The market averages continued to climb in February until yesterday’s announcement from Google’s CFO that the rate of growth at the internet company was beginning to slow, erasing all the gains for the month. The Dow Jones Industrials (+.36%) and Standard & Poors 500 (+.27%) finished the month with small gains, and the Nasdaq Composite ended the month down 1.3% Telecommunications services led sector performance, posting a gain of 6.5%, while energy was the worst performing sector with a loss of 8.1%

The economic data released during February continues to support a slowing economy. Consumer confidence declined more than expected during the month, with particular concern for the prospects for the job market in the first half of 2006. The consumer is critical to continued economic growth because consumer spending accounts for two-thirds of overall economic activity. This decline does not surprise us, since consumers face rising energy and healthcare costs, layoff announcements and the steady erosion of pension benefits in corporate America. Nissan announced that it would be eliminating its healthcare benefits for all its U.S. workers and instead would provide retired employees with a $2,500/year stipend for healthcare expenses. IBM announced that it would be discontinuing its pension plan for existing employees in lieu of a 401k plan. The health savings accounts (HSA) proposed by the Bush administration provide no solution to the 45 million plus uninsured Americans that are putting upward pressure on healthcare costs.

The housing market also continued to show signs of a slowdown when Toll Brothers lowered its 2006 home-delivery estimate. The luxury homebuilder said signed contracts fell 21% in their fiscal first-quarter from the prior year. The number of unsold homes across the country hit a record high 528,000, despite the warmest January on record. In one of the most active real estate markets in the country – Phoenix – the number of new empty homes across the Valley now stands at over 6,800, up from 4,000 a year ago. Existing home sales fell for a fifth consecutive month. Housing has had a spectacular run over the past 20 years, as inflation has declined from 13% to just 2% and long-term interest rates have declined from 15% to just 4%. It now appears that this bubble is slowly deflating, which will put pressure on consumption in the year ahead. The deflation of the housing bubble in the U.K. last year took consumption down from 10% to 2% on a year-over-year basis.

First quarter GDP will likely be strong, rebounding from the fourth quarter rate of 1.6%. Most of this rebound can be attributed to lower energy spending due to warmer than normal weather. We believe this rebound will be short-lived, and that GDP growth will slow to 2-3% in the second quarter Inflation as measured by the CPI was up 4% year-over-year in January, due to a spike in energy prices, but core inflation (minus food and energy) increased just 2.1% year-over-year in January.

Ben Bernanke and the Federal Reserve Board face a serious dilemma at their next meeting, scheduled for March 27-28. Core inflation remains well contained, but wages are not keeping pace with rising food, energy and healthcare costs. The Federal Reserve wants to maintain its tough stance on inflation, but it runs the risk of crimping consumer spending if it raises rates too high. We believe that higher energy costs are reducing consumer spending on other goods and services, in turn having the same impact that higher interest rates would normally have on core inflation. For this reason, we think the Federal Reserve will not raise interest rates at the March meeting. The markets are discounting two to three additional 1/4 point increases in short-term interest rates. News that the Federal Reserve has moved to a neutral stance, believing that monetary policy is no longer accommodative, would be welcomed by the market, leading to higher stock prices.

We remain fully invested in our model equity asset allocation with an overweight in the energy and financial sectors. Japan remains the focus in our international allocation. We have reduced our exposure to technology stocks in our model equity portfolio, looking for opportunities to increase our weighting in the financial sector. Financials will likely lead any market advance once the Federal Reserve announces that they have ended their string of interest rate hikes.

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