With the mid-cycle slowdown in full swing, a combination of strong corporate earnings reports and slower economic growth propelled the market averages to new highs for the year. The Dow Jones Industrials (+3.4%), Nasdaq Composite (+4.8%), and Standard & Poor’s 500 (+3.2%) all finished the month with solid gains. Consumer discretionary led sector performance for a second month in row with a gain of 6.4%. The healthcare sector was the worst performing sector with a gain of .4%.

This summer we predicted significant stock market gains in the second half of the year, based on our forecast that economic growth would slow, core inflation would peak, the Federal Reserve would complete its rate hike campaign, and stock price/earnings multiples would expand even as earnings growth slowed. It appears we underestimated corporate earnings growth, which is on track to accelerate from second quarter levels, at a rate of 17% year-over-year. This is amazing!

Last month we discussed how the stock and bond markets were sending investors a mixed signal. How can the bond market be signaling a weakening economy at the same time the stock market is reflecting economic strength? We think this is a reflection of an unprecedented market environment - one in which we see declining prices (disinflation) and stable economic growth. The powerful forces of globalization, outsourcing and technology are working to drive down prices for goods and services, yet at the same time they are allowing companies to improve productivity and profit margins. We believe this environment sets the stage for still significant market gains in the months ahead.

Weakness in the housing and auto industries resulted in tepid GDP growth of just 1.6% in the third quarter. Economic growth is likely to remain in the 1.5-2.5% range. Auto production in the fourth quarter is scheduled to decline 20%. The median price of a new home in September declined by the largest amount in 35 years, and existing home prices are likely to post their first annual decline on record. Mortgage interest payments as a percentage of household income are the highest on record. The negative savings rate combined with the negative wealth effect from declining home values will eventually slow consumer spending. The decline in consumer spending will continue to drag on economic growth into next year. We think the Federal Reserve will respond with rate cuts in the first quarter of 2007.

With the mid-term elections one week away, we think it is critical to assess the investment implications and political risks, should the Democrats take control of the House of Representatives. In our view, the healthcare sector would face the greatest threat from policy change as a result of a Democratic House. The Democrats would push to reduce the amount the government pays HMOs for participating in Medicare. They would likely vote to negotiate and lower the prices for the drugs purchased by Medicare. These policy changes would benefit the consumer, but they would be very negative for the pharmaceutical industry and managed care companies. The longer term and more significant risk for the industry would be the possibility of universal national health insurance. While this has no chance of becoming law while President Bush holds office, there is the possibility that it could become a reality should the Democrats win the White House in 2008.

The energy sector is also likely to react to the mid-term election results. Democrats will want to address climate change by reducing carbon emissions and raising the cost of burning coal, which will hurt coal companies and utilities that burn coal. Integrated oil companies will undoubtedly face, for a second time, the threat of a windfall profits tax. We believe the Democrats are more likely to use the threat of a windfall profits tax to force the Bush administration to compromise on legislation that would result in significant funding for alternative energy. An energy bill would likely include tax incentives and government funds for research and development. We see companies focused on solar power, wind power, hybrid vehicles and alternative fuels as beneficiaries.

We continue to believe the stock market will climb a wall of worry through the end of the year. There remains a tremendous amount of buying power on the sidelines. Hedge fund equity exposure is near a two-year low, while overall Nasdaq short-interest positions rose to a record in October. Investors are more concerned about whether or not growth slows, and when the Federal Reserve will stop tightening, as opposed to discounting a peak in inflation, and the possibility the Federal Reserve will lower interest rates early next year.

We remain fully invested in our model equity asset allocation, with an emphasis on large-cap stocks, and we continue to overweight the energy and financial sectors. We also remain fully invested in our large-cap growth stock portfolio. We significantly reduced our exposure to the healthcare sector over concerns that a Democratic victory in the mid-term elections will lead to policy changes which will reduce profitability for the industry. We have invested the proceeds in the energy and technology sectors, with an emphasis on alternative energy and communications equipment. The recent strength in the consumer discretionary sector is based on the belief that the decline in gas prices will continue and that the housing market has stabilized, which will further fuel consumer confidence and spending. We think this is a false hope and are completely avoiding the sector.

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