Third Quarter Update
  “Here we go again”

At this time last year we wrote about the abundance of concerns that the stock market had ahead of itself and advised clients to stay the course during a slight correction. (Don’t panic we have seen this before, 2nd Qtr 05 update)  Well we were correct and client accounts rallied to near record highs by the first quarter of 2006.  Again we find ourselves in the midst of another larger and more likely longer correction and continue to believe that you need to stay the course due to the fact that valuations remain attractive.   So where does this put the stock market?  The bullish case is fairly clear cut. While U.S. economic growth may be slowing somewhat, the global economy appears to be strengthening. And, many larger U.S. companies are well positioned to participate. Corporate balance sheets are very strong. Stock market valuations are attractive. Inflation and interest rates are still low by historical standards. And there is a lot of potential investor buying power (liquidity), with few attractive investment alternatives to stocks.  Stocks remain cheap.
On the bearish side are investors' concerns about the repercussions of the housing bubble and an overly extended consumer. Also, we know from experience that it is unwise to "fight the Fed" when it is raising interest rates to restrictive levels. Furthermore, a yield-curve inversion will pressure financial system profits, and higher short-term interest rates are providing increasing competition for stocks. In addition, as we have mentioned in past Updates, 2006 is the second year in the four-year stock market/presidential election cycle - a year in which the stock market almost invariably reaches some sort of a cyclical low point. The bears also express longer-term concerns about rising budget deficits, the U.S. reliance on foreign financing, possible oil supply disruptions, and the ever-present threat of terrorism.

Our belief is that some of the bearish concerns are overblown. Insofar as the Fed is concerned, the current cycle of rising short-term rates appears to be nearing an end. Our expectation is that Fed Chairman Bernanke will be reasonable and balanced in his approach to interest rates. The U.S. economy is slowing and it is obvious that the Fed has done enough to stem the rise in housing prices. And regarding the potential for a steepening yield-curve inversion, we do not believe that nominal or real (adjusted for inflation) interest rates are at high enough levels to put meaningful pressure on the economy. While it is true that previous yield curve inversions have almost always led to economic recessions or slowdowns, on those occasions interest rates were quite a bit higher and far more restrictive.

The bears' concerns regarding some of the macro issues bother us as well, including the growing budget deficit and our increasing reliance on foreign financing. But while those issues may cause longer-term difficulties, we do not foresee any negative near-term consequences. We also worry about the possibility of oil supply disruptions because a further increase in energy prices from current levels would almost certainly lead to economic weakness. And of course, we worry about the rise in fundamentalist religious unrest and the resulting potential for terrorism. Nonetheless, we think that the financial-market consequences of any terrorist acts will be related to the severity of those acts, and will pass over time, much like the effects of previous disruptions to the stock market.

Conclusion
So, as indicated in prior Updates, we believe the stock market remains in a transition period, somewhere between the post-bubble secular bear market which ended in 2002 and the beginning of the next secular bull market. In our opinion, this transition is likely to continue for another year. In the interim, there is a definite case to be made for a four-year-cycle setback this year, which most likely began during the last few months. But while we are expecting at least a portion of the bear case to be realized, there is little reason to believe that any pullback would be significant by historical standards. And following the low, the positive underlying fundamental environment should quickly push stocks higher once again.
While we have taken some modest defensive measures in order to protect client accounts from an expected interim decline, we believe that the more important task is to position those accounts to take advantage of the positive longer-term trends and opportunities. The S&P 500, which was valued at 25 times earnings in the year 2000, currently trades at close to 15 times, expected future earnings - below the long-term average valuation. Earnings will continue to grow at favorable rates, in our opinion, and the longer the stock market stays in this transition period, the cheaper valuations will become. So the bottom line is that we remain long-term bulls, and remain fully invested while we sit out this correction.

ACM Composite Portfolio (Equity and Fixed Income)

As discussed in the last portion of this update, we remain very comfortable with the long term outlook for equity markets and consequently the current holdings in the ACM composite.   With better than anticipated earnings and revenue expectations, we are confident we will see strong returns from our holdings in the long term.  In continuation from last quarter’s outlook we believe we will see higher interest rates by the end of the year into the first quarter of 2007, putting increased pressure on bonds and increasing signs of commodity led inflation.   The recent sell off in commodities and emerging markets has put pressure on the US equity markets and we believe is the beginning of a transition to new market leaders many of which we own in client portfolios.  During the past quarter we didn’t add any new positions to the composite portfolio.

Our approach for the quarter

Market conditions have changed since the last update as inflation, interest rates concerns and a sell off in commodities and emerging markets have begun to disrupt the equity markets.  As stated earlier, we believe there is a strong possibility for lower equity market prices during the remainder of this quarter.  However we will use any weakness to purchase quality names for client accounts.  Overall we remain very bullish on the year and the long term outlook for the U.S. equity markets.

Closing Statement:

We remain optimistic about the long-term opportunities in the equity markets and continue to feel comfortable regarding the current stock market environment where stocks remain the most attractive broad investment category currently available to the average investor.  Bottom line, we remain constructive on stocks, continuing in our belief that the current risk/reward environment is positive for equity investors. 

While our strategy remains solid we continue to focus on companies with strong earnings and growing revenues as we select new names for the ACM composite.  Our strategic outlook has us positioned for a longer, more powerful bull market. 

As always, ACM values each client and continues to focus on your investment objectives.  If you have any questions or concerns please do not hesitate to call.