Southwest Ranch Financial, LLC
December 2007 Update
The S&P500 is at 1481 on 30-November-2007

This page can be linked to at   ( www.swranch.net/emails/2007-12.htm ).

The Southwest Ranch Financial Market Alert Timing Model is in the stock market.  Since the last buy signal in February 2003, the S&P has risen 79%.

Year to date, the S&P500 index is up 6.1% and the SWR Balanced Portfolio is up 4.6% (with half the stock market risk.)

Here’s the year to date performance of the SWR Balanced Portfolio by asset class.

As of 11/30/07

Market Alert Model
The SWR core model is used to time large cap stocks. It’s currently IN the stock market.  Stay invested with conservative diversification.

Year Ahead Timing Model
The YAT model is used to indicate periods of buy opportunities within the Market Alert Model’s timing cycle. The SWR Market Alert Model always trumps the YAT model. The YAT model is positive.

Interest Rate Model
The SWR Interest Rate model is negative on interest rates and long bonds.  

Gold Model
The SWR Gold Model is positive on gold.

Market Alert Followup
On November 10th I issued a Market Alert stating the S&P500 at 1453 was over sold . I also said oil looked toppy and gold would retreat. Gold fell back by $50 - as predicted. Oil dropped by $8 and stocks rose by 2%. I warned about currency speculation and the major currencies have declined against the dollar and some dramatically. My warning about not buying financial stocks has proven correct as their prices have continued to tumble.

It's doubtful that I will issue anymore Buy alerts for reasons explained below.

Market Summary
The stock market appears under priced by some popular measures. A PE ratio of around 16 seems reasonable and perhaps modest since low interest rates offer little competition to stocks as measured by the so-called Fed Model. Some people believe stocks are outright cheap and should be much higher. The market has been consistently discounting low interest rates for five years and refusing to move up to "full value" thus confounding many market timers. I suspect the market knows it is puffed up with money from debt induced spending. The markets won't be healthy again until the United States takes its medicine and it all washes out.

The forces working against stocks are significant.
1. The consumer has begun to pull back due to declining home equity and difficulty borrowing money against homes. This fact is well known.
2. Corporate profit margins have peaked. A weakening consumer sector puts pressure on companies to cut prices to maintain market share.
3. The fiscal crisis in America requires a reduction in the rate of government spending and debt creation. This is an important factor. This would be very deflationary and therefore officials are reluctant to do what is necessary.
4. Oil prices will continue to rise as world oil reserves are depleted. All other forms of energy are more expensive and the cost will impact consumers.
5. The government wants to raise taxes on the middle class after 2008 to pay for its reckless deficits. It should reduce spending and change its policies to increase the wealth of Main Street and stop favoring Wall Street.

Since 2001, the government has done everything in its power to expand the economy after the stock market crash.. The incredible expenditures of debt money have caused a surge in corporate profits. This can't continue if a new administration is truly intent on fiscal responsibility. The Iraq war is a big money drain. The objective there is to lock up Iraq's 115 billion barrels of proven reserves. At $90 a barrel that oil is worth over $9 trillion. I received a little flack from a couple readers last month when I agreed with Alan Greenspan that America was in Iraq for oil. Let me just quote journalist Robert Fisk who has served many years in the Middle East. "Do you think America would be in Iraq if Iraq's major export was asparagus?". If you accept the premise of an oil war, then it brings home how desperate the oil depletion problem has become. The war confirms that oil prices will continue upward to perhaps $200 a barrel within 10 years - it could happen sooner.

The public is catching on to the oil war and is also becoming aware that they've been sold out by corporate executives earning hundreds of times the average worker's pay. In addition, many realize that the politicians of both parties have been co-conspirators with the president in squandering trillions of dollars on reckless spending. In an attempt to prop up a bloated and over-leveraged finance economy, they've put the nation so deep in hock that it's unlikely to ever see daylight again in the lifetime of most workers. They've doubled the national debt in seven years and debased the currency. All for nothing. They're delusional if they think that allowing the dollar to fall will result in an economic resurgence of manufacturing and business activity. Other nations will eventually do the same thing thus negating any currency advantage. You don't become economically strong by weakening the currency. The Asian countries will have their own currency by 2015 - that's their goal. Until then, Asia needs the dollar.

The problems of government finance became apparent this past week in an article written by Lawrence Summers, the former Treasury Secretary under Bill Clinton. Summers is a good man and pleads for the US government to act immediately to save the economy. He states that the government needs to act to prevent consumption from falling even if it means giving tax breaks, guaranteeing mortgages and expanding the national debt. This is how low we've sunk when these actions are recommended by a competent official. He doesn't specifically say it, but the alternative is a financial implosion of the American system. Summers is probably afraid of a Depression. I suspect a massive asset markdown is coming and investors better get prepared. Whether it's a controlled or a sudden event is uncertain. I've stated repeatedly that the hatch seals are blowing out on the USS Expansion. Clear the decks and get your life vest on. This means you should be in a conservative asset mix in case a worst case scenario evolves. We're in the early stages of the "The Big Markdown". Meanwhile, in 2008, the big money will sell into the market on strength while the middle class continues to buy stocks in their IRA accounts.

Some reputable financial people are even questioning government statistics on growth and inflation. They don't believe the numbers that show inflation is subdued. Headline items like food prices and oil have increased dramatically and some don't accept the official numbers showing inflation as moderate. Other forces are also at work. I too think the government has twisted the statistics, but not enough to greatly distort things. Some prices continue to fall as others rise. Yes, various statistical "adjustments" attempt to negate some obvious price increases. Still, the true inflation rate is probably within 1% of the stated numbers. Inflation is not at 10% as some critics say. The greater danger now is asset price deflation (stocks and houses).

What makes me very curious is the earnings data I'm seeing from Standard and Poors in their bi-weekly forecast of year-ahead earnings. We have declining home prices and falling employment in the real estate industry. We have a contracting financial services sector that makes up 20% of the S&P500 index. Car sales are terrible. Yet, forecasted earnings for the year ahead haven't budged. They're still estimating operating earnings of around $95 for 2008. This seems implausible. At some point they'll have to print something believable - maybe after it becomes obvious to a cub reporter that earnings are tanking.

Let's cut to the chase. It's possible the stock market could make a new high, but I don't expect it to hold. Earnings are in big trouble. The stock market has discounted this to a great extent so I don't expect a market crash. As I've written before, I expect PE ratios to contract over the next several years until they're under 10 for the S&P500. In the meantime, there's little reason to risk your life savings in the stock market. I'd cut back on stock allocations as the market surges occasionally to the higher side of its range. Cash pays a poor return now and that's unfortunate. Low Fed rates will continue while the Fed pretends they can make a difference in this financial environment - they can't. They're out of ammo. They created the housing bubble with their antics after 2001. Doing it again won't work because the housing collapse will overwhelm whatever they try. They'd be better off to keep rates over 4% so the old folks can at least earns some safe interest on their money. Otherwise, many folks will get into speculative investments to get income. The Fed can prevent the middle class from speculating and losing by doing the responsible thing and keeping the Fed Funds rate 2% above the rate of real inflation. Don't sell us out! But, the Fed now serves Wall Street and not middle America. They lost their way just like our politicians who no longer serve the citizens. I'll believe change has a chance when they stop appointing former Goldman Sachs and brokerage mega-millionaires to the job of Treasury Secretary. We need people in leadership roles who care about the working people and not about Wall Street's need for profits and constant growth.

As investors, we are in a tough situation. Doing the right thing and restraining government spending will not be good for the stock market. Raising taxes on people to pay for the growing deficits will not be good for the stock market. Lowering interest rates will kill the dollar and raise the price of imported consumer goods (and oil) which is not good for the stock market. Doing nothing and letting the housing market drop another 20% is not good for the stock market. Houston, we have a problem.

We can't earn much on cash and stocks are dead in the water. Trading currencies is too risky. I don't believe it's wise to invest all your cash in China's oligarchy with secretive communists still running the place. The dollar is surely a screwed up currency though and its reasonable to hedge cash holdings via a diversified world Treasury bond fund like the new BWX. So, where to invest? Gold will likely do better than stocks over the next decade. I'd buy gold at close to its 200 day moving average. You can track the 200 day moving average on Yahoo finance. The MA is currently at about $700 and I'd buy within 10% of the indicated value or presently under $770. This is the only asset that trumps fiscal incompetence, a weak dollar and rising oil prices. Eventually the major currency groups will have to create some kind of linkage to gold to prevent another 50 years of currency abuse. That will be the big lesson learned from "The Big Markdown".

Don't expect good federal governance anytime soon. I've said it before. US officials will do whatever it takes to prop up the economy through the 2008 election so the politicians can get re-elected.

The politicians are dreaming up solutions to the enormous debt problems they've caused. It will come in the form of more taxes like the Federal Value Added tax they're discussing. This is a federal sales tax extracted from the middle class. At the same time, the wealthy congressional paymasters on Wall Street are trying to eliminate the inheritance task so they can create financial dynasties for their offspring. I'd tax the bastards hard on estates over $10 million. I'd cut federal spending to the bone and that includes major cuts in defense. We have 900 military bases of various sizes inside America and over 700 in foreign countries. This is more than a bit excessive. Defense should mean just that and not projecting military might into every corner of the earth. The military is destined to contract anyway due to our debt and dollar problems. Let's not go the route of other dominant powers of the past and swirl deeper into bankruptcy. Let's act intelligently to stabilize our economy. Lest you think I'm some liberal trying to destroy America, I'd suggest you read some of Pat Buchanan's recent books. Or, listen to Republican congressman Ron Paul's discussions on sound money. People of good judgment from both political parties are meeting in the middle to try to combat the reckless ineptitude and greed that has overtaken America.

This brings us to the idea of what constitutes a sustainable size for the economy. If we strip away the unsustainable federal spending that serves to stimulate corporate profits and then get rid of the deficit spending by households, the real economy begins to emerge. Then apply the contraction forces I discussed above. It seems clear that the real economy will become much smaller than the current numbers and forecasts indicate. In a world with rising energy costs and a weakening consumer, growth will be hard to engineer.

The current level of corporate earnings could contract from $90 to probably under $65, inflation adjusted. As of today, if we apply a normal PE multiple of perhaps 16 and $65 dollars in S&P500 earnings, this provides a value around 1000. If they can stop asset deflation and engineer more inflation then in dollar terms the decline can be spread out and nominal stock prices won't fall. That's the goal of the massive fiscal intervention idea - create a controlled contraction so the index levels remain fairly stable. The S&P500 was at 1500 prior to 2000 and that's where it is today.If financial accidents occur, then the contraction phase could overshoot to the downside and could take stocks much lower. This might be why Larry Summers is so concerned about declining asset prices and why he suggests fiscal stimulus. I doubt it will matter what they do because it very likely won't work. Over $5 trillion in new debt was spent since 2001 to keep the indexes from falling. Will we spend another $10 trillion to buy a few more years?

The US economy is not in recession and may avoid that statistical label. Who cares. Stock prices move based on expectations for profit growth and, without growth, PE ratios will decline. That's why I think the market's PE will go under 10. I believe investors should under weight stock indexes until the residential real estate market hits bottom and the government presents and acts on a sound plan to lower debt levels. America is a bloated and mismanaged mess. There's still a lot of speculation and excess in this economy. Buy stock indexes again when they are very cheap and firms actually pay a competitive dividend. It will be a long ride down before we hit bedrock. Several false bottoms lie ahead.

In my book I recommend various portfolios that have never lost money. I'd reduce those stock percentages by a third and hold more cash. My stock market models are very good at detecting the direction of the market and now say stocks are safe to hold - that means they won't drop much - yet. However, the contrivances underway with all aspects of the financial system have raised risk levels and some published data looks dubious to me. In addition, the leading indicators for economic growth are in a slow steady decline. My advice is to get more liquid and fast as a precaution. I wouldn't sell all stocks, but holding 60% of your savings in index equities with the present risk levels probably isn't wise. There's little sustainable upside to this market.

Best Regards,
Southwest Ranch Financial, LLC    (www.swranch.net)
Tom Gleason, Manager & Researcher

Author of: How To Invest If You Can't Afford To Lose

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Disclaimer:.
Investing involves risk and the future performance of the models cannot be guaranteed. SWR is not a registered investment advisor and nothing published by SWR should be considered personalized investment advice. Any investment recommendations made by SWR should be made only after consulting with your investment advisor and only after reviewing the prospectus or relevant financial statements.  SWR does not receive any compensation for mentioning stocks, funds, or financial products.