3rd QUARTER 2006 MARKET COMMENTARY & OUTLOOK

 
 
OCTOBER, 2006
 
As we reflect on recent market activity and review our last quarterly letter it seems particularly appropriate to highlight our comment, “How quickly market perceptions can change….” The context of that comment was made as we recounted the positive nature of the markets through April and the sudden change in perceptions that created a market downturn, leaving investors with negative perceptions and grave concerns as we headed into the third quarter. At that time the evidence pointed to a more positive outlook than reflected in the mood of the markets.
 
How quickly market perceptions can change….
To refresh everyone’s memory, “way back” at the end of June, oil prices were near their highs and the Fed had just surprised investors by signaling it might not be finished raising rates. High oil prices led to heightened inflation fears as well as worries about consumer spending, which was already showing signs of weakness via the housing market. This led to more caution in corporate management comments about earnings visibility beyond the second quarter. Decreased earnings visibility combined with inflation fears resulted in downward pressures on both the equity and bond markets.
 
As the third quarter began North Korea test launched seven missiles. Shortly thereafter, Hezbollah kidnapped two Israeli soldiers which led to the outbreak of war in the already unstable Middle East region. By mid-July, these events validated the pessimistic sentiment that investors seemed to be seeking at the end of June. In his testimony to congress on July 19, Federal Reserve Chairman Bernanke surprised the markets by hinting that the Fed was almost finished raising interest rates, touching off a one day 200+ point rally in the Dow, off what proved to be the market bottom during the quarter. This set the tone for positive equity returns not only in the U.S. but around the world. As the quarter continued, the lack of a Fed rate increase at either the August or September meetings combined with news of an unexpected drop in wholesale prices provided the necessary catalysts for solid equity performance in the third quarter. This news was also good for the bond market, which rallied as rates began to decline from recent peaks. The U.S. Treasury 10 year bond yield declined from 5.14% on June 30th to 4.63% on September 30th.
 
So what is it that changed the Fed’s approach? We think there are several pieces of data that now indicate an economy growing at 2.5-3.5%, an acceptable range for Fed policy makers. This information, combined with lower energy prices and the likelihood that all the prior rate increases have not yet had their full effect on the economy, may have had a significant impact on the Fed’s rate decisions. The question now, as always, is: Where do we go from here?
 
At the end the third quarter, the Dow Jones Industrial Average flirted with new all-time highs while longer term interest rates continued to decline. By the second trading day of this new quarter, we have pierced the all-time high for the Dow Industrials set in January of 2000. The Fed to date has successfully walked the fine line between slower economic growth and choking off the economy too abruptly. Investor expectations are for slower, moderate growth to continue, which will allow for better earnings visibility and an overall soft landing. We agree with this outlook. The combination of moderate growth, lower energy prices and a steady employment market should allow the consumer to remain an important part of the economy. As long as we see evidence of a healthy consumer and continued strong capital spending by the business sector we will continue to be optimistic about the economy. With regard to the equity markets, in our opinion the move in the third quarter has priced in much of this optimism. Many opportunities continue to exist within the markets, but we believe the broad market indexes have priced in much of the good news.
 
The yield curve is currently inverted; short-term rates are higher than long term rates. Normally we would express caution about an inverted yield curve. In this instance, however, we are not as concerned. The short end is where the Federal Reserve has influence and control, the long end is where the market expectations have influence. In this case we think the market has gotten ahead of the Fed on repricing bonds for a soft landing and moderate growth.
 
The wild card for the fourth quarter may center on the elections, in both the response to rhetoric and media activities leading up to the election as well as the actual election results and activity in Congress during the lame duck session. As always, we believe uncertainty is the undoing of the markets. For now it seems the conventional wisdom is that at least one house of Congress, and possibly both, may change from Republican to Democratic control. In the past we have expressed concern over the uncertainty a change of control brings. For now, however, it seems that investors have accepted and determined such a change will not create uncertainty in the financial markets (i.e. tax and commerce policy will be left alone). The possible wild cards would include: an election outcome different from expectations; unanticipated legislative changes passed in a lame duck session; and most importantly, the recognition that a change in control may mean significant changes to policies that affect the economy as well as possible changes to the sectors that become winners and losers in the equity markets. As investors begin to focus on these issues, uncertainty with regard to future policy may create anxiety for investors.
 
In closing, we express our appreciation for your continued trust in our advice and our services. As always, please be sure to contact us or your portfolio manager with any questions you may have or any changes to your financial situation about which we should know.
 
Sincerely,
 
SPERO-SMITH INVESTMENT ADVISERS, INC.
 
    


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©2007 Spero-Smith Investment Advisers, Inc. All rights reserved.

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