The market averages marched higher in January as long-term interest rates continued to rise and crude oil prices plunged to 18-month lows. The Dow Jones Industrials (+1.2%), Nasdaq Composite (+2.0%), and Standard & Poor’s 500 (+1.5%) all finished the month with impressive gains. Materials led sector performance with a gain of 4.5%. Energy was the worst performing sector with a loss of 1.8%.

The economy has reaccelerated from the slowdown that began in the spring of 2006. We attribute this to the decline in long-term interest rates this past fall, and to an unusually warm winter, which has led to a precipitous decline in energy prices. These events have lifted housing activity, spurred job growth and fueled consumer spending. In concert with the recent economic strength, long-term interest rates (10-year Treasury yield) have risen from 4.5% in December to nearly 4.9%. Expectations of rate cuts by the Federal Reserve have vanished.

We would be concerned with our bullish stock market outlook if we thought the rise in long-term interest rates was caused by rising inflation, but we don’t see it. Employment costs, which include wages and benefits, declined from the third quarter to the fourth quarter. Rents are also declining, as vacancies increase due to frustrated home sellers putting homes up for rent until the real estate market improves.

A more logical explanation for rising interest rates is that the Treasury market has temporarily lost its best customer–foreign oil-exporting nations. Record-high oil prices in 2006 led to skyrocketing profits for oil producing nations–profits which have been funneled into U.S. Treasuries. This demand has put downward pressure on yields. The recent decline in oil prices to 18-month lows has reduced the purchasing power and subsequent demand for Treasuries by foreign countries, but demand for Treasuries should increase once oil prices begin to recover from their recent decline.

The economy grew at a rate of 3.5% in the fourth quarter, ahead of analysts’ expectations, and corporate earnings growth is on track to increase 10%. Growth is generally a good thing, so long as it does not prompt the Federal Reserve to raise interest rates. We think GDP growth in the first quarter could also be north of 3%, before the current mid-cycle slowdown resumes and GDP growth slows to 2% for the remainder of 2007. The slowdown will resume as housing- and auto-related unemployment claims rise and the growth of consumer spending slows. Long-term interest rates will approach 4%, and the Federal Reserve will be forced to lower rates in the second half of the year.

Speculation about accelerating economic growth in the first quarter of 2007, following the fourth quarter 2006 gain, could cause investors to worry about another federal funds rate increase by the Federal Reserve Board. As a result of this temporary growth scare, we do see the potential for long-term interest rates to reach 5%. This could put downward pressure on stock prices in the weeks ahead, but we think any correction will be mild and temporary. We now believe the Federal Reserve will delay any cuts in short-term interest rates until the second half of 2007.

As oil prices declined from a record $78/barrel last July to nearly $50/barrel in recent weeks, we have been listening to the ever louder drumbeat of bearish strategists forecasting lower prices based on deteriorating supply/demand fundamentals. We disagree with their view that additional oil supply in 2007 from both OPEC and non-OPEC nations will ease spare capacity concerns and result in lower oil prices. We also disagree with their argument that a slowing U.S. economy will slow global demand for oil, leading to lower prices.

Oil production for many of the largest producers is actually in decline. Iran is the second largest OPEC producer behind Saudi Arabia, pumping 3.7 million barrels of oil per day. Aside from the geo-political tensions that continue to mount in the Middle East, Iran’s oil production is in decline due to a lack of reinvestment in its infrastructure. Recent reports indicate Norway and Mexico, which are the second and third largest non-OPEC producers behind Russia, are seeing depletion rates of 7% and 5%, respectively. This accounts for 7.5% of total world supply.

Oil demand continues to increase despite the slowing U.S. economy. China’s economy grew 10.6% in 2006, the greatest rate of expansion in the past decade. India’s economy grew 8% for the fourth year in a row. The combined developing economies (which include China and India) now exceed the size of the U.S. economy. There is no evidence that their growth rate or demand for energy will decline any time soon.

A new source of demand was announced by President Bush in his State of the Union address last week. He intends to double the size of the Strategic Petroleum Reserve (currently 700 million barrels), which analysts estimate will increase demand from the U.S. by 100,000 barrels per day. This announcement may spur other nations to increase their strategic reserves, especially as the situation in the Middle East deteriorates. The energy sector continues to be the most significant weighting in our investment portfolios.

In light of the recent acceleration in growth and the potential for a temporary rise in long-term interest rates, we have reduced the equity exposure in our model equity asset allocation and our large cap growth portfolio by 5% and 10%, respectively. We are looking for any near-term weakness in the market to reposition our cash. Ultimately, we believe the rate of growth and inflation will slow, and the Federal Reserve will lower interest rates. This will set the stage for another rally in the stock market.

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