The Prudent Investor

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From the Editor - July 06

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Commentary on AVCT

Though it has not typically been our custom to offer detailed commentary on the stocks in our Model Stock Portfolio, going forward we would like to highlight certain stocks in The Prudent Investor. Doing so will give you a better appreciation of what we look for in selecting a particular stock. We will try periodically to give a more focused description of one or more stocks in our model portfolio. At the end of this newsletter you will find a description of Avocent Corp. (AVCT) and what we consider attractive about this newest stock in our Model Stock Portfolio.

Second Half Forecast

Although we at The Prudent Investor do not put much faith in future market forecasts offered by analysts and economists, we cannot resist the temptation to offer one ourselves, knowing full well that if we are correct, our readers will speak of us with glowing admiration (because we will be certain to remind you of our prescient foresight). And if we happen to be wrong, it is almost certain that our faithful readers will simply overlook the erred forecast (and more likely, will forget we made it in the first place).

DISCLAIMER: Before we say anything further, we remind our readers the importance of following an investment model faithfully, and not deviating because of insights from “experts” claiming to divine the future, no matter how credible the expert appears. Our last two newsletters spent a great deal of time showing how the Fed model could deliver superior long-term returns for the investor who has the courage to follow it regardless of what emotions may be urging, and regardless of what the so-called experts say.

It is generally acknowledged that the months from June through October tend to be weaker for stocks than the months from November through May. Various reasons are provided to explain this phenomenon. Given the conditions existing in the U.S. at present, we think this trend is especially likely to repeat itself in 2006. Our expectation is derived from what we believe the Feds are likely to do with interest rates. Historically, the Federal Reserve Board has raised rates higher than most market participants were expecting, creating in the process excess volatility in the markets (especially to the downside). Arguably, this has already occurred. One year ago very few Fed watchers were predicting a fed funds rate to reach 5% (it was at 3% last June and is 5.25% today). It is probable that we’ll see another rate increase in August, and possibly one final one in September.

The danger, of course, is that interest rates will be pushed up too high, and cause a slowdown in the economy that could drift into a recession next year. History suggests this is a very possible outcome. While the Feds do not want a recession, they want even less inflation that is too high by their definition of “high.”

We make no official guestimates about the probability of a recession in 2007 (though our gut instinct is it won’t occur). We are a little more confident, however, in predicting a flat market for the next two or three months. The market hates uncertainty. Until it is more evident that the Feds are finished raising rates, we think the markets will be choppy. This will create a few good opportunities to pick up some extra shares of stocks in our Model Stock Portfolio at good prices.

Once the market is convinced the Fed is finished raising rates, it will likely rejoice and move up again, giving us a good year-end rally. Oddly enough, this may be true even if there are dark clouds of a pending recession. In the twisted logic of the markets, an ominous event like a recession is perceived as good news, because it means the Feds will have to start lowering rates to eliminate, or at least soften, the threat. And lowering rates is good news for the economy and corporate profits, which ultimately is good news for the stock market.

Our recommendation to our readers is to use any strong pullbacks in the stock market to add to your positions. You’ll know when to buy more because your stomach will be telling you you’re crazy to do so! That’s usually close to a local bottom for the market. Try to be fully invested in stocks by the end of October, in time to catch what we think will be a year-end rally.

We have mentioned before and will reiterate again, this is a good time to pick up some attractive yields on CDs and long-term bonds. The ten year treasury note is currently at 5.16% We think it could go another 0.25% or so higher, but probably not much higher than that. Once the bond market perceives that the Feds are finished raising rates, there is a greater probability of a nice bond market rally (which means the bond yields will go down as a consequence).

The next six months should offer some interesting investment opportunities for the patient and prudent investor. We wish you well in your investment choices!


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