Our Newsletter

MARKET VIEWPOINT January 2007

Chicken Little Takes a Holiday

The Economy

“The sky is falling, the sky is falling” Chicken Little proclaimed and so did many economic forecasters. Last year at this time, many economists prognosticated that the U.S. economy would be in recession by early 2007. Despite all the uncertainties, risks, and negative events of the last few years, the biggest economic story of this time is the incredible resiliency of the U.S. economy. Neither war, record oil prices, prolonged credit tightening, a slumping housing market, or destructive hurricanes have been able to shake the upward momentum of the American economic expansion. We know that economies move in cycles - - what goes up must come down and vice versa. As we approached the sixth year of the current expansion, all of the negative forces mentioned above pointed to the declining phase of the business cycle. It seemed the logical consequence - - at least to the gloomy forecasters. However, just as this was supposed to happen, surprise of surprises, the U.S economy seems to be accelerating, not declining. Recession is nowhere in sight.

This is clearly good news. The evidence underscores this judgment. The economy, for all intents and purposes, is at full employment. The unemployment rate is at 4.5% - - a historically full employment level - - and at least 100,000 to 150,000 new jobs are being created every month. Inflation rates are slowing. Oil prices have dropped over 30%. The stock market is buoyant; real incomes are now rising and the housing market shows signs of stabilizing. Leading economic indicators are pointing upwards. At this stage and from this vantage point, the economic expansion appears to have a lot of life in it.

But as Chicken Little saw nothing but doom, it is equally deceiving to see the world only with rose-colored glasses. The risks that shadowed the economy in this new century still pertain. We should not forget them. Energy prices remain volatile, demographic trends point to increasing demands on government budgets, world economies remain highly leveraged, and monetary policy represents a seat of the pants approach, acting and reacting to economic events as they unfold. I keep my eye on these. Nevertheless, I am surprised and encouraged by the underlying power of the U.S economy. I see economic expansion continuing in the coming year, with currently no signs of great excesses. It is a positive undercurrent for financial markets.

The Financial Markets

2006 was good for stocks. The U.S. and most foreign markets achieved excellent rates of return for the full year. The U.S. market indices all rose at low double-digit rates. Helped by a moderately falling dollar, European, Asian and developing country markets mostly exceeded U.S market performance. U.S. bonds on the other hand achieved only modest returns, as long-term interest rates remained stable and the yield curve inverted. High-yield (junk) bonds and foreign bond markets did better. Public real estate investments (REITs) did exceptionally well. The REIT index advanced over 30% for the year. Despite persistent news of a housing slowdown, commercial real estate and rental housing markets continued a long-term advance. The worst performances were in commodities. Gold, silver, oil, and many industrial metals declined sharply from their highs achieved last spring.

Although I believe the economic setting is favorable, stock values already reflect much of this sanguine outlook. I still look for a positive year, but not a repeat of 2006. I think it will be difficult to again achieve double-digit returns in stocks. Foreign markets provide better opportunities, as the probabilities of a continued, but modest, decline in the dollar remain. The biggest unknown factor is monetary policy. Further credit tightening by the Fed would be unexpected by the markets and a substantial negative for stocks. It is not probable, but also not out of the question. World political uncertainty, as always, shrouds all markets. Any serious conflagration or terrorist attack could send world financial markets into turmoil.

Bond markets should again provide nothing better than coupon returns. Only a meaningful economic slowdown could bring interest rates substantially down from current levels. The biggest risk lies again in Fed tightening which could push both short and long-term interest rates upward. Under these conditions, the best bond market prospects are in inflation-protected securities (TIPS), municipals, which are somewhat cheap on a tax equivalent basis, and foreign bonds, which will again benefit from a declining dollar. The high-yield market is expensive and does not reflect any potential for a decline in credit quality. High-yield bonds should be avoided.

The long-term trend in commodity prices is upward. The commodity sell-off of the last part of 2006 provides an opportunity to again invest in commodities. The broad index funds, particularly a number of newly created Exchange Traded Funds (ETFs), present the most diverse and risk averse way to do that.

In sum, financial markets present reasonable prospects for 2007, reflecting persistent and enduring economic growth.

Summary

The yearend surprise for 2006 was the underlying strength of the U.S. economy. The economy defied the normal course of the business cycle and the pessimistic forecasts, which relied on the negative effects of a declining housing market. Rather than decelerate into recession, the U.S. economy accelerated instead. Prospects for continued economic growth without inflation excesses remain good. Financial markets reflect this. 2006 was a very good year for stocks. 2007 could also be good, although stock market prices already incorporate much of that favorable outlook. Risks remain. Rising interest rates and energy costs, as well as geopolitical uncertainties, are the most prominent of these risks. Investors should continue to diversify among assets. Foreign stock and bond markets present opportunities, as do commodities. As always, the prudent investment strategy should consider risk equally with returns. I never forget that.



This publication is NOT deemed an offer to buy or sell securities for which more information including product prospectuses (where applicable) as well as disclosure documents would be offered.


Stephen M. Gross is a Registered Representative offering securities through Cambridge Investment Research, Inc., a Broker/Dealer, member FINRA/SIPC. Investment Advisor Representative, Stephen M. Gross, a Registered Investment Advisor, Cambridge and Stephen M. Gross, Inc. are not affiliated entities.