FOURTH QUARTER 2006

The final quarter of 2006 was an uncharacteristically comfortable period in the markets. US equities posted steady gains against a backdrop of moderate economic news, evenly divided opinion about the likely future course of US interest rates, and midterm election results that exceeded observers’ expectations for Democratic gains in Congress. The holiday shopping season was a bit light, but while the US stock market fell back a bit during the last two weeks of the year, it still boasted encouraging results for the quarter and the year. For the quarter, the S&P 500 returned a strong +6.70%, bringing its full-year figure to +15.81%. Mid- and small-capitalization stocks were strong in October and November, but about flat in December. For the quarter the S&P Midcap 400 index returned +6.99% (+10.31% for the year), and the Small Cap 600 index returned +7.85% (+15.11% for the year). (Index returns: Standard & Poors)

The Fed Open Market Committee (FOMC) met twice during the quarter, and left its Fed Funds target unchanged at 5.25% at both meetings. Market participants viewed the accompanying statements as conciliatory enough to indicate that the Fed may be becoming a bit less aggressive in raising rates. By year’s end, market comment seemed to focus on when the Fed might begin to lower rates, in spite of the preference of at least one FOMC member for further tightening, and reminders in the Committee’s statement that inflation risks remain. The bond market’s action seemed to agree more with the FOMC’s words — rates across the US Treasury yield curve rose a bit. The yield on the 10-year US Treasury note rose from 4.64% on September 30 to 4.71% on December 31. The two-year yield rose from 4.71% to 4.82% during the quarter. A year ago, the ten-year yield was 4.39%, and the two-year yielded 4.41%. As a result, bonds had a quiet quarter. The Lehman US Aggregate Bond index returned +1.24% for the quarter, returning +4.33% for the full year. (Index returns: Lehman Bros.; Treasury yields: US Treasury)

International equities were broadly parallel to US stocks. Measured in local currencies, the MSCI Barra EAFE international equity index (with dividends, net of local taxes) returned +7.04% (+16.46% for the year). The US dollar weakened against European currencies. It fell against the euro ($1.320 to the euro at 12/31, from $1.267on 9/30) and the pound Sterling ($1.959 to the pound on 12/31 from $1.872 on 9/30), but it rose a bit against the Japanese yen (118.95 on 12/31, up from 118.04 on 9/30). A year ago, the dollar stood at 117.94 yen, $1.184 against the euro, and $1.721 against the pound Sterling. With the currency movements, EAFE in US dollars returned +10.35% for the quarter; +26.34% for the year. (Index returns: MSCI Barra; Currency rates: Yahoo! Finance)

After a strong first quarter, US markets continued their upward trend in April and into May. The S&P 500 rose +1.34% in April, and by May 9, it had returned +6.82% year to date. On May 10, the Fed Open Market Committee raised its target for the Fed Funds rate by 0.25%, to 5%, as widely expected. However, the FOMC’s statement accompanying its policy announcement disappointed market participants that had been looking for a signal that the Fed’s string of rate increases may be nearing its end. The market began a persistent slide lasting about five weeks. Between May 9 and June 13, the S&P 500 index lost –7.42%, before recovering a bit toward the end of June. The Fed played a role then, too. On June 29 the FOMC raised its Fed Funds target again, to 5.25%, but the market read the June 29 statement as a signal that we may finally be nearing the end of rate increases. On that day the S&P 500 jumped by +2.16%. Even that wasn’t enough to overcome the earlier losses, though, and the S&P 500 returned –1.44% for the second quarter, its first negative quarterly return since the first quarter of 2005. Year-to-date, the S&P 500 has returned +2.71%. Risky assets of all types performed poorly in the quarter just ended. As a result, mid- and small-capitalization stocks underperformed large stocks. The S&P Mid-cap 400 index returned –3.14% for the three months (+4.23% year to date), and the Small Cap 600 returned –4.56% (+7.69% year to date). Value stocks generally outperformed growth, more strongly among large cap stocks than among smaller ones. (Index returns: Standard & Poors)

International equities also performed poorly. Measured in local currencies, the MSCI EAFE international equity index (with dividends, net of local taxes) returned –4.25% (+3.59% year to date). The US dollar also weakened sharply in April and May, before bouncing back a bit in June. For the quarter the dollar fell from 117.71 to 114.44 yen, and weakened from $1.214 to $1.2787 against the euro, and from $1.7369 to $1.8484 against the pound Sterling. The weakness of the dollar just about offset the weakness of international equities, and the EAFE index returned +0.70% (+10.16% year to date) in US dollars. (Index returns: MSCI. Currency rates: Yahoo! Finance)

As I’ve already noted, the Fed Open Market Committee met twice during the quarter. The FOMC raised its target Fed Funds rate by +0.25% each time. That rate now stands at 5.25%. Longer-term interest rates followed suit, rising by around 0.3% up and down the yield curve. The yield on the ten-year US Treasury note rose from 4.86% to 5.15%. The two-year Treasury yield rose from 4.82% to 5.16%. The interest rate increases, on average, slightly more than offset bonds’ coupon income, and the Lehman US Aggregate Bond index fell slightly, returning –0.08% for the quarter (–0.72% year to date). (Index returns: Lehman Bros. Treasury yields: US Treasury)

Market participants entered April apprehensive about the length, breadth, and strength of the stock market’s recovery during the previous year, which had raised the US equity market by 75% its lows of March 2009. Would growth continue? Could corporate earnings reports due in the second half of April justify the levels the market had reached, or would they disappoint investors? What about the debt problems of Greece and other European countries, which seemed no nearer any resolution than when they first surfaced a few months earlier? Markets were firm in April, but as the quarter progressed, fears of a sovereign default in Europe increased, and the market sold off sharply in May. The selling continued in June, as a series of tepid economic reports contributed to a gathering atmosphere of nervousness regarding the durability of the economic recovery. Fears of an imminent European government default abated, but doubts about those nations’ financial stability persisted, contributing to the overall weakness of equity markets. The net result was a bad quarter for equities. The S&P 500 index lost –11.43%; (–6.65% for the year to June 30). Mid- and small-cap stocks did better; the S&P Midcap 400 returned 9.59% (–1.36% year to date), and the Small Cap 600 –8.73% for the quarter (–0.88% year to date). Value and growth were about even in the large- and mid-cap ranges, but small growth performed better than small value. [Index returns: Standard & Poors]

Global markets largely mirrored the US market, in part because of those continuing concerns about the Greece. The MSCI Barra EAFE international equity index ended the quarter with a return of –11.15% in local currencies (–7.34% year to date). The US dollar rose dramatically against the euro. At the end of June, the dollar stood at $1.229 to the euro, compared to $1.353 at the end of March. It also moved ahead to $1.4947 against the pound Sterling, from $1.5186 at the end of March. It dropped against the yen, ending June at 88.49 yen, compared to 93.40 in March. The overall currency effect was a negative for US investors, and EAFE returned –13.97% in US dollars for the quarter (–13.23% year to date). [Index returns: MSCI Barra. Exchange rates: Federal Reserve H.10 release]

The combination of economic concerns in the US and sovereign debt worries in Europe led to a sharp fall in US Treasury interest rates. The yield on the two-year US Treasury note ended the quarter at 0.61% (down from 1.02% on 3/31/10), and the yield on the ten-year ended June at 2.97%, well below its level of 3.84% on March 31. The Barclays Capital US Aggregate Bond index returned +3.49% for the quarter (+5.33% year to date). [Index returns: Barclays Capital. Treasury yields: US Treasury].

US markets began the year strongly. The S&P 500 index added 45 points, or around +3.7%, by January 11, before falling back at the start of earnings reporting season. The index bounced around for the rest of the quarter, ending March at nearly that same January 11 level. Including dividends, the S&P 500 returned +4.20% for the quarter. Mid- and small-capitalization stocks continued to outperform large stocks. The S&P Mid-cap 400 index returned +7.62% for the three months, and the Small Cap 600 returned +12.83%. Value stocks outperformed growth by about three percentage points across the capitalization range. (Index returns: Standard & Poors)

International equities continued to perform strongly. The US dollar also weakened slightly against the euro and the pound Sterling, adding to returns for US investors. The MSCI EAFE international equity index (with dividends, net of local taxes) returned +8.19% for the quarter in local currencies and +9.40% in US dollars. During the quarter the dollar drifted from 117.94 to 117.71 yen, and weakened from $1.184 to $1.214 against the euro, and from $1.702 to $1.7369 against the pound Sterling. (Index returns: MSCI. Currency rates: Yahoo! Finance)

While short-term US interest rates have continued to move higher, overseas interest rates have also begun to rise, curtailing the dollar’s recent advance. The Fed Open Market Committee met twice during the quarter, once under retiring chair Alan Greenspan and once under new chair Ben Bernanke. The FOMC raised its target Fed Funds rate by +0.25% each time. That rate now stands at 4.75%. This quarter, longer-term interest rates followed suit, rising by nearly one-half of one percent across the board. The yield on the ten-year US Treasury note rose from 4.39% to 4.86%. The two-year Treasury yield rose from 4.41% to 4.82%. As a result, the Lehman US Aggregate Bond index fell, returning –0.64% for the quarter. (Index returns: Lehman Bros. Treasury yields: US Treasury)