Home
Contact

December 31, 2006 Market Commentary and Outlook

2006 Market Recap

In 2006, the U.S. economy came in like a lion and went out like a lamb, with U.S. gross domestic product growing at a 5.6% annualized growth pace in the first quarter, only to slow to 2.0% in the third quarter. Fourth quarter growth figures are not yet available, but estimates range from 0.5% to 2.7%.

Paradoxically, in 2006, U.S. stocks did the exact opposite. After a weak +2.7% total return in the first half, the S&P 500 Index of large cap stocks closed the year up +15.8% -- the market’s best showing since 2003. The second half rebound in stock prices was driven by several factors:

  • Declining oil prices. Per-barrel cost dropped from $77 to $56 between July and November, supporting consumer spending while cutting industrial production and transportation costs.
  • Record U.S. corporate profitability. New technologies and an increasingly global labor market enabled after-tax corporate profit margins to climb to the highest levels in over 80 years.
  • Corporate mergers and acquisitions. Corporate buyouts, by both competitors and independent private equity firms, rocketed to 1999 levels. The surge was fueled by moderate borrowing costs and a desire by corporations to shake off the burdensome regulations that arose in the wake of the Enron and WorldCom scandals.

International stocks blazed to a +26.3% return, ranking as the top asset class for a third year in a row. Foreign share prices were supported by a number of factors, including strengthening currencies, accelerating economies, and a growing investor class. Nordic countries led among developed regions, while China led among emerging markets. Jordan, Israel, and Turkey were among the year’s weaker performers with sub-zero returns.

Bonds began the year on a sour note as investors worried that inflation was rising out of control. The Federal Reserve soothed investor concerns by raising its overnight interest rate to 5.25% in June. By late summer, declining oil prices further reduced inflationary pressures. Intermediate term bonds recovered to close the year with a +4.1% return, but they trailed Treasury bills for the second year in a row.

 

graph1

Outlook for 2007

Despite the buoyant stock market, analysts expect the U.S. economy to experience slow growth in 2007. Some estimate there may be as much as a 50% chance of recession in the coming year, due to the following factors:

  • Sluggish housing market. Wilting home prices reduce the “wealth effect” of home appreciation, causing a drop-off in home equity borrowing and consumption.
  • Tapped-out consumers. Retail sales lag expectations as households struggle to keep up with high energy prices and rising payments on adjustable rate mortgages.
  • Downshift in Manufacturing. Due to weakness in autos, housing, and business investment, demand remains soft for manufactured goods.
  • Inverted yield curve. Long-term U.S. treasury bonds have been yielding lower returns than their short-term equivalents for several months, an unusual occurrence that has historically been a harbinger of recession.
  • Earnings downturn. Corporate earnings guidance for the 4th quarter of 2006 has turned negative, with downward revisions outnumbering upward revisions by a wide margin.

However, as we saw in 2006, economic growth and stock market results don’t always go hand-in-hand. Surely, negative economic news may throw some cold water on the sizzling U.S. stock market. But will it put the fire out?

History tells us that market rallies have a way of becoming self-sustaining beyond any semblance of reason. The momentum of the current wave of corporate mergers and acquisitions, driven by low borrowing rates, could power the U.S. stock market for months or years to come.

In 2007, the U.S. stock market may be supported by an unlikely player: the faltering U.S. dollar. Since 2001, the dollar’s exchange value has decreased by more than 6% per year, due to a persistently growing trade imbalance. Should the dollar continue to gradually weaken, it could lift stock prices in two ways:

  • As U.S. dollars become cheaper, U.S. exports become more price-competitive, providing a boost to export-oriented companies.
  • Foreign companies and governments, flush with depreciating U.S. dollars, may seek to put those dollars to use in ways that protect against currency devaluation. Attractive acquisitions might include U.S. companies that control tangible assets such as airlines, toll roads, ports, mines, oil fields, and real estate – assets whose value would be expected to persist even if the dollar depreciates further.

Thus, a gradually sinking dollar can drive U.S. stocks higher. We emphasize the term “gradual” because if the U.S. dollar were to undergo a period of rapid decline, the opposite might happen: nervous foreign investors could dump their U.S. investments indiscriminately, triggering stock and bond market corrections, and causing prices of imported goods to rise sharply.

We continue to see strong opportunities in overseas markets. However, we are concerned that pent-up geopolitical and trade pressures may be released in unpredictable ways. Should a global shock occur, U.S. and overseas stock and bond markets could lurch in opposite directions. We look to geographical diversification to help manage this risk.

Our outlook towards bonds is cautious: If the U.S. economy continues to slow, domestic bonds may appreciate in the first half of 2007. But, given current yields of roughly 5%, domestic bonds simply do not offer an appealing risk-reward profile when default risk, inflation risk, and price risk are factored in. We continue to find short-term investments (e.g. money market funds) and global bonds to be excellent diversifiers to intermediate-term bonds.

Managed Portfolio Perspective

We believe that the warnings of the risk of recession in 2007 should be taken seriously. In our tactically managed portfolios, we plan to pursue strategies that embody the factors we discuss in this article. Thus, as we move into 2007, our tactical asset allocation is as follows:

  • Domestic Large Cap: Near-neutral allocation.
  • Domestic Mid- and Small-Cap: Underweight small- and mid-cap stocks to protect capital in the event of an economic downturn or recession.
  • International Stock: Maintain near-neutral allocation.
  • Bonds and Cash: Overweight, tilted towards shorter-term investments. Utilize global bonds to improve diversification.
  • Investment Manager Selection: Seek investment managers that have a demonstrated ability to preserve capital during adverse conditions.

Setting Your Expectations

A key to investing is setting reasonable expectations. In determining whether your investments are likely to be adequate to fund your retirement or other spending, you must make assumptions about the return you expect from each investment. After 2006’s strong stock market results, there is a danger that investors may unwittingly develop unrealistically high expectations. We caution our clients that the recent 26.3% performance of international stock and the 18.3% return of U.S. small cap stock should not be viewed as a guide to future performance. Based on long-term observation of established indices, we’d suggest that an overall equity return assumption in the range of 8-11% might be more reasonable.

Investment Committee
Northwest Capital Management, Inc.
January 3, 2007

Past performance is no guarantee of future results. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Opinions are subject to change without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Northwest Capital Management, Inc. ©2007, Northwest Capital Management, Inc.