This past year proved to be rewarding for patient investors. The Dow Jones Industrials finished 2006 with a gain of 16.3%, the Standard & Poor’s 500 ended up 15.8%, and the Nasdaq Composite ended up 9.5%. While the market advance was broadly based, there were rewards for investors who over-weighted the right sectors. The telecommunications (+32.1%) and energy (+22.2%) sectors easily outpaced market averages, while the healthcare (+5.8%) and technology (+7.7%) sectors significantly underperformed. The international markets outperformed the U.S. for a second year in a row, with the benchmark indexes in China (+97%), Russia (+67%) and India (+46%) leading the way.

We predicted in our Market Outlook a year ago that rising short-term interest rates would lead to a decline in the housing market after several years of above-trend growth. The declining housing market would negatively impact the rate of consumer spending for lower- to middle-income households. These factors would lead the Federal Reserve to stop raising interest rates, which would be viewed positively by investors, allowing the stock market to move higher. We did not view the modest inversion of the yield curve as a negative. In fact, we noted that the past four times the 2-year U.S. Treasury yield rose above the 10-year Treasury yield, the Standard & Poor’s 500 index rose an average of 13% within six months. It is no strange coincidence that the S&P500 finished the year up more than 16%. Our miscalculation was that the Federal Reserve would continue to raise interest rates to 5.25% through June of 2006. This pushed all of the stock market gains into the second half of the year.

What should investors expect for 2007? We think the current mid-cycle slowdown in the U.S. economy will continue to unfold, led by the ongoing recessions in housing and the auto industry. The unemployment rate should rise above 5% in response to housing- and auto-related layoffs. We expect real consumer spending growth to decline to 1%. The core inflation rate, having peaked in 2006 at 2.7%, will likely decline towards 2%. The Federal Reserve will begin to lower short-term interest rates in the first half of 2007 in response to the weakness in employment and the decline in core inflation. The yield on the 10-year Treasury should also decline towards 4% in response to lower inflation and slowing economic activity. We believe the value of the U.S. dollar will continue its gradual decline relative to foreign currencies. Corporate earnings growth rates should decline dramatically for companies that derive the majority of their profits from within the U.S., while large global companies should continue to benefit from emerging market growth and the weak dollar.

We see a continuation in global economic growth, despite the slowdown in the U.S. economy, led by the emerging markets of China, India and Russia. China’s economy should grow 10% this year, emerging as the third largest economy behind the U.S. and Japan during 2007. Infrastructure investment is on pace to continue growing at least 20% as China’s government prepares for the 2008 Olympics, and as the rural population migrates to the cities at the rate of 20 million per year. The growth in China and other emerging markets is the reason oil demand in the U.S. is becoming less influential in determining global demand for petroleum.

Energy continues to be one of our primary focuses. We believe a rise in oil and gas prices to new all-time highs in 2007 will bring alternative energy into the mainstream, resulting in the emergence of an entire new industry over the next several years. The growth potential for alternative energy today is very similar to that of the internet in the early 1990s–explosive! The Chinese government has mandated that it will get 10% of its energy from alternative sources by 2020. Democrats in Congress have already outlined global warming as a top priority in 2007. We will be looking for new opportunities to capitalize on this emerging industry, while at the same time maintaining our weighting in the traditional energy names, so long as the demand for oil outstrips supply.

There are possible headwinds for the stock market in early 2007. One is the potential for stronger economic growth in the first quarter, similar to the temporary rebound we saw in the first quarter of 2006, which may delay the Fed in cutting rates. We also think the market will be measuring the political risks of a Democratic Congress in January. This could put temporary upward pressure on long-term interest rates, which would result in muted gains in the stock market. Ultimately, we believe the U.S. economy will slow throughout the year.

Weak economic data in the months ahead will be good news for the stock market, and despite the fact that earnings growth will slow, stock price/earnings multiples will expand as concerns about inflation ease and long-term interest rates decline. Liquidity is the fuel that drives the stock market higher. Record amounts of cash on corporate balance sheets and in private equity funds are available for stock repurchases and leveraged buyouts. The Federal Reserve is increasing money supply, and the pace of foreign purchasing of U.S. equities has accelerated in recent months in anticipation of a change in Federal Reserve policy.

We think 2007 will be another good year for the stock market. We remain fully invested in our model equity asset allocation and large cap growth equity portfolio. Our initial target for the S&P 500 is 1600, which is 13% higher than current levels. We think large growth-oriented companies with global businesses will lead market performance. Large company stocks should outperform their small and medium company brethren in 2007.

We continue to overweight the energy, industrial and materials sectors, based on the view that companies in these sectors will benefit from the growth in emerging markets and a weaker U.S. dollar. We continue to overweight the financial and consumer staples sectors, based on their historical out-performance during periods of slower economic growth and declining interest rates. We have gradually increased our weighting in the technology sector with a focus on alternative energy and communications equipment. In light of the headwinds faced by consumers, we have no exposure to the consumer discretionary sector. We have significantly underweighted the healthcare sector due to the negative investment implications of potential policy changes as a result of the recently elected Democratic Congress.

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