Market Commentary: December 2006

Fourth Quarter Overview

• The Fed held interest rates steady at 5.25% during the fourth quarter, reflecting their expectation that inflation will be contained by slower growth in the broader economy. While the consensus view is that the Fed is likely done raising rates, the timing of any rate cuts remains in doubt due to mixed economic data and the Fed’s hawkish tone.
• Employment continues to show signs of strength despite a more slowly growing economy. December’s unemployment rate came in at 4.5%, suggesting the labor market remains brisk, supporting robust hourly wage growth.
• The housing market continues to be an area of weakness in the U.S. economy. November’s median home sales price dropped about 3% since the previous year. In addition, the number of homes for sale and their average days on the market remains elevated. Although monthly existing home sales were up slightly in November, the short-term outlook for housing remains cloudy, with the potential that prices could fall further.
• The yield curve remains inverted over various maturities. The 10-year Treasury yield remains below short term rates, but has moved up somewhat during the fourth quarter. While an inversion has typically signaled slower growth expectations for the economy, we continue to believe that other technical factors continue to contribute to lower yields from longer term bonds.
• Oil prices remained flat during the quarter at around $60/barrel. Prices have dropped almost 25% from highs reached earlier in the year, as supply-side fears, stemming from tensions in the Middle East and the threat of an active hurricane season, were diminished. The decreased prices have helped soften the blow of the moderating economy on consumers and have reduced inflationary pressure.
• Unlike 2005, in which the Dollar ended on a strong note, the U.S. currency fell relative to most other currencies in 2006. The high U.S. trade deficit, combined with a slowdown in domestic growth and expectations that short term interest rates have peaked, left the dollar near historical lows against the Euro.
• Foreign stock performance led equities, with strong local market returns enhanced further by the falling dollar. Small caps and mid caps followed. Large cap stocks trailed the smaller asset classes with respectable returns and a string of record-breaking highs for the Dow Jones Industrial Average.
• P/E ratios rose for the small and mid cap equity asset classes, and fell for larger cap stocks, particularly the largest 200 companies. On a relative basis, large caps still appear moderately attractive relative to smaller companies. Growth valuations appear more attractive than value, continuing a trend that has persisted since 2005.

January 2007

Capital Markets

Past performance does not guarantee future results. In the investment world we are all familiar with this disclaimer and its intent to notify investors of the rapidly changing investment landscape. At Plante Moran Financial Advisors, we agree with its sentiment. While using historical information for some of our analysis, we are always aware of the dynamic nature of the capital markets. In our final report letter of 2006, as we have done in the past, we take a few pages to reflect on the historical performance of the markets during the most recent quarter. In a few weeks, you will receive our annual report, which will address in a robust manner many of the issues and trends that shaped the economy and markets in 2006, as well as our thoughts about investing as we move into 2007. We hope you enjoy both of these commentaries and find them helpful as we move into the New Year.

2006 was predominately a year of transition for the U.S. economy and the fourth quarter exemplified this. At the beginning of the year, strong growth and bubbling inflationary pressures were dominating characteristics. In the first quarter, total gross domestic product (GDP) grew at a 5.6% annualized rate. Since then, quarterly GDP has softened substantially to around 2% annualized. Much of this slowdown can be attributed to the delayed effects of the Fed’s 17 consecutive interest rate hikes (over a two-year period) and a tapped-out housing market. In the fourth quarter, the economy’s gradual deceleration has become even more evident.

Although advance estimates of fourth quarter GDP will not be available until the end of January, it is hard to deny a slowing trend in the economy. Intuition may suggest that a slower growth economy may not necessarily be the most conducive environment for business. However, the recent slowdown in growth rekindled investors’ hopes that the Fed will soon ease short-term rates.

Although there has been slower growth, the overall economy has remained healthy. The housing and manufacturing sectors have weighed heavily on the economy. The first, housing, has continued its descent into recession. In October, the number of homes sold decreased 11.5% since last year and the number of unsold homes on the market remains at high levels. This suggests that the much anticipated correction in the housing market could prove to be increasingly severe. Manufacturing also struggled during the quarter, led by a slumping auto industry. In November, the Institute for Supply Management reported that its index of manufacturing activity fell to 49.5, a sign of contracting factory production.

Despite the aching housing and manufacturing sectors, the relative impact of either has thus far been less extensive than initially feared. To date, the service sector, which now makes up nearly 80% of jobs in the U.S., has proven resilient and largely unaffected by that slowdown. A healthy service sector has been the engine for an overall solid job market. Nationally, jobs remained plentiful in the fourth quarter, with the unemployment rate hovering at 4.5% in December. The tight job market has generated an uptick in real wage growth as well. For the year, average hourly earnings are estimated to have grown about 4.2%. With real wages posting solid gains and energy prices coming down significantly from record levels earlier in the year, consumers have maintained their capacity to spend, despite the negative “wealth effect” of declining home prices.

A few economists have conveyed their concerns that the tight job market and resulting wage appreciation will contribute to persistent inflation. While this may be true to an extent, all inflationary measures continue to fall. During November, the core CPI rate fell to 2.6%. This remains higher than the Fed’s stated upper target of 2%. However, relatively high interest rates maintained by the Fed and lower energy prices have allowed the Fed to remain on the sidelines throughout the quarter.



A variety of economic factors have resulted in broad economic moderation, a condition the media has deemed a “Goldilocks” economy. Similar to the storybook character, investors generally benefit in an economy that is “not too hot and not too cold”. This was clearly the case in 2006, as evidenced by fourth quarter stock performance. Domestic stocks finished the year on a strong note, thanks to strong corporate earnings and the prevailing perception that the Fed is done raising interest rates. The Dow Jones Industrial Average, a measure of 30 industrial stocks, broke through its previous high during the opening days of the quarter and posted a series of successive record closes during the quarter, finishing up 6.7%. A more broad measure of large cap performance, the S&P 500 was also up 6.7% for the quarter, contributing to a 15.8% annual return. Despite the fanfare surrounding the record-setting performance of large cap stocks, smaller companies actually performed better during the final quarter. The Russell 2000 Index, a measure of the small cap asset class, returned 8.9% for the quarter, capping an 18.0% return for 2006. Mid Caps trailed small cap stocks as the Russell Mid Cap index provided a 7.7% quarterly return and a 15.3% yearly return.

International stocks edged out the U.S. market, helped considerably by a weakening dollar. Once again, companies located in emerging market countries such as China and India led the way. The MSCI Emerging Markets Index returned 16.9% since September. The MSCI EAFE, which represents international companies in developed countries, returned 10.4% for the quarter. Supporting this performance has been significant investor fund flows to international securities during the quarter. We are carefully monitoring these fund inflows to gauge any potential impact on investment opportunities abroad.




In recent months, highly rated corporate bonds and government bonds have struggled to compete with stocks, as a rosy investment outlook and double digit earnings reports have enamored investors. During the fourth quarter, bonds again posted modest returns. For the quarter, the Lehman Aggregate Bond Index returned 1.2%, while municipal bonds returned 0.6% as measured by the Lehman Muni Bond 5-year Index. Bonds with shorter maturities returned less than their intermediate term counterparts. The Lehman 1-3 year Aggregate Index and the Lehman 3-year Muni index returned 0.9% and 0.6% respectively for the quarter. The resurgence in equities in 2006 may make the comparatively low returns provided by high quality domestic bonds unappealing to some investors. However, should the economy not experience a soft landing as widely anticipated, investor interest in bonds as a safe haven will undoubtedly be rekindled. Regardless of short-term return expectations, bonds continue to provide risk reduction benefits to a broadly diversified portfolio.

In the fourth quarter, international bonds also provided fractionally positive returns. Foreign bonds denominated in U.S. dollars returned 0.7% as measured by the Citi World Government Bond Index Hedged. As with foreign stocks, bonds denominated in foreign currencies received an extra performance boost from the 4% decline of the Dollar during the quarter. As the U.S. economy continues to slow relative to other countries, we expect that the greenback will likely continue to depreciate. Should the Fed cut rates to stimulate the economy, the Dollar will also come under additional pressure.

As 2006 goes into the record books, we remain cautiously optimistic about the prospects for the economy and the capital markets. In last year’s Road Ahead commentary, we projected that 2006 would be a favorable year for the markets. If anything, our outlook proved to be more conservative than the actual results. The performance of the capital markets during the final quarter of the year helped to solidify the strong performance of both stocks and bonds. Now, at the cusp of 2007, we recognize that as the economy has slowed, the potential for recession has increased. However, we still do not believe that a recession in the near-term is the most likely outcome. Given the pockets of strength that remain in the economy and the Fed’s cautionary stance since mid-year, we anticipate that the Fed will manage its task of balancing price stability with nurturing an expanding economy just as deftly as it had in 2006, successfully steering the U.S. economy to a “soft landing”. Even if that outcome is favorable, a repeat performance of the strong equity returns of the past year appears unlikely.

As mentioned above, in a few weeks you will receive our annual report and year-end market commentary, which will outline in greater detail our expectations for 2007. It is true that in the world of investments past performance does not guarantee future results. However, we can guarantee that Plante Moran Financial Advisors will continue to be dedicated to providing you with the highest level of client service and world class financial advising. Thank you for the continued opportunity to serve you.

As always, if you have any comments, questions or suggestions on the report, please do not hesitate to call. We wish you a happy and prosperous new year.