The stock market correction that began in May continued through most of June until the Federal Reserve meeting held on June 28-29. The statement accompanying the 17th quarter-point rate increase, which moved short-term interest rates to 5.25%, lowered expectations of future rate increases. This sparked the largest one-day market gain since 2003. The Dow Jones Industrials (-.16%) and Nasdaq Composite (-.31%) finished the month with small losses, while the Standard & Poor’s 500 (+.14%) held onto a small gain. Telecommunications led sector performance with a gain of 4.7%. The technology sector was the worst performing sector with a loss of 1.7%.

There was more evidence of an economic slowdown in June, with consumer spending, employment, wages and housing all slowing. Consumer spending declined from a 5.2% annual growth rate in the first quarter of 2006 to 1.7% in the second quarter. Payroll employment was up a modest 75,000 in May, well below analysts’ estimates, and unemployment claims continue in an upward trend. There were job cut announcements from companies across many economic sectors. Compensation gains were revised down. Even though average hourly earnings are up 2.8% year-over-year, benefits are being cut, and a combination of higher tax rates and inflation have wiped out consumers’ disposable income this year. The supply of unsold existing homes is up 41% in the past year and mortgage applications fell to a four-and-a-half-year low in June. All data points on housing show the sector is rapidly weakening.

On the stronger side, GDP was revised up to 5.6% for the first quarter, thanks to strong business trends for industrial, materials and energy companies, which are seeing strong orders globally. Unlike consumer debt, corporate debt interest payments relative to profits are the lowest they have been in 30 years. Productivity has continued to outpace labor costs, keeping profit margins near record levels. S&P 500 earnings estimates have actually been on the rise as we enter earnings season. The backend of the economy remains very robust.

We see chilling similarities between today’s housing market and the tech-laden Nasdaq back in 2000. If this were a Broadway play, the story line would be the same, but with a slightly different cast of characters. The equity market in 2000 has been replaced by the housing market today, and the corporation has been replaced by the consumer. The dramatic rise in publicly traded companies and excess liquidity is mirrored by the unprecedented rise in new housing starts and speculative lending. Margin has been replaced with mortgage-equity-withdrawal. The Federal Reserve was draining liquidity and raising short-term interest rates back in 2000, in the same manner it is today. Now we see delinquencies and foreclosures replacing margin calls and de-listings.

The major difference is that the consumer was able to survive the corporate-led recession that followed the tech crash relatively unscathed, in large part because of the dramatic rise in real estate values and the fact that real estate was a far more widely held asset than equities. Today the consumer faces an uphill battle. We estimate there are between $1-2 trillion of adjustable-rate mortgages that will reset over the next 12-24 months, resulting in monthly mortgage payment increases of 25-50%. Unemployment claims are on the rise, job growth has slowed and real wage gains are minimal. Oil prices are still above $70 a barrel, and gas at the pump is approaching $3 a gallon. The savings rate has been negative for 12 consecutive months, which means consumers continue to borrow to maintain their current standard of living. While most market seers worry about whether the economy will slow down and when the Federal Reserve will end its series of interest rate increases, we feel that the slowdown has been guaranteed and worry about a consumer-led recession that may follow in 2007-2008.

Fortunately, corporate America is in great shape today, which is a very positive backdrop for the stock market. We have made the case in previous months that the current mid-cycle slowdown is similar to those of 1985 and 1995. Both periods saw dramatic rises in stock prices once the Federal Reserve ended its series of rate hikes. In fact, the S&P 500’s current price/earnings ratio based on earnings estimates over the next 12 months is as low as it has been since 1995. Investor sentiment, a contrarian indicator, is also as bearish as it was back in October of 2002, just as the market bottomed. Corporate earnings are still increasing double digits year-over-year, thanks to strong productivity and contained labor costs. We think the stock market will rise significantly in the second half of 2006.

We took advantage of the recent market decline in June. In May we had increased the cash weighting in our model equity asset allocation shortly after the Fed meeting on May 10th, by reducing investment exposure to small cap domestic equities, Japan and emerging markets. In June we increased our weighting in large cap domestic equities in the energy and financial sectors We also significantly increased our weighting in consumer staples in our large cap core equity portfolio. We are now fully invested. While we continue to overweight the energy and industrial sectors of the market, seeing no signs of a meaningful slowdown in economic activity abroad, a slowing US economy will likely lead to better performance for more defensive market sectors. We continue to avoid all sectors sensitive to consumer discretionary spending and the housing market.

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