The market averages continued their steady advance upward in April until the last day of the month, when Microsoft’s management announced disappointing earnings and forecast a much lower growth rate. The Dow Jones Industrials (+2.32%) and Standard & Poor’s 500 (+1.34%) finished the month with solid gains, while the Nasdaq Composite ended the month down .74%. Energy led sector performance, posting a gain of 5.1%, with the financial sector not far behind advancing 4.0%. The healthcare sector was the worst performing sector with a loss of 3.2%.

It’s earnings season! S&P 500 earnings look like they will rise double digits year-over-year for the first quarter of 2006, well ahead of estimates, thanks to strong reports from energy and industrial companies. First quarter GDP rose 4.8%, rebounding from the 1.6% rate in the fourth quarter of last year. The 10-year treasury yield surpassed 5% as crude oil rose to $75/barrel and gasoline topped $3/gallon. Despite higher interest rates and rising energy costs, the Federal Reserve raised short-term interest rates to 4 ¾% at their March 27-28 meeting. The Fed indicated that they would likely raise the rate to 5% at their next meeting (May 11th), but testimony before Congress by Ben Bernanke following the March meeting led investors to believe the Fed would pause after the May meeting. The equity markets responded positively, led by a long overdue rally in the financial stocks. While our forecast that the Fed would end their rate increases during the March meeting did not come to pass, our expectation for a stock market rally led by bank stocks worked out in the end. The inflation data remains benign and higher energy prices are not passing through to core inflation. We believe the Fed will be sensitive to the lagging impact higher energy prices and interest rates will have on the economy later this year, and that they will end their rate hikes at the May 11th meeting with the Fed Funds rate at 5%. GDP growth should slow to the 2.5-3.0% range in the second and third quarters.

Our main concern in the months ahead is the U.S. consumer. There seems to be a cognitive disconnect between the lifestyle that consumers continue to lead and the amount of savings and investment required to maintain that lifestyle. While wages have been increasing, they are not keeping pace with rising energy and healthcare expenses, and the savings rate has been negative the past 12 months. Unemployment claims are beginning to rise again, and employment gains are likely to slow, considering a large percentage of these gains came from housing-related industries. Employers are freezing and/or discontinuing pension plans and healthcare benefits. Interest rates are rising and bank regulators are tightening lending standards. So what is keeping the consumer afloat? A robust housing market which has enabled consumers to withdraw equity to consolidate debt and maintain discretionary spending levels.

The problem facing consumers is that the housing market has begun to slow. Our economy is extremely dependent on rising prices of housing, which has fueled consumer spending and accounted for more than 70% of the country’s job growth over the past five years. Many consumers who have taken out interest-only loans will be faced with significant payment increases over the next couple of years, while home price appreciation has begun to slow dramatically.

Washington politicians have reignited the debate about high gas prices (temporarily sweeping new laws to govern immigration under the rug), looking at the oil industry executives as scapegoats, in an attempt to pacify their angry constituents (there must be an election soon). Yet here lies the cognitive disconnect. Consumers continue to buy gas guzzling SUVs, and the federal government has allocated a paltry sum ($150 million for 2006) for the research and development of alternative fuels. Nascar is the fastest growing sport in the United States. Most people are still willing to pay $4 for a cup of coffee at Starbucks. Are Americans really as concerned about the impending energy crisis as they say they are? There may be an upside to this crisis in addition to energy stocks (which we own). Rising oil and gas prices are making alternative energy sources (wind, solar, ethanol) more attractive. This will eventually lead to new industries, creating jobs and the prospect for economic growth.

We believe the inevitable consequence of these unfolding events is a steep decline in the consumer spending growth rate and in overall real economic growth. The question is when the Federal Reserve will become active in promoting a recovery in real growth. Another concern is how slower U.S. economic growth will impact the foreign markets that rely on American consumer purchases.

We remain fully invested in our model equity asset allocation and large cap core equity portfolio with an overweight in the energy, industrial and financial sectors. We continue to underweight all consumer related sectors of the market. Our international focus continues to be Japan. While our outlook for the equity markets remains bullish, we will be watching our technical indicators closely in the months ahead for any significant changes in the relationship between supply and demand. Historically, the stock market declined on average during the period between the last rate hike and the first rate cut by the Federal Reserve.

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