The Standard & Poor’s 500 reached a five-year high, as the economy continued to show signs of moderating growth, and inflation fears dissipated, alleviating concerns that the Federal Reserve would raise interest rates. The Dow Jones Industrials (+2.6%), Nasdaq Composite (+3.4%), and Standard & Poor’s 500 (+2.6%) all finished the month with impressive gains. Consumer discretionary led sector performance with a gain of 6.4%. The energy sector was the worst performing sector for the second month in a row with a loss of 2.8%.

Many market pundits believe the stock and bond markets are sending investors mixed signals. The debate is focused on which market is accurately forecasting the health of the economy. The bond market appears to have a very pessimistic view of the economy with long-term yields nearing 4.5% and the yield curve inverting by nearly 75 basis points. The stock market appears to be far too optimistic, with major market averages nearing all-time highs. So which market is right? We think both are right on target. The bond market is reflecting slower economic growth and a peak in inflation. The inversion of the yield curve is a message to the Federal Reserve that it will need to lower short-term interest rates in early 2007. The stock market advance is in response to low valuations after record corporate profit growth over the past five years. The combination of slower economic growth, lower interest rates and declining inflation expectations is consistent with previous mid-cycle slowdowns, and it is very positive for future stock market returns.

The recent plunge in long-term interest rates is an accurate portrayal of both the current and future state of the consumer and housing market. Consumers cut back on spending in August by the largest amount in a year, mostly due to the drop in auto sales. The savings rate has now been negative for 17 months in a row. Temporary employment has shown no growth for nine months, and monthly job gains are gradually slowing. The recent decline in federal and state income tax receipts suggests that the rise in wages over the past year is stalling. The widely reported rise in wages has been misleading, since median hourly wages, adjusted for inflation, have declined 2% since 2003.

We don’t think the housing market correction is over. Housing starts have declined 26% from their peak, and in 1990 they declined 50%. Properties entering foreclosure were up 53% year-over-year in August. Both existing and new home prices were down year-over-year in August. The ratio of house prices to incomes has risen 30% above prior peaks. Home price appreciation will either have to slow to a rate below the overall inflation rate for several years or decline outright over a short period to correct the imbalances. Price declines will be a psychological blow to wealth-dependent consumers, and a huge negative to future employment gains, considering 20% of job growth for the past three years has come from housing-related industries. The benefit from the temporary decline in gas prices will be far outweighed by the first ever annualized decline in home prices early next year, leading to a continued retrenchment in consumer spending.

Fears of an economic slowdown, the possibility of a housing-related recession, and the impact these factors may have on economic growth in Europe and Asia led to a significant decline in commodity prices during the third quarter. Many analysts are forecasting that as global growth slows, oil demand will suffer and prices will continue to decline. We think the 20% decline in oil prices from recent highs of $79/barrel is simply a correction similar to the three previous 15-20% corrections we have seen over the past two years. During previous mid-cycle slowdowns commodity prices have declined an average of 14%. This summer the CRB commodity index declined nearly 18%. The differentiating factor this time is China. We think Europe and Asia are likely to disengage from the U.S. and therefore not slow as much as many predict.

China’s oil imports rose 35% year-over-year in August, which was the most in seven months. China’s year-to-date oil demand is running 10% above last year’s levels at the same time global growth has begun to slow. Storage levels in Europe have fallen below normal for the first time since May 2004. We do not see any signs that slower global economic growth is leading to demand destruction. We wouldn’t be surprised if the bottom in oil prices coincided with the demise of the $10 billion Amaranth hedge fund, which lost over half its value in September speculating in the energy markets.

We continue to stand by our forecast outlined in previous Market Outlooks. The economy will continue to slow, core inflation has peaked, and the Federal Reserve has finished its rate hike campaign. The stock market will continue to climb a wall of worry as long-term interest rates decline, and stock prices will play catch-up with the rise in corporate earnings over the past five years.

Here is a statistic that bodes well for our bullish market outlook over the next 12 months. Since 1950, stocks have never been down from the fourth quarter of a mid-term election year through the third quarter of the following year. The average gain has been 30%, and we don’t think this is unrealistic for the present time. Even if the stock market returned 10% per year through 2010, the 10-year return would only be approximately 3% per year.

We remain fully invested in our model equity asset allocation, with an emphasis on high-quality large-cap stocks. We continue to overweight the financial and energy sectors within our model. We also remain fully invested in our large-cap growth stock portfolio, and continue to favor the financial, energy and consumer staple sectors. We are significantly underweight in the consumer discretionary and technology sectors and we believe the recent rally in both groups will reverse course. The only argument for buying technology stocks is that corporations are flush with cash that they will likely spend on new equipment. The problem is that they are not spending it. In fact, capital expenditures are declining. The only rationale behind the rally in consumer discretionary stocks is the recent drop in gasoline prices, but this is not likely to trump the headwinds of a deteriorating housing market, minimal employment and wage gains, a negative savings rate, and tighter lending standards on the horizon.

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