Who We Are - President Letters - When Everything Seems as Good as it Gets, it Usually is

February 10, 2010

Dear Clients and Friends,

When everything seems as good as it gets, it usually is.

Following the theme of previous writings, one cannot be complacent in times like these. Read on and let me explain why. There is a significant difference between good news and less-bad news. We have yet to see significant signs of good news for our economy. Further, we feel that the rally fueled by less-bad news is overdone.

Over the past ten months we have experienced the action of a severely 'overbought bounce'. This is when investors realize that the market went from "too low to too high". We remain positioned for this and feel that there is an increased likelihood for a larger correction on the horizon, as mentioned in previous letters. There are several factors that supported the recent stock market rally. Below, you will find our thoughts regarding how recent and potential changes to each of these factors will affect the economy and financial markets.

US Job Market Still Sliding
Recent headlines of improvement in the unemployment picture have centered on monthly job losses, emphasizing that the economy is getting better. What doesn't show up in the government statistics is that many who have lost their jobs have taken new positions that pay significantly less. Not a good sign for the economy in the near future.

Further, the economy generates approximately 125,000 new entrants to the job market each month, including high school graduates, college graduates and drop outs comprising the majority of new job seekers. This means that we need to increase jobs by this amount to keep the number of unemployed Americans flat. We still have some ground to make up just to keep the number of unemployed from increasing. The estimate is 18 million people are either unemployed or under-employed!

Lack of Real Consumer Sales in the US GDP
The Fourth Quarter 2009 GDP Report was received as a great economic improvement; however, it appears that much of the 5.7% GDP growth was from inventory increases - and not consumers buying more goods. In fact, real final sales were up only 2.2% in the fourth quarter, compared with an increase of 1.5% in the third. This is not a robust recovery of the consumer! Upcoming GDP numbers will not benefit as much from inventories and we expect less impressive GDP reports as we move through 2010. Keep in mind that the consumer is 70% of our economy. If people don't spend, the economy will not improve significantly. Those with jobs are saving much more than in recent years and unemployed people don't have money to spend.

Rough Road Ahead for Housing Prices and Mortgage Rates
Since early 2009, mortgage rates have remained at very low levels due to the mortgage buy-back program of the Federal Reserve (Fed). However, the Fed plans to stop this program at the end of March. The end of this Fed assistance may lead to higher mortgage rates and fewer borrowers, putting more pressure on mortgage rates. The result is most likely more bad news for home owners with another large decline in the residential real estate market. Further, Federal tax credit programs for first time home-buyers and existing homeowner home-buyers are set to end in April. If these programs end (they may be extended) then that is yet another issue for the residential real estate market. Be aware, 1 out 4 homes in this country are worth less than the outstanding mortgage (under water)!

Changes to the Historically Low Federal Reserve Rates
Banks can borrow for 0% and lend at 5% or more - and they still are not lending! If the Fed raises this 0% rate, it will mean higher rates for loans that less people and companies can afford to borrow. When the Fed raises the 0% rate, you can expect a Wall Street sell-off. Unfortunately, the only way for rates to go is up! Commercial Real Estate Issues Below the Surface

In the heart of the crisis, accounting rules were put in place to require banks to reflect the 'real' value of assets (mortgages and loans) on their books. The banks quickly realized that they would have to raise A LOT of cash if they used these values because their loans were not worth as much as when they were issued. Our government quickly repealed the rule, thus allowing banks to value the loans themselves. The bottom line is that the bad loans are out there, they are getting worse, but nobody will see this issue until loan defaults start flowing through to bank bottom lines as losses.

...ABOUT THOSE STOCKS & BONDS

In recent days, we have seen the fragility of this stock market. Specifically, Chinese efforts to slow down their growth and European sovereign debt (Greece & Spain) concerns have taken a toll. These seemingly distant and unrelated events resulted in several violent declines in the stock market over the past weeks.

Overall, there is little room for all of any of these factors to improve, but there is much room for each to get worse. If there are events that destabilize the fragile support of the stock market, then we may be looking at a very significant decline. It is time to protect your portfolio (or have AFC protect your portfolio for you). We continue to feel that 'conservation of capital' is the prudent approach at this time. As such, AFC will remain conservative in our approach until we see a better economy...or a worse one. In times such as these, if we are wrong, we would rather be OUT of the market when we should have been in, and NOT in the market when we should have been out.

As always, we welcome your calls and emails. We want to hear from you.

Sincerely,
Barry Cliff
President
Barry@AFCAssetManagement.com

Jim Young
Vice President
Jim@AFCAssetManagement.com

AFC Asset Management Services, Inc.
18310 Montgomery Village Avenue, Suite 440
Gaithersburg, MD 20879
301-588-5000
www.afcassetmanagement.com