Market Commentar y

Market Commentary

KESSLER INVESTMENT ADVISORS, INC.

August 20, 2009

Full economic recovery, U.S. inflation, and theFed removing accommodation – still years away

Summary and Contents Guide

How too much focus on equities (the “less bad” rally) and the anticipated end of recession

wrongly cali- brates

today’s place in the business cycle -- and overlooks consistent patterns of falling inflation andTreasury yields after recessions end.

(page 1 & throughout)

U.S. economic indicators

throughout 2009

point to strong

disinflationary

trends and enormous slack in re-source utilization – while higher prices on commodities only act as a “tax” on consumers who can’t de-mand higher wages

(page 2)

Too little money is now

moving in the economy

as households differentiate saving from investing, and as ahistoric share of unemployed remain out of work for six months or more.

(page 3)

The Fed signals it will keep rates historically low and keep policy options open (despite self-serving mediahype) a Fed posture underscored by major absence of the demographic and business conditions whichaccelerated an unusual and vicious cycle of U.S. inflation in the late 70’s.

(page 4)

Unintended consequences: warnings by officials helped create “alternate universe recession,” then reboundin long rates increased economic damage and elevated consumers’ costs of carrying debt, weakening theeconomy & lengthening the recession.

(page 5)

As banks cut off

consumer

credit lines abruptly, enforcing a drop in consumer spending, the consumer creditcrisis begins anew, even as liquidation sales demolish securitized mortgage pools.

(pages 5, 6 & 7 )

Declines in commercial real estate threaten

that

mortgage market -- and vice versa – as the second-ordereffects of recession take hold.

(pages 7 & 8)

Lower costs or carrying debt / borrowing will be necessary for consumer spending to be renewed -- whetherpolicymakers get rates and yields down

sooner

(the easy way), or a worse recession and “bust cycle”mechanisms drag them down

later

(the hard way).

(Page 8 & 9)

Headwinds from traders anthropomorphizing the equity market’s “rational” abilities – and ignorance of tools to exploit value in the Treasuries -- let markets dismiss comprehensive historical data and analysisfor the short term, and reinforcing opportunities for returns on UST

(page 10 & 11)

Objective analytic tools, designed specifically to tell when inflationary pressures are mounting, provide noevidence of an inflationary cycle approaching, contradict simplistic beliefs on asset correlations & rein-force direct observations

(page 11)

Rallies in equity and commodity markets built on artificial and temporary stimulus by governments, a sur-feit of investment capital, the investor herd mentality & corporations cutting costs to the bone -- are

not

crystal balls or sustainable trends, but vulnerable investments and economic blips

(pages 12, 13 & 14)

Noticing that investors follow a housing index built by a noted academic, but disregard his findings that abig common denominator in setting p/e ratios (and thus equities prices) is investor sentiment (that has-n’t absorbed changes from deleveraging)

(page 14)

Why the return of actual of GDP (not popular rate of change figures) to pre-recession levels (and inflationary pressures) looks years away

(page 15 & Chart on page 16)

Market Commentary

KESSLER INVESTMENT ADVISORS,INC.

August 20, 2009

Full economic recovery, U.S. inflation, and theFed removing accommodation — still years away

Anyone setting their investment strategy these days by watching what thefinancial markets are doing day to day — as many market participants wouldappear to be engaged — would be confused in 2009. Particularly influential isactivity among equities and along the U.S. Treasury yield curve. Assumedrelationships between these asset classes have been self-reinforcing. Hot money is visibly reacting to each piece of economic and corporate data (and each breathof political rhetoric). Traders then pile in (or out) — often supporting market-moving bets on momentum with complex hedged positions in futures andoptions which are

not

immediately reflected in directional moves in equitiesmarkets averages. (Also, some participants now use ETFs that may differ fromindex funds in their impact on index averages and debt issues.)

The

h

ot

m

oney

r

eactions

a

nd

m

edia

c

hatter

a

bout

t

hem

a

re

n

ot

n

ecessarily

b

asedon

t

horough

r

esearch.

For

e

xample,

d

ay

t

o

d

ay

c

ommentary

o

n

f

inancial

m

arketsuniformly

f

ails

t

o

i

dentify

t

he

t

ypical

f

all

i

n

i

nflation

w

hich

h

as

l

asted

r

oughly

1

.5to

3 y

ears

a

fter

r

ecent

r

ecessions

h

ave

e

nded.

S

imilarly,

m

arket

o

bservers

d

o

n

otseem

c

ognizant

o

f

t

he

o

verriding

t

rend

d

ownward

i

n

1

0

-y

ear

T

reasury

y

ieldsduring

t

hat

p

eriod.

Only in this deep recession is the public finally being madeaware of the historical pattern of joblessness — and economic weakness —persisting and even increasing after the formal end-date of recession.

Informal

c

ommentary

o

ften

c

onfuses

t

he

t

echnical

e

nd

o

f

r

ecession

(

when

r

ealGDP

s

tops

f

alling)

w

ith

r

ecovery

t

o

t

he

n

ominal

l

evels

o

f

r

eal

G

DP

(

rather

t

han

i

tsrate).

Recovery

r

equires

a r

eturn

t

o

a

ctual

m

easured

l

evel

o

f

e

conomicproductivity

p

rior

t

o

t

he

o

nset

o

f

d

ecline.Historically,

o

nly

a

t

his

p

oint

o

f

ullrecovery

i

s

t

he

U

.S.

e

conomy

v

ulnerable

t

o

i

nflationary

f

orces

overriding

longstanding

s

lack

i

n

t

he

l

abor

f

orce

a

nd

o

ther

p

roductive

c

apacity.

Otherwise,a rise in GDP may be termed “growth,” in popular parlance, but except inisolated pockets of the economy it will not look, feel, or operate like growth.Similarly, equities gains that

do not

exceed earlier index averages

do not

operatein the broader economy as a positive wealth effect. While relief over theanticipated end of recession is legitimate, false impressions are easily fostered.

The

“

end

o

f

r

ecession”

d

oes

not

signal

t

hat:



The economy has recovered to its levels of production before GDP startedfalling;



Inflation must take off (especially not from consumers bidding up prices instores or demanding wage increases);



Jobs have stopped disappearing (or that everyone will be quickly rehired); or,



Interest rates must rise, (particularly not longer-term rates associated with10-year Treasuries).

Kessler Investment Advisors Market Commentary p. 2

August 20, 2009

In

d

ue

t

ime

a

nd

w

ith

a

mple

h

istorical

p

recedent,

h

owever,

f

undamental

e

conomicforces

d

o

a

ssert

t

hemselves

a

nd

m

arket

p

rices

d

o

r

evert

t

o

u

nderlying

m

easures

o

fvaluation.

A variety of economic indicators show disinflation firmly entrenched

Reality

a

gain

b

egan

t

o

f

ilter

i

n

a

sthe

B

ureau

o

f

E

conomic

A

nalysis

revised

a

way

a

previously

r

eported

upward

t

rend

i

n

c

ore

i

nflation

a

s

m

easured

b

y

t

he

c

ore

P

CEdeflator

(a numberonce watched closely by former Fed Chairman Greenspan and themarkets). The new analysis revised the core PCE deflator downward in April andshowed it falling in May. Then it slid in June to 1.5% year-over-year. Also, non-farmunit labor costs plummeted in Q2 to produce a negative measure for four quarters.Fundamental relationships again prevailed as the popular CPI (Consumer Price Index)measures of inflation made news, inflation fears abated, and Treasury yieldsdropped, particularly on the inflation-sensitive 10-year maturity. The overall CPI was

unchanged

for July and posted a historic 2.1%

decrease,

year over year. Core CPI roseonly 0.1% in July, and fell to a 1.5% rate year-over-year, the lowest in 2009.

This

w

eek,releases

o

f

t

he

P

PI

(

Producer

P

rice

I

ndex)

a

lso

s

howed

a c

lear

p

attern

o

f

disinflation

.The

monthly

July

f

igures

w

ere

b

oth

n

egative

(

core

a

nd

o

verall).

More important, the volatile

overall

year-over-year figures have remained in

negative

territory sinceDecember, while the year-over-year

core

rate for July of 2.6% was

lower than any inthe previous 12 months,

and has trended downward since December.

Despite

a m

onthly

g

ain

i

n

I

ndustrial

P

roduction

f

or

J

uly,

o

n

a y

ear

-o

ver

-y

ear

b

asisit

f

ell

b

y

1

3.1%,

t

he

k

ind

o

f

d

ecline

l

ast

s

een

i

n

t

he

m

id

-1

970s

a

nd

l

ate

1

950s.While

c

apacity

u

tilization,

the

p

rimary

m

easure

o

f

s

lack

i

n

r

esource

u

tilization,

alsoedged

h

igher

i

n

J

uly,

a

t

6

8.5%,

i

t

l

anguished

f

ar

b

elow

p

revious

l

ows

i

n

t

he

e

arly1980s

— a

nd

e

ven

f

urther

b

elow

i

ts

r

ecord

o

f

c

apacity

b

eing

p

ut

t

o

w

ork

a

ny

t

imein

o

ver

4

0

y

ears.

Even though manufacturing has continued to migrate overseas,over-investment in overall economic capacity in the boom years has giveneconomic

growth

enough rope to hang itself. Concrete resources are in great excess,from labor to retail space to office space.

In a slump,

the ability to use technology to enhance productivity lets companies jettison jobs and overhead,

rather than

contribute to expansion.With more infrastructure and workers idle than at any time in the memory of mostmarket participants, we find it bizarre that any serious student of economics ormarkets would believe that GDP

merely turning around from depressed levels

wouldspark an inflationary spiral.

In

t

his

e

nvironment,incidence

o

f

h

igher

c

ommodityprices

i

mported

f

rom

o

verseas

(or

p

rices

o

n

c

onsumer

g

oods

t

ied

t

o

il

o

r

o

thercommodity

p

rice

s

pikes)

can

o

nly

a

ct

a

s

a “

tax”

u

pon

t

he

c

onsumer

(

and

o

nbusiness),

n

ot

s

park

c

ost

-p

ush

i

nflation.

Anecdotal accounts in the press uniformly report that consumers are

trading down

(or simply acquiring better goods atdiscount prices) not bidding prices up.

Most

i

mportant,

u

nemployed

c

onsumerssimply

c

annot

d

emand

a r

aise,

and the employed workforce, worried about losing their jobs and the survival of its employers (corporate or otherwise) is in no positionto do so. Many small business owners have stopped taking salaries.

The

i

nflationary