Reports over the last month continue to confirm that the US economy is in a slowdown.  According to the latest government report, Gross Domestic Product slowed to an annual rate of only 2.9% in the 2Q, down from 5.6% in the 1Q.  Consumer spending rose only 2.6% in the 2Q versus 4.8% in the 1Q.  More recently, consumer confidence fell to the lowest levels in a year in July and August.  Meanwhile, the housing markets continue to slump.  New and existing home sales were down over 4% in July, and the inventory of unsold homes is up 40% in the last 12 months.

The disappointing economic news over the last few months has led more analysts to conclude that we are headed for a recession either later this year or in early 2007.  As I will discuss in the pages that follow, I do not agree that the latest economic data portends a recession, but rather just a prolonged slowdown, barring any unexpected major surprises.  The Bank Credit Analyst agrees that a recession is not the most likely scenario.  We take a detailed look at the economic outlook in this issue.

To the surprise of many, the Fed elected to leave interest rates unchanged at the August 8 FOMC policy meeting.  Most analysts expect the Fed will raise rates at least one more time this year, since inflation is still above the Fed’s target.  Yet as you will read inside, BCA believes the Fed is finished raising rates.  Not only that, the BCA editors believe the Fed will begin cutting interest rates early next year and will do so several times.  This is not the current thinking on Wall Street, but what else is new?

With all the economic uncertainty, Fed unknowns, wild energy markets and the continued threat of terrorism, I expect the investment markets will continue to be extremely volatile for the foreseeable future.  This should be especially true in the stock markets.  High volatility is very unsettling for most investors.  It is for this reason that I will revisit Third Day Advisors in this issue of F&T.  Third Day has a strategy that seeks to take advantage of market volatility in both directions - up and down - and even in trading range type markets.  I have recommended Third Day since early 2005 for investors who are suitable for an aggressive strategy such as this, and I still do.  For more details and performance information, see pages 5-8.

Introduction

This month we take a fresh look at the latest US economic data which continues to point to a slowdown led by the housing sector.  We will discuss what the economic slowdown means for the Fed, and what Bernanke & Company are likely to do, or not do, just ahead.  After leaving short-term rates unchanged on August 8, it remains to be seen what the Fed has in store at upcoming FOMC meetings on September 20, October 24/25 and December 12. 

I will also give you the latest analysis and forecasts from our old friends at The Bank Credit Analyst.  BCA continues to believe that the economic slowdown has another 2-3 quarters to run but that a recession is not likely.  Based on their economic forecast, BCA believes the Fed is finished raising interest rates for this cycle and, in fact, the editors predict that the Fed will begin cutting interest rates by early next year.

Next, we will analyze what the stock markets have been doing, or not doing, as the case may be recently.  Some of the market indexes have risen to new highs in recent weeks while others are still languishing in broad trading ranges.  In general, a slowdown in the economy is not positive for stocks; on the other hand, if the Fed is done raising interest rates and energy prices don’t soar again, those are positive developments for equities.

In my view, the overall environment for the investment markets will remain uncertain for at least the balance of this year.  I expect market volatility to remain high pretty much across the board, not only in the stock markets but in areas such as energy, metals and other commodities.  The real estate markets are likely to remain on the defensive in most parts of the country. 

Given this outlook, this seems like an appropriate time to revisit Third Day Advisors LLC, a professional money manager I have recommended several times in the last couple of years.  Third Day's investment strategy is well suited to these types of markets.  (If you took my advice and invested with Third Day last year, you should be very happy!) 

The Economy In Slowdown Mode

The US economy continues to slow down, but there are no signs that we are headed for a recession.  The current modest slowdown is being led, predictably, by the slumping housing market and high energy prices, which in turn are also negatively affecting consumer confidence.  None of this should come as a surprise to readers of my weekly E-Letter.

The Commerce Department reported that Gross Domestic Product rose at an annual rate of 2.9% in the 2Q, up slightly from its previous estimate of 2.5%, but still far below the 1Q pace of 5.6%.  In the same report, the government also announced that consumer spending - which accounts for over two-thirds of GDP - rose at an annual rate of only 2.6% in the 2Q versus 4.8% in the 1Q. 

The government's Consumer Confidence Index plunged 7.4 points in July (latest data available) to the lowest level in over a year.  Not surprisingly, orders for durable goods fell 2.4% in July as consumers continued to cut back on big-ticket items.  The University of Michigan's Consumer Sentiment Index fell to 78.7 in August, the lowest level since just after Hurricane Katrina a year ago.

As noted above, the slump in the housing market is dominating the economic front.  New home sales fell another 4.3% in July and are down a full 21.6% from the same period one year ago.  Sales of existing homes dropped another 4.1% in July.  Despite the continued drop in home sales, the average sale price of existing homes managed to record a minor gain of 1.17% to $232,000 in the 2Q on the national level; however, it was the smallest quarterly increase in home prices in over 30 years.  On a regional basis, existing home prices are actually falling in some areas.

The most troubling aspect of the housing slump is the sharp increase in the inventory of unsold homes.  According to the National Association of Realtors, the inventory of unsold homes (new and used) soared to a record 3.86 million units in July.  That is an increase of 40% in the last 12 months and represents a 7.3-month supply of unsold homes on the market, the largest since 1993.

As with every housing slump, there is a big debate regarding whether we are in the early to middle stages of a full-blown "bust" or whether the recent retrenchment is merely the inevitable "correction" following the housing boom of the last decade.  No doubt, there are strong arguments on both sides of this debate.

While it is certainly possible that either scenario could play out, I tend to believe what we are seeing, and will continue to see, is more along the lines of a correction rather than a bust.  The last two major housing slumps were in 1978-1982 and 1988-1992.  In both of those periods, we had a recession which exacerbated the housing slump.  That is not the case today, as we will discuss at more length below.

While I do tend to believe the housing slump is more of a correction than a bust, it is clear that we are not close to the end of this downward cycle, and some regions of the country will fare considerably worse than others.  As noted above, the overhang of unsold houses is the largest in over a decade, and it will almost certainly get at least somewhat worse before it gets better.  But provided we avoid a recession, I don't see a major bust in the housing market.

No Signs Of A Recession Yet

While growth in GDP slowed dramatically in the 2Q to 2.9%, that is still a solidly positive number which certainly does not suggest a recession.  Job growth in the US remains quite strong with the unemployment rate falling to 4.7% in August.  The ISM manufacturing index, while down fractionally in August, is still solidly above 50 (54.5 actually), and any reading above 50 is an indication that the economy is expanding.

The Index of Leading Economic Indicators (LEI) fell only fractionally (-0.1%) in June and July, which while negative does not suggest a recession.  For all of 2006 (Jan - Jul), the LEI is down only 0.7%.  The LEI is consistent with an economy that is slowing down as I have suggested for several months, rather than one headed into a recession.

All this can change, of course, especially if consumers continue to put the brakes on spending.  The government reported that personal consumption expenditures rose at an annual rate of only 2.6% in the 2Q versus 4.8% in the 1Q, again consistent with a slowdown in the economy.  Yet in June and July, retail sales increased 1.7% and 1.8% respectively according to the Commerce Department, another good indication we're not headed for a recession.

BCA Believes The Fed Is Done

In their September issue, the editors at The Bank Credit Analyst make it clear they believe the Fed is finished raising rates.  On August 8, the Fed's Open Market Committee voted to leave interest rates unchanged after two years and 17 consecutive rate hikes.  In its statement that accompanied the announcement, the Fed predictably left the door open for more rate increases in the future depending on the inflation data.

The Fed also made it clear in its August 8 statement that it feels core inflation is still too high.  The latest GDP report pegged core inflation (minus food and energy) at 2.8% in the 2Q, well above the Fed's target.  Based on the Labor Department’s Consumer Price Index, core inflation rose 2.7% for the 12 months ended July, also above the Fed's target.  But in its August 8 statement, the Fed suggested that it expects inflation to cool down with the slowdown in the economy.  Thus, they left rates unchanged.

As usual, there is a great debate regarding whether the Fed will hike rates again next week at the FOMC meeting on September 20, or if they will elect to stand pat once again.  The consensus among most market analysts seems to be that there will be one or two more rate hikes before the Fed is done.  That is probably true, if inflation continues to rise.

BCA, on the other hand, believes the Fed is done raising short-term interest rates.  The editors at BCA believe the Fed is very concerned about the slumping housing market and the general slowdown in the economy, and that Bernanke & Company will not risk making matters worse.  So BCA predicts no further rate hikes from the Fed this year - unless, of course, inflation surprises on the upside.

BCA also predicts the Fed will begin to cut rates early next year and will likely do so on several occasions. This forecast is based primarily on BCA's view that the economy will continue to be in a slowdown for the next 2-3 quarters, and that inflation will come down.  In this scenario, BCA believes the Fed will soon be more preoccupied with the slowing economy and avoiding a recession than fighting inflation.

A Challenging Environment For Investors

The prospects for a continued slowdown in the economy for at least another couple of quarters does not present the most optimistic of backdrops for the investment markets.  While a few equity indexes have recently moved to new highs, the Dow, S&P 500 and Nasdaq are still below their record highs and remain in broad trading range. 

At the same time, volatility remains extremely high in the stock markets.  For example, from May 1st through August 31st, the S&P 500 had 19 days when the Index had a daily gain or loss of 1% or more, with two of these being moves in excess of 2% in a single day.  These big moves were almost evenly split, with 10 positive days and 9 negative days. 

This is a reminder that high volatility cuts both ways - up and down - especially recently, and this pattern could well continue for the foreseeable future.  In the near-term, for example, if it becomes clear that the broad market is not going to follow-through to new highs, we could see a significant correction on the downside.

If the outlook I've outlined above, and in recent weeks, continues to be generally on target, the major investment markets are likely to remain very volatile for some time to come.  While a recession does not appear to be the most likely scenario, keep in mind that things can change.  The Fed could throw us another curve or two, thus hurting the economy.  The energy markets could surge again.  The threat of more terrorism is still out there.  Surprises happen.

“Active Management” Strategies

It is no secret that I am a big proponent of so-called active management strategies and professional money managers who employ them.  Active management strategies, in this case, include those that have the flexibility to move out of the market and/or “hedge” long positions in an effort to protect from large market downturns.  Active management strategies are in many ways the polar opposite from the so-called buy-and-hold approach which argues that you stay 100% invested at all times and simply ride out the periodic large downturns in the market.

In the case of the stock markets, it is true that a buy-and-hold approach has been profitable historically, assuming one really does buy and hold over long periods of time.  My argument over the years with buy-and-hold has simply been that many investors don’t have the emotional staying-power to ride out the big losing periods, and often end up selling out near the bottom. This is precisely why I believe most investors should diversify with active management strategies.

With that in mind, and given the economic and market conditions that could well persist for some time to come, let’s revisit one of my favorite professional money managers.

A Money Manager For Volatile Markets

In January of 2005, I first introduced clients and readers to Ken Whitley, founder of Third Day Advisors.  I have continued to recommend Third Day since then, and I still do for investors who are looking for a more aggressive approach and the potential for higher returns in the equity markets. 

Over the years, Ken Whitley has developed an investment strategy that not only doesn't mind market volatility, but actually has the potential to take advantage of it and generate investment gains.  Third Day's investment strategy is designed to capitalize  on short-term market trends, and even has the potential to take advantage of down markets through specialized mutual funds that "short" the market.

For years we searched for a mutual fund money manager that had a successful performance record utilizing both the "long" side and the "short" side, and that had made money both in bull markets and bear markets in stocks.  I am happy to report that when we discovered Third Day in late 2004, we found a money manager who: 1) made money in the bear market of 2002; 2) made money in the bull market of 2003; and 3) who even made money in the highly volatile and sideways markets of 2004.  Third Day is also having another outstanding year thus far in 2006.

In the information that follows, I will describe Third Day's program in more detail, including its actual performance numbers which I trust you will find extremely impressive.  The performance figures I will quote are real numbers - not hypothetical - and are net of all fees and expenses.  Keep in mind that you don't get results like these without taking an aggressive approach to the markets, and therefore Third Day is not suitable for all investors.  Past results are not necessarily indicative of future results.

 The Third Day Aggressive Strategy

As an overview, the Third Day Aggressive Strategy provides investors with a leveraged long and short exposure to the Nasdaq 100 Index.  As I will discuss below, Third Day invests in specialized mutual funds which use leverage to attain market exposure in excess of a one-to-one ratio.  But before we get into the leverage aspects of the program, let's talk briefly about how the strategy works.

Third Day's Aggressive Strategy is a proprietary blend of momentum, trend-following and overbought/oversold indicators.  There are six basic indicators that Ken uses to analyze the market, with a number of sub-indicators that also factor into each trading decision.  Each indicator "votes" on whether to be long, short, or neutral in the market.   The relative strength of each indicator then determines to what extent the Third Day program will be invested in the market.  The model is 100% "mechanical" (ie - systematic) though Ken does reserve the right to override his system's signals in the case of a national emergency or other unusual circumstances.

The investment vehicles used are the Rydex Dynamic OTC and Rydex Inverse Dynamic OTC mutual funds.  These funds are part of the Rydex Dynamic class of funds that seek to provide investment returns that correlate to 200% of the daily performance of the Nasdaq 100 Index, with the Dynamic OTC Fund providing a positive correlation (long) and the Inverse Dynamic OTC Fund providing a negative correlation (short). 

These specialized mutual funds allow Third Day the ability to be "long" or "short" the market depending on its signals.  Also, unlike most other mutual funds, the Rydex Dynamic funds allow Third Day to trade in or out of a fund two times per day, once at 10:45 AM Eastern time and again as of the close of business at 4:00 PM Eastern time.  This can be a big advantage.

In an effort to limit risk, Third Day will only allocate up to 75% of an account to any fund position, resulting in a 150% maximum exposure to the Nasdaq 100 market.  However, maximum allocations (75%) are rare.  Historically, Third Day's allocations are in the maximum range only 12% of the time on the long side, and only 2% on the short side.  The program is projected to be in cash (money market fund) an average of 38% of the time in any given year based on historical performance and back-testing.

The Third Day Aggressive Strategy does not currently employ any traditional stop-loss techniques to automatically exit losing trades.  This is another reason why the program should only be considered by aggressive investors who are comfortable with high volatility and significant periodic drawdowns.

While the Third Day program has been successful in limiting losses, it should not be considered as a low-risk program.  While Third Day's Aggressive Strategy has had only a -12.18% maximum month-end drawdown since inception, (see next page), Ken says his long-range target is to limit drawdowns to no more than -20%.   You should keep this in mind when evaluating this investment for your portfolio.

Steady Performance In Choppy Markets

Many times, strategies that claim to be effective in all types of markets can do well in a bull or bear market, but usually not both.  Even the ones that can negotiate both up and down markets often get whipsawed during sideways markets due to volatility and the lack of tradable trends.

Fortunately, Third Day's strategy has been tested by a variety of market environments in the past, and has fared very well in each.  Since Ken started actual trading of his program at the end of 2001, we are able to see how it handled the bear market of 2002, the big recovery in 2003, and the volatile and sideways markets since then.  Thus, even though the track record is relatively short, the Aggressive Strategy has successfully navigated a number of different market environments over that period of time.

Since my recommendation of Third Day last year, I have been very pleased with the performance of the Aggressive Strategy, especially in light of the continued market volatility we have experienced.  Third Day has delivered very impressive risk-adjusted rates of return, handily outpacing the performance of the S&P 500 Index, the Nasdaq Composite Index, and the Nasdaq 100 Index.

The Third Day Aggressive Strategy’s net average annual return from inception in 2001 through August 2006 is 19.23%, with a worst drawdown of -12.18%.  So far in 2006, through August 31, Third Day had a net gain of 12.3% on average.  These are real returns, net of all fees and expenses.  Past results are not necessarily indicative of future results.

The performance tables on the following page provide a more complete picture of Third Day's impressive track record.  However, be sure to read the Important Notes on page 8 for additional disclosures related to this performance information.

Our analysis has also shown that Third Day's historical returns show little or no correlation to the other Advisors I have recommended over the past several years.  Thus, the Third Day Aggressive Strategy may be an ideal complement to the other actively managed investment programs we offer, or that you may hold elsewhere.

As noted above, it is important to keep in mind that Third Day's system is a leveraged program that trades both long and short in the market, giving investors the potential to gain (or lose) up to 150% of the up or down move in the Nasdaq 100 Index.  Because Third Day's program does short-term trading and will short the market from time to time, it is an aggressive strategy that is not suitable for all investors.  However, if you are a sophisticated investor, I encourage you to check out the Third Day Advisors program. 

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  BE SURE TO READ THE IMPORTANT NOTES AND DISCLOSURES BELOW.

Conclusions

The Third Day Aggressive Strategy can be an attractive option for investors who understand risk and want to diversify their portfolios by adding an investment that has both a long and short exposure in the market.  Since inception in 2001, Third Day has an annual average return of 19.23%, with a worst-ever drawdown of only -12.18%.

So far this year, the program has gained 12.30% as of August 31, 2006.  These are actual results, net of all fees and expenses.  Past results are not necessarily indicative of future results; see additional important disclosures on the following page.  Also, you should know that I have a chunk of my own money invested with Third Day, as Ido in every investment program we recommend. 

To me, the most impressive thing about Third Day’s program is that it has shown outstanding results during the last four years of very different market conditions, including a bear market, a bull market and an extended sideways market.  While no system is perfect, Third Day's program has certainly resulted in impressive gains for our clients who got in when I first made my recommendation in January of 2005 and since then.  

If you would like to get Third Day on your team, give us a call at 800-348-3601 for more information.    Remember, the minimum account requirement is only $50,000.  Finally, if Third Day's program is too aggressive for you, we have several other professionally managed programs that may fit your particular investment objectives and risk tolerance.                                                 *            *            *            *

IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM), Third Day Advisors, LLC (TDA) and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. This publication is not intended as personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor.  Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors. For more information on HWM, TDA or PAS, please consult HWM Form ADV Part II, PAS Form ADV Part II or TDA Form ADV Part II available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) and the Nasdaq 100 Index represent unmanaged, passive buy-and-hold approaches. The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Advisors. Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC through December 2004. Performance numbers from January 2005 forward represent performance for a single Purcell Ultra Lite (Third Day Aggressive) account, which is considered representative of the majority of clients' accounts in the program. The actual performance of your account may vary substantially from these results based on several factors, including but not limited to account restrictions, differences in transaction costs and other expenses. PAS utilizes research signals purchased from Third Day Advisors, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Third Day Advisors. In all cases, performance histories reflect a limited time period and may not reflect results in different economic or market cycles. Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Investment returns and principal will fluctuate so that an investor's account, when redeemed, may be worth more or less than the original cost. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. All dividends and capital gains have been reinvested. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Performance for other programs offered may differ materially (more or less) from the program illustrated.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.