Commentary and Articles

4th Quarter 2006 Quarterly Synopsis

“Firm Foundation?”

The market indicators kept moving higher in the 4th Quarter, and economists continued to ask, “How much will the slowdown in housing affect the U.S. economy?” Investors answered the question by driving equity prices higher despite the concerns in housing and other key areas.

In the 4th Quarter, U.S. equity markets entered into one of the longest bull markets in history, far outlasting the average period of increasing stock prices of 36 months. Currently, U.S. markets are at 48 months without a 20% decline. The positive and negative factors should be closely weighed in predicting where markets move next.

The slowdown in housing coupled with relatively high energy prices seem to indicate that a slowdown is imminent for the U.S. economy in 2007. Like overstock in any inventory cycle, the housing market will simply take time to run through current inventory for prices to begin rising again as supply and demand balance. The problem with this issue in housing is that consumers have tapped home equity over the last few years to keep spending at consistent levels. The pullback in home prices means that many consumers are topped out on the amount of reasonably priced credit available to them.

Offsetting these concerns, employment numbers have been very strong and seem to have forestalled any drastic effects of fuel and housing related issues. On the other hand, the strong labor markets have created wage pressure for U.S. businesses which in turn adds to the concern that businesses will also slow spending in 2007.

Some of the concerns actually play into the scenario of a soft landing where the U.S. economy grows at a slower pace without inflationary concerns. The falling dollar, while also having potential negatives, will help to drive U.S. exports. In addition, any slowdown in the economy further suggests that the Federal Reserve may lower short-term interest rates in 2007. A decline in short-term rates would flatten the yield curve from its existing inverted slope in which the bond market has already factored in a future decline in economic activity.

The positives, such as lower interest rates, may very well trump these negatives in the New Year. Additional positives include continued high levels of corporate liquidity, giving additional fuel to the boom in merger and acquisition activity as well as increased prospects for higher dividends and stock buyback plans. Valuations on corporate stocks are still attractive and we are taking advantage of good opportunities in the market. In 2006, equity holdings Goldman Sachs (GS, NYSE), McGraw-Hill (MHP, NYSE), Chevron (CVX, NYSE) and General Dynamics (GD, NYSE) were just such opportunities, outperforming the market and their peer groups. However, we are not overly sanguine and are taking steps to limit risks in the U.S. and global economies. Our allocation in the U.S. is still largely in large companies with strong fundamentals. We have also increased exposure in accounts to foreign stock and other asset classes with less correlation to U.S. markets.

In Fixed Income, we continued to allocate a portion of assets to strategies which benefit from the falling dollar in addition to favorable durations based on client income needs.