Prepared by AIC Investment Advisors, Inc.

Here today, in the lazy days of August, with major market averages off only slightly from record highs, it would be well to pause and consider where the market has come from in a little over four months. Major market averages, the Dow Jones Industrial Average, the Standard & Poor's 500 index and the NASDAQ Composite index have surged ahead since mid-April when all three traded down to their respective 200-day moving average curves. Because the Standard & Poor's 500 is a broader and a more representative index than the other two, we will confine our remarks to this measure of equity prices.

Market followers will recall that equity prices reached a peak in August of 1987 with the S&P 500 index recording an average monthly price of 329.36. Our trend-cycle curve of the S&P 500 in August 1987 was 281.12 putting the S&P 500 index approximately 48.24 points, or 17.0%, higher than the trend cycle curve at that point in time. The downturn that developed in September and which turned to panic selling in October 1987 was an outgrowth of an attempt by the market to correct.

In August 1997, the S&P 500 index's average monthly price (latest data through August 12) is 944.88. The trend-cycle curve of the S&P 500 index is 834.44. The S&P 500 index is 110.44 points, or 13.3%, higher than the trend cycle curve for August 1997. It is probable that we are now approaching a corrective phase for the market, if not already into the correction at this writing.

The chart shows the AIC trend-cycle of the S&P 500 index. At this time, the rate-of-change in trend cycle curve remains above the 100 line at 100.73 for August 1997. This curve is in a steep downward slope, but this slope is not indicative of projecting that equity prices will commence to contract. At this time,

If equity markets commence to retrench from recent peaks, we would expect that price declines would be well received by market participants during the initial, say 10%, decline in the averages. Most professional money managers would consider such a pull-back as a buying opportunity. We suspect that money would continue to be attracted to equity mutual funds. With more than $1.0 trillion sitting in money market funds, strong support would persist as long as the major market indices did not fall more than about 15.0%. It would be within the 15.0% to, say, 25,0% retrenchment area where the proverbial shoe would begin to pinch.

A 25.0% decline in the S&P 500 index would carry this average down to the 700 to 720 level, not exactly a collapse, but a taste of what a bear market could held in store for fairly novice investors. At this time, investors should not become complacent about the upward trend in prices.

Corporate Cash Flow-S&P 500

The accompanying chart depicts the Standard & Poor's 500 index (solid line) and the Corporate Cash Flow (dashed line) since 1961. The same scale is used on both axes so the picture of the relationship is not distorted, From the early 1960s through early 1973, the two lines moved in tandem. Beginning in mid-1973, the two lines began to diverge significantly. Corporate cash flow continued to trend higher at a fairly constant rate over time. The Standard & Poor's 500 (S&P 500) index generally traded flat from 1973 through July of 1982 before a significant upward move developed. From 1982 through 1994, the S&P 500 gradually closed the gap that developed in 1973 and grew worse with the passage of time. During this period, the dollar suffered a debasement that lowered the gold/dollar relationship by approximately 10 to 1.

From late 1994 forward, the Standard & Poor's 500 index has advanced at an unprecedented rate-advancing from the 450 level to 950 in approximately three and one-half years, or at a rate of nearly 23.8% per annum. It is unlikely that this rate will be sustained during the years ahead, especially if the economy turns lower in the face of higher long-term interest rates. Although the Federal Reserve is capable of manipulating short-term rates, long-term rates will be set by the world's capital markets. If markets demand higher rates of return for long dollar- denominated investments, short-term rates will eventually follow long-term rates higher. When that event occurs, equity markets will become more skittish than at present and a worthwhile retrenchment may well occur.

Be Wary-AIC expects that either corporate cash flows must increase more rapidly in the months ahead or the advance in equity prices will exhaust itself despite the amount of new savings pouring into equity mutual funds. The failure of cash flows to expand more rapidly could initiate the long-awaited correction that bear market gurus are awaiting. Meanwhile, the bull market in stocks will run its course. The relationship of corporate cash flows to the S&P 500 index bears watching during the year ahead.

The accompanying chart shows the trend of Corporate Cash Flow since mid-1977 (dashed line) and the percent change from a year earlier. The latter curve rises above and drops below the 0.0% change line. Since late 1991, corporate cash flows have moved higher at rates ranging from 1.0% to a high of near 14.0% in early 1995. Since the peak rate of growth in corporate cash flow at that time, the rate of expansion has declined to near the 4,0% level.

From 1980, through the first quarter of 1997, corporate cash flow rose at an average annual rate of 17.5%. Since the first quarter of 1990, cash flows: have risen at ark average annual rate of slightly less than 6.0%. The most recent increases have been in the 4.0% to 5.0% range. The significantly lower rate of corporate cash flow growth should give pause to market observers. If a recession develops, corporate cash flows could be impacted to the downside. Any slowing in the growth in cash flows and earnings, at rates much less than those currently being recorded, could do psychological damage to already nervous investors. Equity prices would follow, if not lead, the downturn.

Q: I've heard one reason why share prices appear resistant to a decline is that a good sum of money is coming into the market through mutual funds each month. If this is true, how much is coming into the market and does this make stocks safe from a downturn?

A: Safe from a downturn is a relative concept for most investors. Some investors are unnerved by a 10% contraction while many professionals consider such a retrenchment a correction, other professional money managers are willing to sit through a somewhat larger decline without reducing equity allocations. Most managers will attempt to avoid a downturn of much above the 15% level. Their methods of offsetting the risk of a decline would include the use of options, puts and calls and other means. Some of these methods are fairly new and did not exist 20 or 30 years ago. How these new methods will function during a serious market downturn has yet to be fully tested. A structural change in the market place has occurred in the past 30 years that changes the manner in which investors react to market downturns. An important aspect of equity investment is that shares represent an ownership interest in the means of production of much of the wealth of the nation and the world. In this regard, shares represent a better long-term holding than dollars-the purchasing power of which has declined for nearly sixty years. Notwithstanding this fact, some investors still believe that the dollar is a safe haven, but safe from what? For the past sixty years, ownership of stocks has been safer than ownership of paper dollars. In other words, stockholders in general, have maintained the relative purchasing power of their invested capital while holders of dollars have lost approximately 92 percent of their purchasing power.

At this time in the evolution of equity markets, the steady inflow of dollars into money markets accounts and equity mutual funds provides a ready source of support to stock prices. The constant stream of funds is a major reason that share prices appear resilient to a major drop. The money keeps flowing into equity funds and, under the particular stipulations of these mutual funds, the assets must then be invested in common stocks. For example, the cash flow into money market mutual funds for the week. ended August 6 was $19.86 billion. Additionally, the monthly cash flows directly into U.S. equity mutual funds was $23.0 billion in July; $16.6 billion in June and $20.5 billion in May.

At the end of each day, investors must ask the important question "Would I rather hold dollars (sell shares) or shares (sell dollars)?" Based on investment results during the past 60 years, investors must conclude that equities have been far superior to dollars.

Q: President Clinton just signed into law the Taxpayer Relief Act of 1997 which was recently passed by Congress. After reading some of the contents, I am more confused than ever. Who does this "Relief Act" actually help?

A: The final version of the Tax Relief Act of 1997 that was signed into law by Mr. Clinton was less than straight- forward in reducing the taxes Americans must pay on realized capital gains. The complexity of the new law in requiring investors to report gains during 1997 might well be of equal benefit to accountants, tax preparers, and lawyers during the coming years. The new law contains provisions to categorize capital gain tax rates into distinct time periods. The distinct time periods include:

-Qualifying investments (excluding intangibles) held less than 1 year and sold at any time during 1997.

-Investments retained for more than 1 year and sold before May 7, 1997 and investments held more than 1 year but less than 18 months and sold during the interval of May 7, 1997 to July 28, 1997.

-Investments held more than 1 year but not more than 18 months and sold between May 7, 1997 and July 28, 1997 inclusive.

-Investments held more than 18 months and sold on or after May 7, 1997.

Tax rates range from 15% for married couples filing a joint return with taxable income of less than $41,200, to a high of 39.6% for a couple with taxable income of $271,051 reporting gains from short-term gains on investments sold before May 7, 1997 along with other short-term categories.

The revised tax law is extremely complicated for anyone reporting gains from investments sold during 1997. Presumably, the Internal Revenue Service working to simplify the form to be used in reporting capital gains and losses.

It will not be long before investors begin to demand a realistic and simplified reform of the tax laws. The Taxpayers Relief Act of 1997 is not a useful exercise at reforming existing tax laws and regulations.

Consumer debt outstanding remained unchanged in June. The Federal Reserve Board reports that it was the first time in four years that consumer debt outstanding did not increase. Consumer debt outstanding remained unchanged from a month earlier at a seasonally-adjusted $1.2 trillion. Consumer debt outstanding had risen 2.5% and 8.9% in May and April, respectively. Among the components, consumer installment debt rose at a annual rate of 5.8% in June and auto and other debt declined 0.2% and 9.5%, respectively.

Semiconductor chip sales rose to $11.4 billion in June the Semiconductor Industry Association reported-rising 1.6% from May and 7.5% from the year earlier level of $10.6 billion. By region, the Americas recorded a 14.0% increase in year-over-year sales while sales in the Asia-Pacific region advanced 9.3%. The computer industry continues to expand at an attractive growth rate.

Producer Prices dropped for the seventh consecutive month in July suggesting that inflation (rising prices) at the wholesale level are not a threat to continued economic expansion. The report, together with the Consumer Price Index, which will be reported shortly, will provide little support for those economists expecting the Federal Reserve to increase interest rates in the near future. Slower consumer spending, and a downturn in consumer debt outstanding indicate that inflation will not be a problem in the near future. The competition in the marketplace for sales, even in the rapidly growing computer industry, is forcing lower prices and tighter controls over costs. More of the same seems likely in the year ahead.

August 18, 1997 Richard F. Maloney

AIC Investment Advisors, Inc.

440 South Street, Pittsfield, Massachusetts

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