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Expect higher equity markets by the end of year

William Creekbaum
Special to the Appeal

U.S. equities stumbled into June, driven lower by negative news flow out of the financial sector, rising oil and natural gas prices, and continued fears about the state of the global economy, in my opinion. For the trading session, the blue-chip Dow Jones Industrial Average declined 134.50 points, or 1.06 percent, to 12,503.82. The broad-based S&P 500 fell 14.71 points, or 1.05 percent, closing at 1,385.67. The technology-laden Nasdaq Composite dropped 31.13 points, or 1.23 percent, to close at 2,491.53.

Last week’s market decline was widespread, as nine of 10 S&P 500 sectors finished the session in negative territory. Financial and Information

Technology stocks were among the day’s worst performers, while securities in the e0nergy sector managed to post small gains. Market breadth was decidedly negative, as the number of declining shares on the New York Stock Exchange outpaced the number of advancing shares by more than 3-to-1.

Financial stocks opened the session in the red and declined further throughout the afternoon as investors digested disappointing financial news, including a negative profit pre-announcement from a U.K.-based bank, management changes at two prominent financial companies, and several credit downgrades in the brokerage arena from a large ratings agency.

We believe the trifecta of disappointing data caused investors to once again focus their attention on the financial sector, where continued uncertainty, negative earnings-per-share revisions, and worries about further asset write-downs continue to suggest that the credit crunch is not yet fully behind the market.

In our view, the negative news flow from the financials sector overshadowed any potential impact from the Institute of Supply Management’s (ISM) May manufacturing report, which came in slightly above consensus expectations. The ISM report stated that its manufacturing-activity index rose to 49.6 in May, up from the 48.6 reading in April and ahead of the consensus forecast of 48.5. A reading above 50 usually indicates expansion for that portion of the economy. Production rose, employment was flat, orders were up, and exports also strengthened. We believe the overall report was better than expected, though prices paid continued to rise, which may have ignited fears about inflation.

We believe persistent problems in the housing and credit markets and their potential impact on U.S. economic growth will continue to cause volatility in the equity markets over the near term. We note that many of the issues plaguing risky assets at present may take some time to work their way through the system. Longer term, however, we believe the equity market is reasonably well positioned to contend with these concerns; we point to attractive valuations, solid corporate balance sheets (excluding financials), and strong free cash flow generation as drivers for equities going forward. Indeed, a number of the firm’s proprietary valuation and sentiment indicators point to higher equity markets by the end of 2008, although our generally positive outlook is predicated upon successful policy implementation by the Federal Reserve and others. Risks to a sustained market rally include a continued deterioration in credit markets, persistently high oil prices, and meaningfully slower global economic growth. Given our longer-term positive view, we would use periods of market weakness to upgrade portfolios and build positions in high-quality companies that generate strong free cash flow and possess above-average prospects for growth.

Please contact our offices if you would like to discuss how the current market environment might be impacting your investment holdings or investment strategy.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.