The market averages continued to climb higher, as inflation fears subsided and long-term interest rates declined. The Dow Jones Industrials (+1.2%), Nasdaq Composite (+2.7%), and Standard & Poor’s 500 (+1.9%) all finished the month at new highs for 2006. Energy led sector performance, rebounding from its recent slump, with a gain of 8.0%. The consumer staples sector was the worse performing sector with a loss of 1.1%.

Economic growth continued to slow in November, led by lower spending on housing and a slower growth in spending on general merchandise. Nearly a third of the jobs created since 2001 have been tied to the boom in the housing market. Consumer spending and consumer confidence have been supported by strong employment gains, rising home prices and easy access to home equity. Now the tide is beginning to turn. For the fourth quarter we should see reports of reduced construction activity on homes and lower auto production, leading to higher unemployment claims. Higher unemployment claims, lower consumer confidence and a decline in consumer spending are likely to bring only a one-to-two % real growth rate for the US economy in the first half of 2007.

These higher unemployment claims and reduced activity levels for construction and manufacturing activity have led to a renewed weakness in the value of the US dollar.
We are forecasting a down trend in the value of the US dollar which supports an upward trend in the US equity market. The decline in the value of the US dollar will increase foreign demand for crude oil and cause oil prices to rise, since oil is priced and traded in US dollars.

While US consumers will clearly be a drag on economic growth moving forward, the environment for corporate America is approaching nirvana. Corporate earnings posted an astonishing 20% year-over-year gain in the third quarter. While estimates are for earnings growth to slow to 10% in the fourth quarter, companies continue to benefit from globalization and technology. They are using the huge amounts of cash on their balance sheets to buy back stock, make acquisitions and boost dividends. Large US companies with a major global presence will benefit from the relative weakness of the US dollar as economic growth slows.

The Federal Reserve will play a pivotal role in whether or not the current mid-cycle slowdown leads to a recession. With 10-year treasury yields at a 10-month low (4.5%) and the Fed Funds rate at 5.25%, the yield curve has been inverted for more than three months. This is a clear indication that the bond market is forecasting slower economic growth and lower inflation, yet the Federal Reserve is more concerned with the opposite. The Fed needs to cut rates soon. We think it is waiting for unemployment claims to rise higher before making its next move.

The significant decline in oil and gas prices in recent weeks has led many analysts to forecast lower energy prices in 2007. This forecast is based on the assumptions that slower global economic growth will reduce demand and that additional output from both OPEC and non-OPEC producing countries will mitigate concerns about lack of oil production capacity, which have kept oil prices high.

Global economic growth has slowed dramatically since the beginning of the year, but demand has continued to increase. In the third quarter, oil demand in the US increased 5% year-over-year, and oil demand in China increased at a rate closer to 10%. It is important to remember that two-thirds of the oil consumed in the US is used to power vehicles. While there are approximately 148 million cars in the US for a population of 300 million, there are only 18 million cars in China and 9 million in India for populations that are each four times as large. The number of cars in China has increased 400% in the past five years. Oil demand in the US is gradually becoming less influential in determining global demand.

As for spare capacity, we are more concerned that capacity doesn’t keep up with demand, and that geopolitical risks will only intensify next year. As the situation in Iraq deteriorates, there is a risk that it will be unable to maintain its current production of 2 million barrels/day. Saudi Arabia is building a $7 billion fence along the Iraqi border to protect its oil fields from the spreading violence. Russia, the largest non-OPEC producer, has seen its oil output slow dramatically as a result of President Putin re-nationalizing the energy industry. The capital investment required to maintain and increase production has not occurred. Unrest in Nigeria and poor U.S. relations with Iran and Venezuela only add to our concerns about spare capacity. Our view is that global oil capacity will not keep up with demand, and that both oil and gas prices will hit new highs next year.

We remain extremely bullish on the stock market in the near term. As the mid-cycle slowdown in the economy unfolds, the rate of inflation will decline and long-term interest rates may approach 4%. Ironically, investors are still concerned about another increase in short-term interest rates by the Federal Reserve. We believe the Fed is done with rate increases, and that instead their next move will be to cut rates in the first quarter of 2007. As investors come to the realization that inflation and interest rates are no longer headwinds, the stock market will move higher. We believe stock price/earnings multiples for S&P 500 companies will expand to the point that the index approaches 1600 in 2007. This would be a 15% upward move from current levels.

We remain fully invested in our model equity asset allocation and our large-cap growth stock portfolio. We continue to overweight the energy, financial and consumer staple sectors. We continue to avoid the consumer discretionary sector completely.

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