Market Commentary: November 2006

With the holiday season upon us, investors have already received an early gift from the markets. For the fourth consecutive month, the major equity and fixed income sub-asset classes posted positive returns. The chief reason behind the market’s positive performance: continued moderation of the economy. Preliminary estimates released in November show that in the third quarter the economy’s growth slowed to 2.2%. This is down significantly from the first quarter’s pace of 5.6% and indicates a moderate deceleration from the second quarter as well. For many, the relationship between a slower growing economy and a resulting surge in market performance may not be intuitive. The answer lies in the impact that a slower economy will have on monetary policy. With slower growth, inflationary pressures generally tend to subside, allowing the Federal Reserve to either maintain or lower interest rates. At this point, investors increasingly expect that a continued slackening of the economy will result in interest rate cuts in 2007, which should prove supportive of both stock and bond market performance.

Weighing particularly heavily on the economy has been the housing market. In October, the median sales price for homes slipped 3.5% to $221,000 from the October 2005 median sales price of $229,000, the largest year to year percentage drop on record. Despite that decline, the average home price remained unchanged from September, suggesting that home prices may be stabilizing, at least temporarily. Experts including Fed Chair Ben Bernanke have warned that much downside potential for home prices remains given the persistent excess supply. Despite the state of the housing market, comments made by Bernanke and others on the Fed Open Market Committee have consistently indicated that squashing high inflation continues to be their primary target. During October, the core CPI, a measure of inflation (excluding energy and food), rose 0.3%. Further, its year-over-year rate of 2.7% remains well above the Fed’s implicit target range of 1% to 2%. Despite hopes that the Fed will cut rates soon, it appears that the central bank is poised to hold out until they are confident that inflationary pressures are well contained.

With the economy easing into slower growth, it is no surprise that stocks continued to perform well throughout November. However, with headlines announcing the record breaking levels reached by the Dow Jones Industrial Average and the S&P 500, mid-sized and smaller companies actually led the domestic equity markets. During the month, the Russell Mid-Cap Index and the Russell 2000 Index returned 3.6% and 2.6%, respectively. Large cap stocks on the other hand returned a solid but lower 1.9% as measured by the S&P 500. Falling energy prices and a rash of corporate consolidations also helped to boost equity prospects. These particularly lent themselves to smaller companies which are often more sensitive to economic forces such as volatile energy costs and are more often targeted for consolidation than larger companies.

Economic indicators that continue to suggest that a “soft landing” for the U.S. economy is a likely scenario have also bolstered the outlook for the global economy. This has emboldened investors who continue to look to the international markets as sources of potential return abroad. Again in November, those markets did not disappoint. Leading the way for all equities, the MSCI Emerging Markets Index returned 7.6%. The MSCI EAFE, which tracks developed countries’ stocks, returned 3.0%. Contributing to strong performance of international stocks was an appreciation by most currencies relative the U.S. dollar. Most notably the Euro reached an all-time high relative the dollar on November 24^th. The British Pound and the Japanese Yen also continued their cyclical appreciation relative to the greenback.

A slower economy gave bond investors reason for optimism, as did a sixth consecutive month of positive performance. In November, the Lehman Brothers Aggregate Bond Index returned 1.2% to pace the domestic markets. Intermediate term municipal bonds returned 0.4%, as measured by the Lehman Muni Bond 5-year Index. Short-term taxable bonds returned 0.5% and municipal short-term bonds returned 0.4% as measured by the Lehman Aggregate Bond 1-3 Government Index and the Lehman 3-year Muni Bond Index. Foreign bonds returned 0.8% during November as measured by the Citi World Government Bond Index-Hedged. Not reflected in the Citi index was the impact of a falling dollar on bonds issued in local currencies. While the impact of a falling dollar varied across currencies, investors in non-dollar denominated bonds have benefited from that currency tailwind.

As the economic picture heading into 2007 takes shape, we expect that economic moderation will stabilize. The housing market does not appear to have yet found a floor and the full impact of the decline cannot be fully gauged. While lower home prices have not yet curbed consumer spending as dynamically as initially feared, the effects of the housing slowdown combined with slowdown in the auto industry could have ripple effects that extend into the rest of the economy. While it appears improbable that the weakness in housing and durable goods will lead to a recession, the slowdown may be sufficient to take the wind out of inflation’s sails. That would seem to be the best possible outcome, probably allowing the Fed to hold short-term rates steady. While the Fed continues to balance a slowing economy with persistently higher inflation, we continue to be conscientious of both the threats presented by a slowing economy and opportunities available if the Fed lowers interest rates. In this light, we recommend that clients remain committed to a strategically diversified portfolio, which will help provide return opportunities without unnecessary exposure to risk.