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THIRD QUARTER, 2008

THE ECONOMY: GROWTH DURING THE LAST NINE MONTHS BARELY POSITIVE - SIMILAR PERFORMANCE LIKELY DURING THE NEXT SEVERAL MONTHS

During the March quarter, Real Gross Domestic Product (Real GDP) grew at a very modest 1.0% annual rate, after increasing by only 0.6% during the December, 2007 quarter. Federal government spending, consumer spending on services, and exports were among the primary contributors to growth. Major detractors from growth were consumer spending on durable goods, and residential fixed investment. Most of the factors that experienced positive growth during the March quarter increased at a diminished rate compared to the December quarter. Personal consumption spending grew 1.1% in the March quarter after expanding 2.3% in the December quarter; nonresidential structures increased 1.2% in the first quarter (the gain was 12.4% in the final quarter of 2007); software and equipment rose only 0.2%, after expanding 3.1% in last year’s final quarter; exports grew 5.4% in the March quarter after gaining 6.5% in the December quarter. Residential fixed investment remained in the doldrums, declining 24.6% in the March quarter after a 25.2% drop in the December quarter. Federal government spending grew 4.3% in the first quarter - up sharply from a 0.5% rate in the last quarter of 2007. State and local government spending rose 0.8% in the March quarter after a 2.8% gain in the December quarter.

A swing in business inventories caused the slightly higher rate of growth in the March quarter. During that period, inventory change contributed 0.02 of a percentage point to overall growth, after penalizing growth by 1.79 percentage points in the December quarter.

The tepid rate of economic growth has produced a series of economic statistics that are mostly negative. On the positive side:

  • The core segment of the consumer price index (the volatile food and energy sectors are excluded) increased 0.2% in May, and was up only 2.3% from May, 2007, according to the Department of Labor.

  • Retail sales increased 1.0% in May, as reported by the Department of Commerce. (The gain was likely aided by the economic stimulus payments that were sent out late in April.)

  • The core portion of the producer price index rose only 0.2% in May.

  • Bolstered by the federal disbursements, personal income increased 1.9% in May.

Negative statistics include:

  • The University of Michigan’s index of consumer sentiment declined to 56.4 in June. With the exception of its readings just prior to the recession of 1980, this was its lowest reading in over one-half century.

  • Industrial production declined 0.2% in May after falling 0.7% in April. The level was down 0.1% from May, 2007; this was the first time since the recession of 2001 that production was down from a year earlier.

  • New home construction declined 3.3% in May, according to the Department of Commerce.

  • In May, permits for new home construction declined by 1.3%.

  • Capacity utilization declined to 79.4% in May.

  • A report released by Standard & Poors/Case-Shiller concluded that single family home prices in 20 large cities declined 15.3% in April, 2008 from April, 2007. Additionally, the prices of these homes are now back to the levels they were at in 2004.

  • United States automobile sales declined 18.0% in June. The large car and SUV sectors experienced the largest percentage declines in unit volume.

  • A Bureau of Labor Statistics report disclosed that non-farm payroll employment fell by 62,000 in June. Non-farm payroll employment peaked in December, 2007, and has declined by 438,000 since then.

The Federal Reserve Board’s survey of our national economy taken during the second quarter concluded that “…economic activity remained generally weak…”. Five of the 12 districts indicated that conditions were “…stable or little changed…”, while the remaining districts used terms ranging from “…modest economic growth.” to “…lower…”. It was noted that increases in energy and food costs had a dampening effect on consumer spending. Increased costs of energy also reduced tourism domestically. The pattern of activity in non-financial services was mixed throughout our country. Reports ranged from “…weaker business conditions…” in some parts of our country, to “…generally strengthened…” in other locations; the labor pattern in service sectors was similar to the foregoing, although the Boston and Dallas regions did indicate “…tight labor markets for some skilled workers.”. With the exception of a few moderately favorable spots, manufacturing “…was generally soft…”. Weaker “…demand for housing-related products continued to be widespread.”, and there were reductions in employment “…related to slumping home sales and construction.”. Residential real estate“…was generally weak…”, there were “…increases in home foreclosures…” and “…limited credit availability…” in some regions. There were a few indications of better home sales as a result of lower prices. Most areas “…reported increases in input prices…especially…for energy, petroleum derivatives, and food.”

Our economy continued to perform poorly during the June quarter, and the next several months do not present a pretty picture. There is no sector that is poised to rebound vigorously and propel our overall economy into a V-shaped recovery. Interest rates are already quite low, and, as inflation remains a concern, further interest rate reductions by the Fed are not likely. Oil prices in the $140+ per barrel range, and gasoline and food price increases have gotten to a point where these accelerated costs offset the tax rebates. There is illiquidity in the banking system, and lenders are extremely cautious about making loans. Major generalized declines in housing prices are depressing consumers’ propensity to spend. The lackluster economy will produce rising unemployment for the next several months.

All of the foregoing indicate that economic underperformance will continue into 2009. We estimate a gain of 1 - 11/2% in Real GDP in 2008, and an increase in inflation (as measured by the consumer price index) of 3.0% this year.

THE STOCK MARKET: ECONOMIC CONCERNS PRODUCE STOCK MARKET DECLINE

The Dow Jones Industrial Average (DJIA) declined 7.4% in the June quarter. Housing sector problems and high oil prices continued, as did concerns over the financial sector of our economy. Additionally, there were heightened antagonistic pronouncements between Mid-East countries currently not in armed conflict.

Seven companies were sold including a health benefits provider, a retailer of consumer home products, a gaming products business, a diversified industrial firm, two hotel operations and a financial institution. Two positions were purchased including a global producer of agricultural nutrients and products, and also an industrial mining equipment company.

The current position of the total managed assets of Harold Davidson & Associates’ client portfolios is as follows: cash & cash equivalents - 13%; government bonds - 1%; municipal bonds - 5%; corporate bonds - 7%; common stocks - 26%; equity mutual funds - 19%; real estate equities - 5%; real estate trust deeds - 24%.

Short term volatility in both directions is likely in the months ahead as a fragile stock market responds to various news releases.

BOND MARKET: CREDIT MARKETS REMAIN WEAK AS INVESTORS SEEK SAFETY

At the Federal Reserve’s FOMC June 25th meeting, a near unanimous committee voted to keep its overnight fed funds rate target at 2.00%. While the committee believes inflation will moderate later this year and into 2009, there was still concern that high energy and commodity prices will create “uncertainty” about near-term inflationary pressure. The Federal Reserve finds itself in a challenging predicament attempting to balance between inflationary concerns and slow economic growth. If the Federal Reserve keeps rates at its current level, there is the risk that inflationary pressure could build, particularly as investors try to hedge against a weak dollar by purchasing commodities including oil, gold, and copper. Conversely, if the Fed raises rates, it risks continued sluggish economic growth and possibly higher unemployment. Ironically if the Fed were to raise short-term rates, it is possible longer-term rates may come down as inflationary fears subside. Lower long-term rates would be beneficial to mortgage borrowers.

Fixed income investors continue to purchase only the safest issues, including Treasuries and municipal offerings. The yield spread between Treasuries and corporate bonds remains wide, especially with financial industry bonds including banks and brokerage firms. Liquidity concerns at Ambac and MBIA, two prominent municipal bond insurance firms, has led investors to focus only on underlying issue quality and debt coverage ability. Harold Davidson & Associates, Inc. remains highly selective in our bond purchase criteria. We are focusing our corporate bond purchases on shorter duration bonds outside of the financial sector with an S&P rating of A or better. Among municipal issues, our firm is only considering underlying credit ratings of at least an A by S&P, and shorter maturities to protect against duration risk should rates move higher.

REAL ESTATE: THE IMPLICATIONS OF A DECLING MARKET ENVIRONMENT

Residential real estate values are continuing to fall, down an average 20% from 12-months ago. We expect property values to continue to decline at least another 10% over the next 12- to 18- months while lenders work through their foreclosed inventory. Credit markets remain constricted and resale housing inventory now exceeds 10 months supply, up from a low of 3.6 months in early 2005 and 7.5 months one year ago.

The outlook for residential real estate remains largely negative in the near term. Both Fannie Mae and Freddie Mac, which own or insure almost half of the $12 trillion U.S. home loans, are both likely to require government intervention in the near term. Various financial institutions have taken large write-downs on their mortgage related investments.

Commercial real estate has weathered the recent negative environment better than residential real property. However, valuations are showing signs of weakness and financing assets is becoming more difficult as lenders tighten criteria across the board.

The current real estate investment market will be very challenging in the short term. We expect trust deed investments to continue to see a reduction in value as well as a tough investment market as sellers are reluctant to adjust their sale prices, and lenders are being extremely conservative in their lending practices.

SUMMARY & CONCLUSION: DESULTORY ECONOMIC AND STOCK MARKET PERFORMANCE LIKELY DURING NEXT SEVERAL MONTHS

Current economic woes are likely to continue for some time. Our dependence on foreign oil, along with other countries competing for the same resources, will likely keep energy prices high. Slumping housing prices will diminish consumers’ propensity to spend. The foregoing will dampen overall economic activity. We expect Real GDP to post a gain of 1 - 11/2% this year. This tepid economic growth will create an increase in unemployment, which will also dampen consumer spending. The bad news is that there does not seem to be any one area that will initiate a dramatic upturn and create a speedy return to vigorous overall growth. The good news is that an economic debacle is unlikely, and a gradual upturn will probably begin in the first quarter of 2010. Outside of occasional short term volatility, the stock market will probably begin a sustained rally once investors perceive the economic upturn.

"'Economic Outlook & Investment Perspective' is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved."

 

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