If there is one entity that is supposed to be able to forecast the economy it is the Fed. The investment markets rely on the Fed to set monetary policy that will promote non-inflationary economic growth. This is no small task, and it may even be an unrealistic expectation, but nonetheless it is what the market expects.

The much anticipated minutes of the latest Fed policy making meeting have been released and some of the language was unsettling to investors. The minutes showed that the Fed officials discussed leaving interest rates unchanged or raising them half a percentage point. Ultimately they decided to raise them a quarter point as they have for the past sixteen consecutive meetings. The message received by the market was that the Fed has no clue as to the direction of the economy, nor to its future strategy regarding interest rates. This uncertainty has done little to build confidence in the new leadership at the Fed under Ben Bernanke. The Fed Chairman’s philosophy of releasing more information to build transparency may sound like a good idea, but only if the Fed is clear in its thinking, which it is clearly not. In contrast, investors rarely understood Greenspan’s message, but they were convinced he knew what was going on. Bernanke seems to be accomplishing the opposite. At this point, investors fully understand that Bernanke doesn’t know where the economy is heading much less where interest rates might go.

Second guessing the Fed is now more popular than criticizing President Bush for the mess in Iraq, and that is no small fete. Understandably, investors fear the Fed will either tighten too much thereby choking off growth, or will not tighten aggressively enough allowing inflation to accelerate out of control. Importantly this emotional Fed-bashing won’t end until the Fed figures it out. When that will occur is anybody’s guess.

All of which goes a long way to explain why May was such a difficult month for the market. In fact, with the overall market down over 3%, as measured by the S&P 500, it was the worst May in over twenty years.

Meanwhile, nagging corporate governance issues continue to overhang the market. Recently, companies including Pfizer, Home Depot and Exxon Mobil have been the target of shareholder discontent in response to excessive executive pay. One recent study by The Corporate Library cited eleven companies that authorized $865 million in pay to CEOs who were in charge while their companies lost $640 billion in shareholder value. Yikes!

In Exxon Mobil’s case, institutional investors such as The North Carolina Retirement Systems and the Connecticut Retirement Plans & Trust Funds all withheld votes for board members who served on Exxon Mobil’s compensation committee, which authorized a ridiculous pay package for retiring CEO Lee Raymond of $168 million. I suppose he can make it on that amount if he’s frugal…

At the same time, other corporations such as Juniper and KLA Tencor are under scrutiny for supposedly backdating option awards to top executives. Obviously, none of this helps the mood of the market.

Is there a bright side to this storm of discontent?...

Underneath this sea of uncertainty there are some interesting developments. Despite the weakness in May, positive earnings revisions over the last thirty days outpaced negative revisions by a margin of 3 to 2. This may not seem like a big deal in the context of the aforementioned issues, but ultimately earnings do matter, and eventually stock prices will reflect underlying earnings growth.

Some interesting statistics…

The average expected earnings growth for the 185 companies on our monitor list is 17.9% in 2006 and 19.8% in 2007. The PE for this group of stocks based on 2007 estimates is 15.9, which equates to a PEG ratio (PE divided by earnings growth) of .80X. Historically this is quite low, but it reinforces that the market is preoccupied with other issues.

A big part of our strategy going forward will be to identify companies that can achieve or better yet exceed earnings expectations. This list will include companies that out compete their peer group in terms of innovation, productivity, and reinvestment of cash flow.

The mood of the market may be sour at the moment, but the storm of discontent will eventually pass. Predictable, high-quality earnings growth companies will eventually win the day.