email:                         phone: (248) 835-9112                            fax:(419) 858-4570                       2139 Brinston Dr. Troy, MI 48083
Katto Financial LLC                                     News Letter 06/11/06  


The Economy:

The latest core inflation rate reading which excludes energy and food rose by more than economists had anticipated. Investors are nervous about the Fed raising rates too aggressively to counter inflation. Some are worried that the new Fed Chief Ben Bernanke may go too far to show that he is the man who is not afraid to go to extreme measure. Some are nervous that there may be a Bernanke ego issue that investors are afraid will dictate the Fed policy. Some notable economists like Larry Kudlow are advocating a 50 basis point increase the next time the fed meets to shock the economy and slow down inflation. As a result, the market has taken a tumble the last two weeks and there has been a large volume sell-off even on days like last Friday when the Al-Qaida leader Al-Zarqawi was killed in Iraq. High interest rates are bad for equities for two reasons: they increase the cost of borrowing money, which leads to less capital spending and investing by corporations. Also, high interest rates raise the return in money market funds making investing in those funds more attractive than investing in equities.

My view is that Interest rates are still historically low and the economy is firing on all cylinders as evidenced by low unemployment rate and high GDP growth. That is why we have inflation to begin with. I look at the recent drop in the market as an opportunity to dollar cost average at these low prices. If you invest for the long term, which is the way to go for your retirement, now is the time when you buy low to bring down your average purchase price. The market may go down further but the indexes like the NSADAQ and the S&P500 are trading at historically low multiples of 16-17 times earnings.

Geopolitical Concerns:

Iran huffs and puffs every now and then to keep oil prices high. Oil prices are the reason that inflation is high. Oil is a component in every commodity and service. High oil prices eventually translate into higher prices for everything else. The outcome of the standoff with Iran over its nuclear ambitions is very important to the markets. If there is conflict, then there will be a severe short-term drop in markets worldwide especially if Iran succeeds in carrying out its threat of shutting down the straight of Hormuz. If there is a peaceful resolution, oil prices should go down and markets should go up. My view is that the risk that the Iran conflict represents has kept oil prices artificially high. Some argue that it is the increase in demand for oil by countries like China and India that has caused the high prices. While I think global high demand for oil has caused oil prices to rise, I believe that the rise has been too steep to be justified by the demand alone. The geopolitical risk premium is a larger factor in my opinion. The evidence is in the Saudi Oil minister’s comments that there is plenty of oil and supply is exceeding demand. As a result investing in oil is speculative and oil prices can go either way. Recent news from Iran seems to tilt toward a peaceful resolution, which is good for low oil prices and lower inflation. The Iraq war is important to the markets only in the sense that oil supply is influenced by the outcome of that conflict. There is a market psychological element but oil is more important. If there is security and stability in Iraq, then oil flow should increase and the risk premium from that conflict should be lifted. Recent developments such as the killing of the Al-Qaida leader in Iraq are positive for the markets but there is a long way to go before security and stability is achieved as the bombings continue nevertheless.


The herd is moving away from stocks and investing in commodities such as gold and oil. Some in the herd are starting to move away from the market completely and taking money out and investing it in cash or fixed income such as short term bonds and money market funds. Jim Cramer is recommending recession proof stocks such as retailers, drug companies, and consumer staples. My view is that even though in the short term stocks may go lower, nobody knows where the market bottom is and that point is influenced by many factors such as economic indicator readings and geopolitical events discussed above. The market is undervalued and staying the course is the best strategy as market timing has been proven to be a failed investment strategy. Investing should be for the long term and sooner or later the market will go higher. Technology stocks are sensitive to interest rates and many bellwether stocks such as Microsoft, Intel, and Cisco Systems are at multi-year lows. Internet stocks such as Yahoo, Google, Ebay, and Infospace are also at 52 week lows. There are attractive buys out there but in the short term we may see more drops.

Disclosure: I currently own shares of Microsoft and Infospace

Mike J. Katto

Registered Investment Advisor

email:                         phone: (248) 835-9112                            fax:(419) 858-4570                       2139 Brinston Dr. Troy, MI 48083