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Alas, this pleasing scene could not last. The sheer breadth and momentum of the economic advance raised fears of a new inflation spiral. Growth seemed to be catching on overseas also, especially in some long time laggards such as Japan and Germany. Rather than seeing this broadening growth footprint as a positive for the world economic picture, however, it was viewed by many commentators as additional evidence of rising inflation pressures and impending shortages of raw materials. The Federal Reserve continued its singular focus on withdrawing monetary accommodation, and foreign central banks also began to raise their interest rates. Some of the public comments of the new Chairman sowed confusion about the Fed’s intentions, adding to the market’s already nervous state of mind. Inflation numbers, driven by rising energy costs, made for very poor reading. Aside from the intense economic tea leaf reading, the news generally was increasingly discouraging, and exacerbated the anxiety of investors. Terrorism and sectarian violence in Iraq seemed to get worse, there were reports of kidnappings of foreign workers in Nigeria, Iran continued its bellicose statements, and Russia threatened to withhold natural gas supplies from some of its neighbors if it did not receive a large price increase. The oil outlook deteriorated and the price of crude rose to new heights as some experts predicted $100 a barrel on the horizon. Gasoline sustained prices above $3 per gallon for the first time. The onslaught of depressing news cast a pall over the stock market which ended the second quarter on a weak note. July brought a broad decline in the market. One can trace the slide directly to the sharp increase in the price of oil which hit a high of $79.92 a barrel on July 14, coinciding exactly with the intra month low in the Standard & Poor 500 Stock average of 1236.20. Trading volume increased sharply during the month. Excellent earnings reports from numerous corporations were used as an opportunity to “cash out”, and individual stocks declined severely. The transition from the euphoria of the first quarter to depression was dramatic. The turbulence in the stock market and geopolitical scene has obscured some positive developments. The Federal Reserve opted to keep the overnight rate steady at 5¼% after raising it 17 times since June 2004. Consumer prices last month rose at the slowest pace in five months and producer prices increased a meager 0.1%. While the Fed may increase the funds rate again later, depending on unfolding data, we now believe it will remain on the sidelines at least until after the fall elections. The housing market is clearly slowing and the refinancing of mortgages is also flagging. Housing has been the fastest growing section of our economy in recent years, and a retrenchment will weigh on the economy. Consumer spending, however, is likely to remain healthy. Wages are growing at the fastest pace in over five years, there are a record number of people working and the economy is at virtual full employment. These favorable trends will underpin consumer spending. A decline in the price of gasoline, which we believe likely, would give an enormous boost to consumer confidence. Other sectors of the economy, such as construction and industrial production, have remained strong. While growth in the United States is shifting to a lower gear, it is accelerating in Europe. The euro region is poised to post the largest improvement in growth among the world’s industrial nations. European consumers are spending again and this, combined with increased investment spending, is offering a more optimistic projection for the region. Europe’s timely revival after five years of stagnation could help make global economic growth less reliant on U.S. households to absorb the world’s exports. We do not take the present fears lightly. Prospects for worldwide and domestic growth remain quite healthy, however. We believe that at current valuation levels of 15 times Standard & Poor 500 average earnings for 2006, and 14 times in 2007, the stock market is discounting a far more serious level of economic distress than will materialize. Time and again our economy has demonstrated a resilience and growth bias, which is unique among industrial nations. Conditions today exist for a modest economic slowdown, an easing of inflation pressures over time, potential easing of energy prices, and growing world economies. These conditions do not add up to a disaster but to opportunity. Investment Policy Committee Alfred A. Lagan, CFA, Chairman Daniel A. Lagan, CFA, President August 24, 2006 This information is intended solely to report on investment strategies and opportunities identified by Congress Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell of any financial instrument. 2 Seaport Lane Boston, MA 02210 www.congressasset.com
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