2006 Forecasts in Review. 2007 Hopes and Fears.

This paper reviews our forecasts for 2006 and presents our hopes and fears for 2007. Please note the date above. We have had to move forward the date of this to accommodate our statement mailing protocol.For another year, our forecasting success has been a mixed bag, but with more good calls than bad. We thought the economy would grow slower than the consensus economist forecast of 3.4%. We said the Federal Funds Target Rate (FFTR) would go to at least 4.75% and we “wouldn’t be surprised to see… 5.00%.” We thought the dollar would decline against major foreign currencies. Regarding bonds, we said that we would see the “peak in long-term interest rates in 2006.” We thought stocks would have a better second half than a first half and would produce a total return of 6.60%. We continued to emphasize the energy and materials sectors, and we expected healthcare stocks to perform well. We advised staying away from consumer exposure.

Although we will not know until well into 2007, it appears that the economy will have grown in the neighborhood of 2.0 – 2.5% in 2006. The Federal Funds Target Rate is presently 5.25%. The dollar declined significantly on a trade-weighted basis in 2006. The 10-year treasury note peaked at 5.25% in June and is presently at 4.62%. The two consumer stock sectors, which we liked least of all, returned an average of 13.8%. The sectors we liked best did well in 2006. The energy sector was up 25.4%; materials, 15.5%. Both beat the S & P 500, which returned (thus far) 15.1%. That leads us to our calls that were not so good.

We underestimated, by more than half, the strength of U.S. equities in 2006 (6.6% v. 15.1%), although we called the halves of the year correctly: weak first half, strong second half. Healthcare stocks were the worst performing of the groups, returning a mere 4.7%.

Equity indexes around the globe performed well in 2006, and returns to U.S. investors were helped by the weakness in the dollar. The returns below include reinvested dividends.

Foriegn Indexes Local U.S. $ Domestic Indexes
Brazil Bovespa 29.0% 40.1% S & P 500 13.2%
CAC 40 (France) 15.7% 28.4% Dow Jones Industrial Avg. 15.3%
China (Shanghai Composite) 101.9% 108.4% NASDAQ Composite 9.1%
DAX (Germany) 20.2% 33.4% S & P 400 (Mid-cap) 11.1%
FTSE 100 (U.K.) 10.2% 25.5% Russell 2000 (Small-cap) 18.4%
Hang Seng (Hong Kong) 29.9% 29.5%
Mexico Bolsa 42.0% 38.7%
NIKKEI 225 (Japan) 6.2% 5.4%

Bond market returns, judging by the results of intermediate-term bond market index funds, were positive at 4.6%.

2007 Fears

1. Third-longest cyclical bull market without a 10% correction
It is difficult to enter 2007 and not be concerned that this is the third longest run in a cyclical bull market without at least a 10% correction. It is healthy for a market to have periods of advance interrupted by periodic declines. Markets that advance uninterrupted defer the inevitable.

2. Possibility of higher federal taxes
We presently enjoy near-record-low capital gains tax rates, and dividends are taxed at 15%. A democratic congress is likely to lean toward tax increases and has already discussed rolling back “the Bush tax cuts.” Increases in these rates will make investors reluctant to reallocate capital and will reduce the appeal of dividend-paying stocks. As to which party is in control, the change in control in congress bodes well for equities. Under Democrat control, stocks have returned 6.4% since 1901. Under Republican control, stocks have returned 3.6%.

3. Geopolitical Risks
This could comprise a long list of worries, but let us limit it to three. First, Iran appears to have big ambitions in the Mideast, which could cause the price of oil to rise, perhaps dramatically. Second, a number of terrorism plans have been squelched, but more are in the works. Third, we have not heard much lately about bird flu and other strains of influenza, but according to many smart people, a pandemic is likely.

4. Popularity of foreign investments leads to their underperformance
Again, in 2006, investments in foreign stock funds were many times the amounted invested in U.S. stock funds. The perils of investing in the hottest mutual fund sectors are well documented. Fundamentally, foreign investments continue to make sense, and we still recommend them, but we highlighted our concern about them in our March 31, 2006, outlook. We remain concerned.

2007 Hopes

Soft landing in the economy
We are hopeful that growth in the economy will slow enough to bring inflation under control, yet not slow enough to trigger a recession. Presently, this appears to be the case. The wild card, in our opinion, remains the extent of the slowdown in housing and its effects on consumers. On the other hand, corporate balance sheets are in good shape. This does not mean the next six months will be trouble free, but it should bode well for equity performance.

A cut in the Federal Funds Target Rate

The Federal Reserve always sounds hawkish at the end of rate hiking cycles, and investors have been quick to expect rate cuts in 2007. We do think, though, that the slowing economy and accompanying tempered inflation expectations will allow the Federal Reserve to make the first of a series of rate cuts. We make no guess as to when this might come. In recent experience, however, the Fed has been quick to switch from hawkish to dovish on rates. Presently, the futures markets are expecting two quarter-point rate cuts in 2007.

Lower interest rates
Longer-term rates are not done declining. Subdued inflation expectations and a friendly Fed should help insure that. This will lead to lower mortgage rates, cushioning the blow from the housing slowdown. It can also help support higher price-to-earnings multiples, leading to…

Another decent year for stocks
Valuations on stocks are reasonable, albeit not cheap. The two factors above should enable stocks to have a decent year in 2007. Sentiment toward stocks changes as investors’ moods swing between fearless and fearful. Presently, the pendulum is decidedly in the fearless camp. It may be that some of 2007’s return has been moved forward into 2006. The fundamental conditions, however, are in place for a good year. To the extent that the majority of investors already recognize that reduces future returns for stocks.

As always, feel free to call or e-mail us with your feedback to our year-end recap.

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