MARKET OVERVIEW

Wall Street closed May with mixed results, as a rally in technology stocks counterbalanced fresh pessimism in the financials sector. The Nasdaq Composite advanced a third month, its longest winning streak since October. The S&P 500 edged north, while the Dow Jones Industrial Average edged south.

While the Federal Reserve didn't officially meet in May, the U.S. central bank was a market mover. The Fed published minutes from its April 29-30 rate cut decision on May 21. The report signaled a rebalancing of priorities, from promoting economic growth to preventing inflation. With policy easing on apparent hold, investor optimism crumpled and Wall Street closed with its worst weekly loss since February.

The Fed’s switch to an inflation-fighting stance occurred against a backdrop of record energy prices. Crude crested at $135.09/bbl on May 22, more than double the price from a year ago. Foreign energy producers have been some of the biggest beneficiaries of the rally. Stock markets in Russia, Canada, Norway and Brazil reached record highs in May. With income closely tied to fuel costs, airlines have been among the biggest energy rally losers. Shares of United and U.S. Airways fell more than 40% in May. Northwest and Delta lost more than 25%. American fell more than 15%.

Corporate earnings expectations spiraled south again last month. On May 30, with 99% of firms reporting, Thomson Reuters estimated S&P 500 profits slid 17.5% during the first quarter of 2008. The last time profits increased was the second quarter of 2007, making the current negative streak the longest in six years. Financials remains the softest sector. Battered by the credit crunch and subprime mortgage losses, bank profits fell 80% during the first quarter. Energy firms produced the strongest results, with profits up 26%. Similar trends are expected for the current period. Overall second quarter profits are expected down 7.3%, with financials and energy companies at the respective bottom and top of the heap.

PERSPECTIVE

By Arthur B. Laffer, Ph.D.

Since the early part of this decade, the real exchange rate has not remained constant. Foreign price levels, converted into dollars, have increased at a much faster rate than U.S. prices have increased, indicating that the real purchasing power of the dollar (the U.S. terms-of-trade) has not been constant but, in fact, has been eroding.

The consequence of the weaker dollar, of course, is that imports are more expensive to Americans while foreigners are able to import U.S.-made goods at cheaper prices. U.S. net exports should increase. Laffer Associates thus has advised investing in U.S.-traded goods companies — exporters — for quite some time now. These companies export goods as well as U.S. intellectual capital to rapidly growing “pro-growth countries”. In addition, domestic producers of import substitutes should continue to outperform.

I believe that interest rates are the correct forecasters of inflation, and as of today the market's expectations do not reflect concerns of sustained inflation. Inflation expectations, as derived from the 10-year Treasury Inflation-Protected Security (TIPS) yield, do not reflect the anticipation of higher inflation. Inflation expectations stand at about 2.5% per annum — in the same range in which they’ve been over the past four years.

The development of the weak dollar is not a result of excessive liquidity fueled by excessive money growth. As my late friend economist Milton Friedman noted, “Inflation is always and everywhere a monetary phenomenon.” Yet monetary base growth has been quite constrained. The growth in the monetary base has been declining since 2001, and excess base growth (the difference between the rate of growth of the monetary base and the rate of growth of M1) has been flat to negative for several years. This simply is not an inflationary environment.

EQUITY UPDATE

STYLE AND MARKET CAPITALIZATION

Growth stocks dominated value stocks a second month in May. Growth has outperformed value every month but two since April 2007. This largely reflects weakness in the financials sector and losses related to subprime mortgage defaults and the credit crunch. Financial firms are predominantly value-oriented. From a capitalization standpoint, large firms underperformed in May, while small- and mid-sized firms performed about in line. Mid caps broke into the black on a year-to-date basis.

S&P 500 SECTORS AND INDUSTRIES

A sea change occurred in the S&P 500 last month: information technology overthrew financials as the largest index component. Financials had ruled the roost since February 2002. As of May 30, financial firms accounted for 15.9% of the S&P 500, while IT firms accounted for 16.7%. The energy sector, third largest at 14.3%, is rapidly growing. Energy accounted for nearly half of the increase in S&P 500 earnings in the twelve months to March 31, according to Bloomberg.

INTERNATIONAL EQUITY

International shares advanced again last month, the first back-to-back gain since October. On average, growth shares outperformed value shares, emerging markets outperformed developed markets and Asia outperformed Europe. With crude above $135/bbl, countries with strong energy-related industries, such as Canada, Norway, Russia, Brazil and Argentina tended to produce the best results. Pakistan was the world’s worst performer, with share prices tumbling by nearly a quarter last month. The dollar appreciated versus the euro and yen for a second month, curbing gains in U.S. terms.