High oil prices, and (more noticeable to consumers) increasing gasoline prices, couldn’t dampen optimistic feelings about the U.S. economy last month. Although the domestic stock market failed to maintain its torrid performance from the first quarter, larger cap stocks fared relatively well during April. Better than anticipated growth in first quarter earnings coupled with increasing expectations for first quarter GDP growth contributed to the bullish sentiment for equities. Moreover, recent Congressional testimony from Fed Chief Benjamin Bernanke suggested that the Fed’s future evaluation of short-term rates would be “increasingly dependent” on current economic data. Such hints that the Fed may be close to an end to their tightening cycle was well-received by equity investors. Subsequent “off the record” comments attributed to Bernanke were less optimistic and have contributed to short-term market choppiness.

On the strength of robust nominal and relative April returns, international equities assumed the mantle of portfolio leadership through the first four months of 2006, exceeding the returns of domestic small caps, which had led the markets during the first quarter. The EAFE Index of developed country equities gained 4.8% for the month, pushing its already strong year-to-date returns higher to 14.6%. While respectable returns abroad accounted for about 60% of that return, the remainder (almost 6%) was a direct result of the dollar weakening relative to major foreign currencies. Evidence increasingly points to many foreign central banks further diversifying their currency reserves into alternatives other than the dollar, making further depreciation of the greenback likely. In addition, a weakening dollar could cause a further upward move in long-term interest rates in the U.S. In such a scenario, investors in foreign-denominated securities – either bonds or stocks – should benefit.

Unlike the flourishing equity markets, global bond markets have found the going rough thus far in 2006. The Lehman Aggregate Bond Index slipped an additional 0.2% for the month of April, dragging its year-to-date return down to a loss of 0.8%. The yield on the benchmark 10-year Treasury rose to close the month at 5.07%, its highest level since May 2002. The yield curve also continued to gradually steepen as intermediate and long-term rates all moved higher. Short-term taxable bonds and municipal bonds as a whole outperformed intermediate to long-term taxable issues. The Lehman Muni Bond Index 5-year returned 0.2% for the month, accounting for virtually the entire return for the index since December 31. Should the yield curve continue to steepen toward a more normal slope, municipals may continue to perform comparatively well given their generally reduced sensitivity to yield volatility. International bond markets were again a mixed bag; the Citi World Government Bond Index Hedged lost another 0.5% for the month, dragging the year-to-date loss down to 1.5%. As with international equities, local currency denominated bonds have benefited from the weakening dollar and have consequently fared better than hedged international bonds or dollar-denominated issues.

The maturation of the global economy and capital markets and the increased solvency of much of the developing world are increasingly contributing to a more attractive risk/return profile for U.S. investors. Additionally, the U.S. share of global market capitalization continues to gradually decline relative to international markets. Europe has also recently joined the U.S. in pushing for China and certain other emerging Asian economies to allow greater appreciation of their currency against the dollar and euro. It appears unlikely that a reduction in U.S. demand for foreign goods alone won’t be sufficient to address the imbalance; an appreciation in the Chinese yuan would likely have a greater impact. In their most recently released five year plan, the Chinese government suggested that allowing further appreciation in the yuan may be beneficial to their economy as well. For U.S.-based investors with positions in foreign, non-dollar denominated securities, a gradual weakening of the U.S. dollar would provide additional return from these securities.

The outlook for domestic equities remains mixed, though generally positive. Although their returns have trailed small caps, larger cap stocks continue to appear increasingly attractively valued. Price / Earnings ratios for blue chips remain at perhaps their most attractive levels in a decade, without regard to style. Large cap growth and value stocks both look relatively inexpensive, especially in the largest U.S. companies. Conversely, small cap stocks continued to perform well in the first quarter, but the underlying effects of that performance is noteworthy.

Unlike larger cap stocks that have seen valuation multiples continue to recede, virtually all of the first quarter advance in the Russell 2000 Index of small companies is directly attributable to an expansion in the P/E multiple. Put simply, the gain did not result from improving earnings but from investors collectively being willing to pay a higher premium for the same level of earnings. It may be premature to declare that small caps are in a bubble, but the closure of a large number of small cap mutual funds coupled with rapidly advancing valuation multiples are negative indicators for that segment of the market. We believe that sensitivity to underlying price fundamentals is a critical component of prudent investment philosophy. Nonetheless, it is possible that small cap performance could continue to be strong for some time, even as their underlying fundamentals weaken.