It has been a great summer. After pausing during the month of June, the S&P500 continued its year-long upswing with monthly gains of 7.4% and 3.4% respectively in July and August. While the July rally was largely attributable to better than expected Q2 corporate profits and the seemingly stalled passing of Cap & Trade legislation and Healthcare overhaul, the August rush resulted largely from better than expected housing data, consumer confidence, and a newly built consensus that the recession is virtually over. Fed Chairman Bernanke was reappointed, but that didn't surprise anyone. There has indeed been good news on the housing market. New home and re-sales increased for the 4th consecutive month. Resale of U.S. single-family homes and condos grew 7.2% in July, suggesting a seasonally adjusted annual sales rate of 5.24 million, exceeding economists' projections of 5 million. New US home sales grew 9.6% in July, and suggested a seasonally adjusted annual sales rate of 433,000. There were 271,000 new homes for sale at the end of July, representing 7.5 months of supply at the current sales pace, the lowest since April 2007. Separately, the Conference Board reported that its Consumer Confidence Index rose to 54.1 in August from an upwardly revised 47.4 in July, significantly exceeding the consensus expectation of 48. On August 14, both Germany and France announced Q2 GDP growth of 0.3% from Q1, unexpectedly becoming the first major industrialized nations to technically pull out of the global recession. Naturally, investors are convinced a recovery must be in budding in the US.

While the market seems to concur that many aspects of the economy are positive and indeed improving, we remain skeptical. The market believes: the housing market seems to have bottomed; financial markets have stabilized; the recession's end is around the corner; and although the unemployment rate will continue to rise and reach double digits, the economy will just adjust to that reality. While those beliefs may not be wrong, there are two powerful offsets that give us pause as to how sustainable the current good news is likely to be. First, the $8,000 tax credit for first-time homebuyers that supported many house sales will expire in November and the Fed's $300 billion long-term treasury purchase program, which has helped to keep interest rates low, will end in late October. Like our thoughts for the Cash for Clunkers program, we suspect those stimuli have expedited future house purchases to the present. In addition, despite robust sales, foreclosures and short sales reflected 31% of existing homesales in July, and mortgages either in foreclosure or with at least one payment past due hit 13.16% in the second quarter, the highest percentage ever recorded by the Mortgage Bankers Association. The inventory for existing homes still represented a 9.4-month supply at July's sales pace, unchanged from June. Regarding financial markets, while banks are no longer on the brink of collapse, the FDIC recently announced it had 416 banks on its "problem" list at the end of June, up from 305 at the end of March. Further, the FDIC has closed 87 banks so far this year, on top of the 25 in 2008. Fortunately, the total assets of banks on the problem list was just $299.8 billion, approximately 15% of the total assets of Bank of America, the nation's largest bank in terms of deposits. Ironically, this speaks volumes of the systematic risks of those mega banks, with one potential failure essentially eqivalent to thousands of small banks. However, such an increse in problem banks does foretell additional problems for the sector.

While Bernanke cheered the economy in advance of his re-appointment, the minutes of the Federal Reserve's Aug. 11-12 policy meeting published last week further fortified the belief that the US economic recovery will start in the 2nd half, though it is likely to be weak. At this point, it is irrelevant arguing about the technicalities of defining the inflection point between a recession and a recovery, as that is best left for politicians pitching their elixirs. We think the important question is: What normalized growth rate can the US economy deliver over the next 3 to 5 years? Given that consumer spending accounts for nearly 2/3 of GDP, we think it is only logical to believe the recent stubborness of a rising unemployment rate suggests things are not yet ok with the economy. Combined with current fiscal policies, present valuation levels indicate things will not be ok for the stock market in the intermediate term.

In last month's letter we discussed how we believed the easy money in this market is over. Assuming the vast majority of companies would not go bankrupt, heading into Spring 2009, all investors had to do was buy stocks – almost indiscriminately to book impressive gains. For those that were particularly choosey the gains were "generational". A poster child for such trades is Las Vegas Sands (LVS), which traded at $1.42 in March and now trades above $15, as an improved capital market helped relieve investors' fears of it going broke and news of the company's Macau IPO gained traction. As we pointed out during the depth of the market lows, the market irrationally priced fear, symmetrically to how it irrationally priced prosperity just years earlier.