Aspetuck Financial Management, LLC

Market Update

Over the last twelve months the U.S. market, as measured by the Russell 3000 Index, has declined by 8.0%. Year-to-date it's down 5.5%. As a side bar, China is down more than 40% year-to-date and India 30%. Looking ahead, oil prices must retreat and headline inflation must behave in order for the market to resume its "recession rally".

Until recently the market was in a "recession rally mode" as the economy showed early signs of recovery. But then oil prices suddenly sky rocketed ignited inflationary and recessionary fears. Behind the explosive move, oil rose $17 in less than two days, were a number of bullish reports and a projections of a spike to $150 oil by July 4th (a spike is different from sustainable price of $150, a spike means up and down). The reports showed declines in U.S oil inventories, a decline in Russian oil production, and meaningful declines in Mexico oil production over the rest of the year.

My analysis concluded that speculation has inflated the price of oil by $20 a barrel. This year the only trade in the pits has been long oil. My gut and research tell me anyone buying now should be ready for a major correction coming at anyone's guess. The negative correlation between the US dollar and oil is at a fifteen year high. Finally, crude futures show the shorts starting to build up: 216 million long contracts to 188 million short last week.

The Saudi government said that the current price of oil is not normal. Even though supply is tight, oil should be trading around $110 given supply and declining demand and the cost of bringing it to market (costs ranges from $30-$70). Many energy experts think this market looks like a bubble except analysts at Morgan Stanley and Goldman Sachs.

Historically, demand has declined after run ups like this one. US demand for oil has declined 2.3% year-to- date compared to last year this time. American consumers have begun changing their behavior. Eighty-seven percent of the consumers polled by Auto Futures Group Auto said their next car they buy will be a fuel efficient vehicle. Sixty-six percent said they are driving less. Auto makers are closing down SUV production. Americans consume 23 million barrels of oil a day, compared with 2 million barrels per day for Indians. If American's use less gas this summer it will have an impact on the price of oil. It's in everyone's interest to cut back; the market should react strongly to meaningful drop in US gas. Now China is letting gas prices rise which will cut back on demand too. Once the Olympics are over China's subsidization of gas prices is likely to change.

The rest of the world is slowing down. The World Bank estimates that 2008 world growth will be 2.7% with Developing countries dropping from 7.86% in 2007 to 6.5%. The U.S. Economy is expected to grow 1.1% and Euro zone at 1.7%. Usually, lower economic activity coincides with a drop off in demand for oil.

New supply is on the horizon but may not be enough and too far away. OPEC is talking about ramping up production by 200,000 barrels a day. Shale oil is being produced in the Dakotas. Tar Sands in Canada is another supply source. Another off shore find is in Brazil but still a way off from producing oil. Abundant supplies of coal using technology that minimizes pollution are a few ways that can pump up energy supply. Domestic drilling is being looked at again in closed offshore areas and in Alaska. Greater use of natural gas, nuclear power and solar energy is in the works. The oil man, Boone Pickens, is building a colossal wind mill farm in Texas. Over the long term, these are some of the ways to slow oil's fast ascent but not stop it! Eventually, the world will see $150 oil. Long term the price of oil is up. The IEA projected global oil production will be $100 million barrels per day and demand will be 116 million barrels by 2030. American's have time but need to become less dependent on foreign oil as its primary energy source.

The short term is tricky. These factors could keep oil at current levels: developing market demand and subsidies, it's very difficult to supply more oil, refining capacity is lacking, tension between Israel and Iran, hurricane season, peak driving season, extreme "buy" speculation, and hawkish monetary comments by the Head of the European Central Bank. Going forward, the only relief to higher prices could come from a significant drop in US demand, worldwide demand destruction, a stronger US dollar, and a temporary turn in bullish "oil" sentiment. The U.S. is seeing a drop in demand, but there is still demand growth in the non-OECD countries, including China, the Middle East and Asia. Foreign demand may slow this summer as foreign central banks raise rates to slow their economy in an attempt to combat rising inflation.

Inflation Watch

My outlook on all item inflation is that it will come in at 4.00% for 2008. That's above the long term average of 3.9% since 1950. I project core inflation (ex-energy and food) to be above Fed comfort level at 2.3%. Inflation is much higher than what consumers has been use to since the last recession. Yet it's not high enough to prevent corporate America as a whole from not doing okay. At current inflation levels the stock market and economy has functioned well.

Inflation is completely commodity driven accounting for less than twenty percent of inflation, however, it's the worse kind because it's very visible at the gas pump and food isle. So far, higher energy prices haven't significantly impacted core inflation. Wages and housing are containing core inflation; wage inflation accounts for approximately fifty percent. In a weak economy with higher unemployment it's not likely that wage inflation or housing inflation (25%) should be an issue. I expect the acceleration in commodity inflation to slow down as the economy grows at a snails pace and the dollar strengthens. Over the last two months, the dollar has appreciated based on a halt to Fed rate cuts. The Fed may raise rates a quarter of a point towards year-end. That would promote a stronger US dollar, be anti- inflationary, and keep the speculators from being long. Even with a quarter point hike, the economy should continue to muddle along at non-inflationary 2.3% rate in 2009.

I expect the US dollar to modestly rebound this year against the major currencies as the US economy stabilizes. Bernanke's latest public comments are supportive of a stronger dollar. A stronger greenback is a deflationary force that is likely to slowdown oil's ascent and commodities too. Investors who bought commodities such as oil to protect against inflation when the dollar was falling, tend to sell when the dollar appreciates as it did last week.

Economic and Stock Market Outlook

The battle between inflation and slow growth should play itself out this summer. By fall I expect inflation to stop accelerating, and stabilize at current levels as growth modestly pick-up. The credit crisis is still with us, limiting upside and creating volatility. However, as time goes by the credit market will begin to function normally again. Lending should slowly return in 2009 as the consumer gradually gets back on his/her feet.

In an environment of higher prices and rising unemployment, consumer spending is likely to remain weak. Consequently, the stock market may take a little longer to complete its recession-to- recovery rally. It may even limit a rally's upside. Generally, the stock market produces two years worth of returns in twelve months when the economy comes out of a recession. That's the equivalent of ten years worth of money market returns based on the average money market yield in the Wall Street Journal today. Is that worth the wait?

I see the economy gaining a little more strength by year-end and building on that in 2009. The GDP projections I'm using are 1.8% and 2.5% for 2008, and 2009 respectively. The equity market is likely to move higher given growth comes in as projected. Fourth quarter earnings are expected to rise by 50% year-over-year. Some say the projection is too optimistic. Even so, many analysts see the second quarter as the last quarter of negative earnings growth. Thereafter, earnings growth is expected to resume to an 8% growth rate by year-end. The market could move 5-10% higher from last week's low point, based on S&P 500 operating earnings coming in at about $90 for 2008, and four percent inflation.

If inflation stabilizes, then expect the mountain of cash on the sidelines to flood into U.S. equities not foreign equities. Developing foreign economies are dealing with inflation by raising rates making their currencies stronger but slowing economic growth. Southeast Asia has an inflation problem. For example, China's inflation is eight percent even with subsidized oil. This is one reason we like U.S. Industrial companies.

Is it Different This Time?

I don't think it's different this time, meaning we are in for a decade of stagnation. I do think the economy will recover and market will move up from its lows. Yes there are many economic ills that the economy has to deal with before it can fully recover. Housing sector, credit crisis, and rising unemployment should be with us into 2009.

I do not see the market trading in a narrow range for years to come as it did in the late 60's and 70's. At today's prices, consumer spending on energy is still lower than the 1970's and 1980's. The global economy is too robust and motivated to allow a deep and long recession. There is a new world middle class being formed, working, earning income, and spending. New technology and increased global production capacity will help meet demand. Alternative energy sources will be brought to market. A dramatic change in the way American's use energy is likely to occur. No more Hummer like gas guzzlers! I don't think we are going back in time to the 70's and early 80's when the economy had double digit inflation. Inflation of four percent is more likely. The stock market has produced double digit returns during periods of moderate inflation. Finally, its time our leaders in Washington devised an energy policy that lessens our dependence on foreign oil.

My Advice for the Summer

At this point is be patient. Keep a strategic balance. Don't get out of balance by hording cash, buying Treasuries, or CDs. Those trades will just lock into a negative real return. Money Market fund assets are now 29% of total mutual fund assets. In the past, this has signaled a market low and long term buy opportunity. In the mean time, your portfolio is earning dividends and interest income.

Some areas of the market we tactically favor:

• US Multi-National Industrials - if BRIC and developing countries continue to do well then industrials should do the same
• Technology - less energy dependent and solid earnings outlook
• Health Care - attractive valuations and reliable earnings
• Convertible Bonds - 4% plus yields and appreciation potential
• Global REITs - 5% plus yield plus appreciation potential
• Credit Sensitive Bonds - up to 8% yield
• Adjustable Rate Mortgages - AAA FNMA 5% adjustable rate yields
• Financials - 2009 recovery play plus dividends

• Caterpillar Inc.
• 3M Company
• Research in Motion, Ltd
• Noble Energy, Inc
• Archer Daniels Midland Corporation
• Apple, Inc.
• Millennium Pharmaceuticals, Inc
• Genentech, Inc
• Celgene Corporation
• Consol Energy, Inc

Please call me at 203-226-5733 if you have any questions. Thank you for the confidence you have placed in us.

Enjoy your summer!

Yours truly,

Patrick T. Byrne, Market Strategist

The opinions expressed are those of Patrick T. Byrne as of June 16, 2007, and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. Information and opinions are derived from proprietary and non-proprietary sources. Index performance is hypothetical and is shown for illustrative purposes only. You cannot invest directly in an index. S&P 500 is a registered trademark of The McGraw-Hill Companies, Inc. Nasdaq is a registered trademark of The NASDAQ Stock Market, Inc.Risk Managed Portfolio Program. IT SHOULD NOT BE ASSUMED THAT RECOMMENDATIONS MADE IN THE FUTURE WILL BE PROFITABLE OR WILL EQUAL THE PERFORMANCE OF THE SECURITIES IN THIS LIST. Past performance is no guarantee of future performance. There is no guarantee that participation in the Aspetuck Financial Management's RMP - Risk Managed Portfolio Program will protect you against loss of the money you invest.The mutual funds available in the RMP account incur fees and expenses (including investment management and administrative fees) that are in addition to the fees you pay to participate in the RMP account. Those fees and expenses are reflected in performance numbers. Please call us at (203) 226-5733 for a prospectus on any mutual fund being offered by the Program. Prospectus contains more complete information about the fund including all fees and expenses and should be read carefully before you invest. In addition, ask us for our latest ADV, Schedule F, and Schedule H statements. Read them carefully before investing. Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Advisory services offered through Aspetuck Financial Management, LLC, a registered investment advisor.Securities offered through TD Ameritrade Inc, a registered broker- dealer. Member NASD/SIPC. Securities offered through Charles Schwab & Co., a registered broker- dealer. Member NASD/SIPC. Aspectuck Financial Management, LLC is an independent firm not affliated with TD Ameritrade or Charles Schwab & Co.

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