Inflation fears and concern over the direction of interest rates and commodity prices weighed heavy on the market averages during the month of May. The Dow Jones Industrials (-1.7%), Standard & Poor’s 500 (-2.9%) and Nasdaq Composite (-6.2%) all finished the month with losses. Utilities led sector performance with a gain of 1.1%. The technology sector was the worst performing sector with a loss of 7.1%.

The economy is clearly at a turning point. We have discussed for months our expectation that the economy, led by housing and consumer spending, would slow, and that the Federal Reserve would stop its series of interest rate hikes. The Fed raised the overnight rate to 5.0% at its May 10 meeting, and the stock market correction followed immediately, because at the same time the economy is slowing, expectations of another Fed tightening in either June or August are going up. We do not share this consensus view.

There are parts of the economy which remain strong, bolstering the concern over a rise in core inflation (minus food and energy). There is no doubt that the industrial side of the economy remains robust. Retail sales also remain strong, thanks to home price appreciation to date and rising wages. Even though the housing market is slowing, rents are on the rise. As a result of rising rents, which account for nearly a third of the core inflation number, the core CPI has climbed to the upper end of the Fed’s targeted range (2.1% year-over-year).

On the weaker side, the housing market continues to slow, with the inventory of unsold homes up 30% over the past year. The last time this happened was just prior to the 1974 recession. Housing is starting to impact employment. Weekly unemployment claims have increased from 300k in the first quarter to 315k in the second quarter of 2006. Although wages have increased, benefits are being cut, and a combination of higher taxes, interest payments and inflation have wiped out all the gains in wages. In fact, disposable personal income has actually declined this year. Consumer confidence is at a 7-month low. Another detractor from future economic activity is that regulators are requiring banks to tighten lending standards.

Is inflation really a concern? We don’t think so. Labor costs are a far more important component to the core inflation number than commodity prices, and there is little labor cost pressure to push inflation higher. Unit labor costs have risen just 1% year-over-year, which have kept corporate profit margins strong. Inflation is also a lagging indicator for growth, meaning that the Fed will stop hiking short-term rates before the inflation rate declines.

Our major concern is the consumer. Eventually, people will run out of ways to maintain their standard of living and will start to tighten their economic belts. The mortgage equity withdrawal game is about to end abruptly. Second mortgage adjustable rates are up at least 50% in the last year. The real crunch will come in 2008, as the majority of first mortgage loans, which are interest-only and adjustable-rate, start to adjust to the new reality of current interest rates.

We continue to see similarities between the 1995 mid-cycle slowdown and today. The economy looked strong going into the 1995 mid cycle slowdown. Economic growth in the fourth quarter of 1994 was 4.8%, but then declined to 1.1% in the first quarter of 1995. The unemployment rate was low and there were concerns similar to those of today over inflation and commodity prices, yet the S&P 500 rose dramatically. This was because of the consensus view that the Fed would stop tightening, inflation would slow and the economy would avert a recession. We continue to think that weak economic news will be good news for the stock market.

Globalization is a more significant factor this time around, and our concern is how much China, India and the emerging markets will slow in the face of rising global short-term interest rates and a slowing US economy. Slower rates of real growth may impact the industrial, materials and energy sectors of the US market, which have led sector performance since the 2002 market lows. A pending global slowdown may be the reason why commodity prices and emerging markets have seen dramatic declines over the past month.

Investment dollars are rotating out of low-quality companies into high-quality companies paying dividends. These dividends will likely become more important in the months ahead as earnings growth rates slow down. Historically low interest rates in 2003 encouraged investors to take more risk and fueled the rally in small cap stocks. Now the tide has turned. We see a continued rotation out of small cap stocks into large cap stocks. Along the same line, dollars are moving out of emerging markets and rotating into developed markets as global short rates rise and liquidity is withdrawn. This flight to quality explains why most stocks are down a lot more than the market indices year-to-date.

Our technical indicators reversed down shortly after the Fed meeting on May 10, requiring us to reduce equity exposure and raise cash in our model equity asset allocation. We reduced our weighting in domestic and foreign small cap stocks and commodities, increasing our cash position to 10%. We are looking to take advantage of the recent market decline to increase our weighting in large cap equities and the financial sector in particular in the weeks ahead. We do not see significant downside risk to the stock market. S&P 500 earnings have far outpaced the rise in stock prices since the market low in 2002, which means that stocks are actually less expensive today. At the same time, long-term interest rates are lower today than they were in 2002. When the Federal Reserve indicates to the market that its series of rate hikes has come to an end, we believe earnings multiples will expand and stock prices will rise.

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