure, for that to happen.

Our opinion precisely.  It’s simply astonishing to hear analyst after analyst present their views that the worst case has already been priced into the market.   Hello – earth to McFly! 

To think we slide right through without significantly lower earnings is simply laughable.  Facts to consider:

·        For all the talk of delinquencies and foreclosures over the past few months, we’re just now entering the high-season of increased resets among adjustable-rate mortgages.

·        The consumer has little in the way of savings, having become reliant on the “Home as ATM” phenomenon to maintain an extended lifestyle over the past few years.  Simply removing this increased spending without additional savings will drop GDP noticeably.

·        Financial services companies have a long way to go before their balance sheets are back in order.   Think many, many quarters.   While there is growing concern over Sovereign Wealth funds buying stakes in many of these concerns, they’ll likely look less like geniuses and more akin to the Japanese Real Estate investors of the 1980s in a few years.

·        Non-financial companies are just beginning to feel the pinch of higher input prices and reduced demand.  If one hasn’t noticed layoffs, and good sized ones at that, are a daily occurrence in the financial press.

So, the stock market is already pricing this in, huh?  We’ll continue to take the other side of that bet.

Most of our selected funds continue to turn in solid relative performance in a down market, and that’s great.  With our current downturn showing a bounce early in Q2, now is a good time to review your portfolio.  This quarter we’re taking five funds off our selected list and recommending selling four of them.

We’d recommend looking at the following sectors for inclusion in portfolios at this time: bear market funds (small positions only), Africa/Middle East (low correlation w/ U.S.), Mortgage & Municipal Bonds.

Changes in Fund Recommendations

Deletions

Kinetics Paradigm (WWNPX) – Great fund, wrong time in our opinion.  While the fund’s bias towards global financial exchanges has added real value over the past few years, it’s likely the sector will come under increasing pressure as the slowdown builds.  We’re moving elsewhere in managed accounts and the Pariveda Wealth Advisor models.

Delafield (DEFIX) – relative out-performance has decelerated.  While the fund may continue to be a worthwhile hold over the coming quarters we’re taking it off our recommended list.

Bridgeway Small Cap Growth - N (BRSGX) – it’s extraordinary growth bias makes it susceptible to further losses in a bear market.  Will be a solid choice when the economy bottoms.

Alpine International Real Estate (EGLRX) – faced with a severe credit crunch, nothing good will come of the global real estate sectors for the next few years in our opinion.  Yields are still too low to make the sectors, at home or abroad, attractive.

Cambiar Conquistador (CAMSX) – the team here has shown they’re not savvy at investing for a down market.  As such, there’s no compelling reason to continue holding, so move on.

Additions

Jordan Opportunity (JORDX) – Concentrated, but management looks adept at searching out opportunities in both up and down markets.  While it’s probably worth the transaction fee needed to enter, plan to hold for the long-term and don’t place more than 10% of your investible assets here.

Janus Mid Cap Value Inv. (JMCVX) – Another timely offering from Janus (this time from the value side of the shop).  This is a solid long-term offering that seems to be positioned well for the downturn.  We like many of the individual stock names that currently make up the portfolio.

Royce Dividend Value Service (RYDVX) – Royce has long been a quality small cap value shop and, while the fund is relatively unknown, the management team isn’t.  We like the prospects for this offering.  Given the 50% weighting in financial service companies and the fund’s ability to hold up quite well so far this year, we think it’s got good prospects for solid capital appreciation as the current storm lifts.

Grizzly Short Fund (GRZZX) – a complement to BEARX, the Grizzly Short fund has been turning in far superior risk-adjusted returns over the past quarter and a half.  While the fund focuses more on the small cap sectors of the market, and performance relative to BEARX may trail off, it’s a good diversifier.  There’s nothing more frustrating for an investor than to get the macro call wrong and stumble on the implementation.  Diversifying among even bear market funds provides this.  Recognize that the market sensitivity of BEARX is roughly -0.80 while GRZZX sports a more volatile -1.10 beta.

We’re quite pleased with the recent performance of most of the funds on our opportunities list.  For the most part, they far exceeded the U.S. stock market’s 5.14% increase in 2007 and continue to be adding value relative to their respective benchmarks.

For all the market volatility during the fourth quarter, the impact on the relative attractiveness of most funds we track was quite minimal.  Those that had been doing well going into Q4, continued to do so. We are removing only three funds this quarter, and adding three more.

Changes in Fund Recommendations

Deletions

Janus Overseas (JAOSX) – fund closed to new investors during the fourth quarter.  We still find it quite attractive and will continue to hold in our managed accounts. We recommend individual investors do the same.  What many may not realize is that this is not a traditional large-cap overseas fund.  Instead, the Janus fund has generated quite a bit of recent excess performance through its exposure to emerging markets.

Forward International Equity (FFINX) – fund is just not performing well enough on a risk-adjusted basis for us to continue recommending it.  In all likelihood performance has been negatively impacted by the fund’s significant weighting in financial service stocks – a sector that’s come under intense pressure over the last few quarter and is likely to face difficulties going forward.  Time to move on.

SSgA Emerging Markets (SSEMX) – due to the fund’s recent becoming closed to new investors, we need to SSgA Emerging Markets from our opportunities list. SSgA’s offering has put up a marginally better record than most competitors in the sector, yet we’d continue advising investors to consider our primary recommendation in the sector, Quant Emerging Markets (QFFOX) which has slightly greater exposure to the Asian markets – a region we continue to find attractive.

Additions

Artisan International (ARTIX) – While we’d like to find a more compelling opportunity in this space, Artisan International has a long-term record of moderately out-performing the large cap international sector and with growth now strongly preferred by investors should have the wind at its back for awhile now.

Harbor International Value – Inv. (HIINX)  – Unlike Artisan, Harbor International has relatively large positions within the natural resource and industrial materials sectors, areas we continue to find attractive late into the stock market cycle due to supply/demand imbalances which remain.  Like Artisan, Harbor has had long-term success in modestly out-performing the broad international markets.  It’s a solid long-term holding in our opinion.

T. Rowe Price Africa & Middle East (TRAMX) – to start off, this fund is new, likely prone to incredible volatility and definitely not for all investors.  The regions in which it invests are growing rapidly but are the center of geo-political turmoil and notable human rights tragedies – neither of which caring human-beings are insensitive to.  So, there are a lot of issues investors need to deal with before asking the question on whether the fund is right for you.  

If you’re still with us, here are a couple of quick points.  The Africa and Middle East regions are some of the fastest growing in the world and are relatively under-owned by investors.  The fund invests in many of the largest companies in these regions.  T. Rowe Price is a well-respected investment management company, having invested in the emerging markets sector for years.  The fund does have a transaction fee, and a 90-day short-term redemption fee of 2%.  The fund will likely close when they’ve reached a modest amount of assets (say $1-2 billion).

Besides the potential for strong returns, we likely have a real diversifier here – something that isn’t as closely tied or highly correlated to U.S. growth as many other emerging markets.  Give it some thought.

Gaining Insights From a Flawed Model

Pariveda’s quantitative S&P 500 fair market value model arrives at an interpretation of fair value based on the aggregate operating earnings of the companies that make up the index over the prior 1-year.  While we don’t rely solely on this model in making investment decisions it does provide insight on aggregate value investors ascribe to the market and raises important questions that we should address in understanding market psychology from time to time.

The model continues to signal a strong buy signal with fair value for the market as a whole at 2330, some 58% higher than where it currently trades.  Our confidence in the model remains low for the reasons pointed out below.

The primary reason we don’t ascribe more weight to the quant model in making our investment decisions is that the data-set used to construct it, historical quarterly data going back to 1988, is really too short to provide statistically significant results.  We can get index valuations going back before this, but operating earnings weren’t reported, or re-constituted, prior to that time.

Prior to 2004 the model did a good job of estimating fair value and providing longer-term buy and sell triggers.  Since then however we’ve seen a major divergence between our estimate of fair value and the market’s willingness to pay up for this “value”.

It’s impossible to say exactly why this deterioration has occurred, but it has happened as “value stocks” have been out-performing growth by a significant margin – and within the 20 years of data we’ve used, that simply hadn’t happened before.  In our opinion, it’s likely that investors are unwilling to value cyclicals, with the volatile nature of their earnings streams, at similar multiples to more stable growth counter-parts.  What this means is that the model is apt to continue over-estimating fair value until growth stocks rotate back into favor (which is now beginning).

It’s also interesting to note that financials have made up a large and growing percentage of the index’s total earnings over the past 4 years – but haven’t been rewarded for these earnings.  Look at any money center bank one or two years back and they were being valued at 10-13 times earnings, a much lower valuation than in times past.  Could it be that in aggregate the market was already pricing in, or anticipating, that these earnings weren’t sustainable?

So, while we aren’t wedded to our quantitative model, we can and do gain insights by what it shows us on a quarterly basis.

When compared with 10-year U.S. treasury yields, corporate earnings yields confirm investor skepticism, as stock investors continue to demand a healthy premium to bonds in order to take on stock market risk. 

Our opportunity list, shown below, is comprised solely of actively managed mutual funds that should be available through the Fidelity, Charles Schwab and TD Ameritrade fund platforms as “no-transaction fee” options.  However, if you find an error in availability, let us know and we’ll be sure to correct it next quarter.

Investors continued to rotate towards large cap growth funds and away from small/mid-cap value in Q3.  These macro trends typically tend to last for a year or more, so by our analysis we’re still early in the growth stock cycle with plenty of opportunity for readers to benefit.

This quarter we’re making only a few changes to our recommended fund lineup as most of our recommendations have been faring quite well.

Changes in Fund Recommendations

Deletions

Fidelity Real Estate Income (FRIFX) – we liked the low-risk strategy this fund had been managed to over the past few years, specifically emphasizing REIT preferred stocks for income.  However, over the past few quarters the fund’s manager has taken on more risk, veering into standard REIT shares.  The change has been both untimely and unprofitable and calls into question the overall fund strategy.  It’s not being managed in a way we had expected and it just doesn’t stack up against traditional real estate investment trust funds, so out it goes.

Diamond Hill Long-Short A (DIAMX) – Time to move on from this fund as it’s just not performing well, especially given its long-side bias towards energy which has been a strong performing sector throughout 2007.  What’s happening here?  The short-side of the portfolio has been under-performing, dominated by growth names such as Google, Panera Bread and other high-octane growth stocks which have been coming back in favor.  Given our expectation for continued out-performance for growth over value, Diamond Hill Long-Short is likely in for spell of under-performance. 

Perhaps paradoxically, we continue to recommend that investors remain invested in TFS Market Neutral.  While the fund under-performed significantly during the third quarter, during a period when many quant-based strategies came under fire, it’s our opinion that this is likely to reverse itself over the coming quarters.  Specifically, TFS invests in small and micro-cap stocks where liquidity events, such as that which occurred in August, can have a greater impact on short-term performance.  We’re comfortable with the fund’s strategy.

Forward International Small Company Inv (PISRX) – The fund’s risk-adjusted performance has really fallen off these past six months, again a likely victim of sector rotation.  Moreover the international small cap growth sector, where we’d be pre-disposed to invest funds, is rife with closed offerings.  A better alternative in our opinion would be to allocate this money to an international large cap growth offering, preferably Janus Overseas.

PIMCO Diversified Income – D (PDVDX) – at the present time, the fund is taking on a bit too much risk for comfort in our opinion, and has been spanked pretty much every time the financial markets get into trouble.  That’s not what we’re looking for at this stage in a fixed income offering, especially as the economy slows.  We’d advise moving fund to Franklin Strategic Income – A, or perhaps an international offering to take advantage of the prospects for further depreciation in the dollar.

PIMCO Emerging Markets Bond – Admin (PEBAX) – Given the tightness in spreads and the costs associated with most emerging markets bond funds we’d advise moving out of the sector at this time –the opportunities don’t justify the costs, or risks.  Instead we’d recommend either developed international bonds (Templeton Global Bond – A or Oppenheimer International Bond), or Franklin Strategic Income.

Additions

Janus Overseas (JAOSX) – Janus’ funds are on the upswing again as growth comes back into favor.  Janus Overseas is a perfect example.  It’s a hybrid fund, mixing developed and emerging markets stocks in a single portfolio – but the risk-adjusted returns are compelling.  More importantly, the fund’s performance held up well during the summer sell-off.

Oppenheimer International Bond – A (OIBAX) – a second fund in the international fixed-income space, we’d pick it over Templeton Global Bond A.  We are somewhat reluctant to recommend it if you have to pay either a load or a transaction fee (as we don’t), but for investments of $10,000 or more we think it still makes sense in light of our expectations for further weakening in the dollar.  Moreover you’re getting an excellent management team that has shown a great ability at out-performing their competitors.

Corporate earnings of the stocks that make up the S&P 500 continue to grow at rates above that of their respective stock prices, further boosting “fair value” for the S&P 500 index over the intermediate term, based on our quantitative valuation model.  In fact, at present fair value remains more than 50% higher than the index’s current price of 1526.

Even given the fact that corporate profit margins remain at historically wide levels, the disparity between our model and the market’s current trading range suggest that investor hesitancy remains a strong head-wind for stock prices. 

There are two ways in which the discrepancy between current stock levels and our fair value estimate can come back in line.  Clearly the market could rally sharply to make up the difference.  As noted above, it would take an immediate spike of better than 50% to close the gap, or a move of better than 70% over the coming year, given today’s expectations for one-year forward earnings levels. 

Second, corporate profit’s could either stagnate, or outright fall.  Either of these scenarios would likely be caused by increasing employee wages & benefits and/or supply costs that can’t be passed onto buyers – thus negatively impacting profit margins.

In our opinion, the resolution will likely be a combination of higher stock prices, coupled with tighter profit margins.  Supporting this view, the September employment report released on October 5^th, points to a tight labor market (unemployment rate of 4.7%) and moderately rising wages (0.4% month-over-month).

When compared with 10-year U.S. treasury yields, corporate earnings yields confirm investor skepticism, as stock investors continue to demand a healthy premium to bonds in order to take on stock market risk.  As we’ve noted in previous valuation write-ups, a sea-change in stock-market risk-premium occurred late in 2002 as value stocks began to significantly out-perform their growth counter-parts. As growth continues to rotate back into favor it will be interesting to see whether, and to what extent, this risk premium is removed.

Our opportunity list, shown below, is comprised solely of actively managed mutual funds that should be available through the Fidelity, Charles Schwab and TD Ameritrade fund platforms as “no-transaction fee” options.  However, if you find an error in availability, let us know and we’ll be sure to correct it next quarter.

With investors now more aggressively seeking out opportunities in the growth sectors of the market, we’ve added a few funds that you may find attractive.  Not surprisingly, Janus Capital funds are faring very well again.  The fund complex has long had a growth bias and through the first half of 2007, Janus funds have been faring quite well.  Of course we’re partial to Janus Contrarian as we hold it in our Wealth Advisor model portfolios. Its current large cap, growth bias is arguably the right place at the right time, and the fund’s performance has been quite strong for the past four years, yet Janus Orion – a mid-cap growth offering is also looking very attractive.  We’d caution against holding both in an investor’s account as the returns to both funds will likely be highly correlated.

Changes in Fund Recommendations

Deletions

Allianz NFJ Dividend Value – D (PEIDX) – while performance has been strong, and we’d continue to recommend holding for those who have already purchased, the fund closed to new investors during the second quarter.  In its place we’d recommend new investors focus their attention on FMI Large Cap (FMIHX) or Excelsior Value & Restructuring (UMBIX).

Permanent Portfolio (PRPFX) – Risk adjusted returns have fallen off for this conservative asset allocation fund over the past six months.  While Morningstar continues to rate it “5 stars”, and it may remain a sound choice for more conservative investors, we believe there are better opportunties in funds like Oakmark Equity Income (OAKBX).

Baron Partners (BPTRX) – concentrated holdings make this a difficult fund to hold when it goes out of favor, which seems to be happening now.  We’d exchange for Janus Orion (JORNX), or Kinetics Paradigm (WWNPX).

Quant Foreign Value (QFVOX) – a solid fund we’ve owned for quite awhile in our models.  As value continues to rotate out of favor, we’d suggest exchanging for Forward International Equity (FFINX).  It’s unlikely that Quant can continue to deliver market-beating performance in the face of a strong headwind against its sector biases.

Additions

 Amana Trust Income (AMANX) – solid long-term performance, reasonable diversification, and a relatively small asset base ($250 million or so) make this fund a nice addition to an investor’s large-cap allocations. 

FMI Large Cap (FMIHX) – surprisingly this large-cap fund has remained relatively undiscovered by investors, yet its performance on a risk-adjusted basis is commendable – especially considering its concentration (roughly 20 assets). With only a bit over $500 million in assets, FMI retains the flexibility to move but turnover has been only modest, pointing to solid stock-picking ability. 

Excelsior Value & Restructuring (UMBIX) – with a tilt towards large-cap value, Excelsior Value & Restructuring is an attractive complimentary fund to Janus Contrarian.  Again, performance has been solid, if a bit volatile.  Our concern is that at close to $10 billion in assets, the opportunity for adding value may be reduced marginally going forward.

Janus Orion (JORNX) & Heartland Select Value (HRSVX) – while Heartland Select has added value over time, of the two Janus Orion looks the more timely option at this time.  Combine the two for coverage of the mid-cap value and growth sectors.

Forward International Equity (FFINX) – This is a nice growth-oriented, international investment option with a very small asset base (less than $60 million).  The fund should provide solid performance in a growth-led environment.

SSgA Emerging Markets (SSEMX) – there aren’t a lot of options in no-load, no-transaction fee emerging markets funds available through Fidelity, Schwab or TD Ameritrade, but the State Street Global Advisor Emerging Markets fund will provide robust coverage of the sector, and has shown an ability to generate “alpha” over time.  That said, we’d remain partial to Quant Emerging Markets (QFFOX) if its available to you on a no-transaction fee basis.

Matthews Korea (MAKOX) – Korea has been one of the cheaper Asian emerging markets for the past four or five years.  In fact, the Matthews Korea fund sports an overall P/E ratio of just 12.3x prospective earnings.  While performance has been erratic over the recent past, the diversification benefits shouldn’t be overlooked. We’d recommend tucking a small position (2-5%) away in investor accounts, as a contrarian long-term investment.

With S&P 500 earnings continuing to grow at double-digit rates, though at a slowing pace, our valuation model continues to point to considerably more upside in the market at the start of Q3-2007.

Profit margins remain quite wide, at close to record levels, as companies have only reluctantly increased capital spending.  Instead management teams in all sectors have been deploying capital through increased dividends and stock buybacks – both which should continue to support share prices.  Bearish interpretation is that today’s near-record profit margins are unsustainable and that long-term profit margins of roughly 40% lower are just a matter of time.  In this case, today’s P/E ratios would look substantially under-stated.

With interest rates beginning to drift upwards, the spread between 10-year treasury rates and stock earnings/price ratios tightened moderately over the quarter.  Still, with earnings yields superior to treasury yields, and corporate bond spreads at extremely tight levels, opportunities remain for private equity investors to initiate corporate buyouts – and these transactions have been frequent and well-received by the broad market.  As private equity firms race to go public, look for buyout opportunities to remain at a heightened level.

Based on our work, fair value for the S&P 500 currently remains 55% higher than current index levels – suggesting ample upside for today’s investors.  Recognize that as of today, earnings for the S&P 500 index are roughly 57% higher than at their highest level in 2000.  Since its peak in early 2000, the index itself has risen a mere 0.3%.  From this perspective investor enthusiasm has remained in check throughout this market rally.

Assuming earnings come in as currently expected by Wall Street analysts over the next year, fair valuation 1-year forward would be roughly 69% higher than current levels.