Column by Jim Flinchum, Inside Business - Hampton Roads, July 16, 2007

The stock market had a great second quarter. In fact, it was the best since the fourth quarter of 2003, with the Dow up 8 percent. Imagine how good your portfolio would look if that performance repeated itself every quarter.

Unfortunately, that great performance occurred during April and May but not June. Have we reached the “tipping point” that we all fear? Most forecasters think not for the following reasons.

The economy remains strong. Both the Dow and the S&P are close to recent, all-time highs. Even the badly trounced Nasdaq is at a seven-year high. Share prices are still not overpriced, relative to their earnings. Inflation remains low by most measures. Interest rates in the U.S. are relatively stable, except for a modest increase in long-term rates, which most economists think reflects improving expectations.

Businesses remain extremely bullish. They’ve spent more than $1 trillion in new mergers and acquisitions so far this year. And, businesses made record levels of company share buybacks with $602 billion last year. Both reduce the supply of available stocks for investors to own, which is usually bullish.

Globalization’s big impact

The world financial system looked good in the second quarter with strong stock markets worldwide, e.g., 24.4 percent in China, 25.1 percent in India, and 23.9 percent in Brazil. Globalization continues to blossom with $1.12 trillion in foreign direct investment into the U.S. last year, up 29 percent from the previous year.

The continuing decline in the dollar is pumping up our exports, which is decreasing our net foreign debt, as well as our level of unemployment. Our current 4.5 percent unemployment rate is widely considered “full employment.”

U.S. consumers continue to behave well, with spending still growing, up 0.5 percent in May. Consumer income also rose 0.4 percent in May.

Housing, yen and hedge funds

Some investors are deeply concerned about three things – the depression in housing, excessive liquidity from the yen-carry trade, and another hedge fund collapse. But, these are low on my worry list.

Housing: Treasury Secretary Hank Paulson correctly points out that we are at or near the bottom in residential real estate. Yen: Damage from soaking up the liquidity from the yen-carry trade will be minimized, because it will be telegraphed by movements in currency exchange rates. Hedge funds: A major one collapsed in 1999 and many experts, including Alan Greenspan, felt the financial system was gravely threatened. An even bigger hedge fund collapsed earlier this year and the market barely winced. There will be other hedge fund collapses, but we will survive.

I do not see any danger to the market in the short run and expect GDP growth recovered to trend line of 2 percent or better in the second quarter. I still predict that the S&P will hit 1,550-1,575 by year-end.

Credit derivatives and swaps

A client of mine recently visited Greece and purchased some “genuine” worry beads. He gave them to me since “that is your job.” Today, they hang from my car’s rear view mirror, and I think about them often.

Professional investors often joke about the “Wall of Worry”: Once the market gets over this wall, it will really take off. But, the higher you get on the mountain, the harder it becomes to get over the next wall of worry.

Mount Everest is 29,029 feet high. Less than 200 feet from the summit is a “little” but tough 40-foot climb called “Hillary Step.” A great number of brave climbers reach that point and wisely turn back because the increased risk to attempting the summit does not justify the increased risk of death. Likewise, we should not bet too heavily on where the summit of this investment cycle is.

Of the several walls of worry on the investing front, only one has my close attention – the explosive growth of the credit derivatives and credit swaps.

Warren Buffett describes these as “financial weapons of mass destruction.” Originally styled as “portfolio insurance” 20 years ago, they are extremely useful in distributing credit risk (as well as other risks). It’s similar to a bank making a loan that has a co-signer and no risk of repayment.

Redistributing risk is a good thing, but it is now so distributed that it’s unclear who actually has it and whether they can handle it. Recently, a special study group of the Fed analyzed this without even defining our exposure. Estimates range wildly from $1.5 trillion to more than $30 trillion.

If the “black box” of credit derivatives does blow up, it will largely be a U.S. problem because almost all credit derivatives are denominated in dollars. This is another good reason to have some international exposure in each portfolio.

International economy

I remain bullish on the international economy, although the rate of globalization will begin to decrease for two reasons – it has already grown so much, and Congress unwisely declined to renew the president’s fast-track authority, which expired last month. The emerging international markets are still attractive but the “glory days” are behind us, especially for the developed international markets.

We are fortunate to have witnessed two “sea-level changes” in our lifetime. First was the widely recognized productivity increases from the personal computer. Second was the less widely recognized huge growth in both supply and demand from globalization. The benefits of both are just now starting to impact the emerging markets.

The accompanying graph courtesy of The Wall Street Journal Online clearly shows the developed markets lagging behind the younger, emerging markets.

Handling Hillary Step

According to The Economist, “Since 2003, being blasé has been the most profitable strategy.” Many fret we have become complacent about risk, and maybe we have. However, it is not time to get out of the market, and I would never recommend that extreme form of market-timing anyway. But, it is time to take some of the risk out of portfolios.

As we approach an investment Hillary Step, this is a good time to minimize risks. My firm is handling those conditions the following way. We are taking the remaining high-yield bonds out of our clients’ portfolio, as well as any long-term bond funds. We are reducing our allocation to smaller company stocks and any hedge funds that are not “absolute return.” We are unwinding clients’ private equity or “leveraged buyout” exposure. We are increasing our exposure to those large U.S. companies focused on international trade, especially to the emerging markets. Lastly, we are increasing our holdings in cash or short-term bonds. We think that is the best way to approach the Hillary Step.

Jim Flinchum, a CFP practitioner as well as a certified investment management analyst, is the managing principal of Bay Capital Advisors, an investment advisory firm with offices in Washington, D.C., and Virginia Beach. He can be reached at www.baycapitaladvice.com.