Saturday, January 6, 2007

News - December 2006

At Rollins Financial, we are always optimistic about investing in America and the businesses of our country, especially when considering long-term investment time horizons. This month, we would like to offer reasons for you to be confident about the upcoming year in the equity markets while also discussing some issues of concern that could possibly negatively affect the stock market and the economy in 2007.

First, we would like to address the performance of the various market indices for the year ended December 31, 2006. As the year came to a close, the market reaction was upbeat as the Dow Industrial Average moved to new all-time highs. Recent history has shown that stock market gains have increasingly accumulated towards the last half or even the final quarter of the calendar year.

Over the past few years, the actual earnings have exceeded expectations by the end of the calendar year. Analysts and corporate executives do not want to be held liable for overestimating a company’s expected performance, even though it’s clearly understood by investors to be an estimate. Whether this trend is the result of corporations and Wall Street analysts sandbagging their earnings forecasts early in the year because of increasing litigious liability or genuine conservative expectations, we may never know. This year, just as in the previous several years, the S&P 500 achieved the majority of its yearly gain over the final fourteen weeks of the calendar year.

A summary of the financial markets for the year 2006 is as follows:

The S&P 500 gained 15.8% for 2006 while the DOW gained 19.1%, the NASDAQ gained 10.4%, and the Russell 2000 gained 18.3% for the year. For the month of December, the DOW and S&P 500 gained 2.1% and 1.4%, respectively. International stocks once again outperformed the U.S. market as the MSCI EAFE index rose 26.3% and the Emerging Markets returned 30.7% (as measured by the iShares MSCI Emerging Markets Index ETF).

Real Estate, Telecom stocks, and Utilities were the most noticeable outperformers in 2006, gaining 39%, 34.17% and 20.90%, respectively, as measured by the returns of popular sector ETFs. Healthcare and Technology generally underperformed the broader markets this year.

Interest rates for the 10-year Treasury rose from 4.393% at the beginning of the year to 4.708% on December 29th, although the average mortgage rate declined ever so slightly from 6.22% to 6.18%. The increasingly followed commodity prices were erratic, as oil prices closed the year trading within one penny of the 2005 year end price – $61.05 after climbing close to $80 a barrel during the summer – while gold prices gained $118 to close 2006 at $635.20 an ounce.

The overwhelming sentiment surrounding the financial markets seems to be quite positive considering the rally that has taken place since the last week of September. One of the themes of 2006, and likely to continue into 2007, is the frequent buyout activity. Eight companies in the S&P 500 are scheduled to go private, so it’s obvious that the private equity groups feel that many public companies are trading at cheap valuations. While these groups are not infallible, they control billions of dollars and are generally run by very successful, savvy investors.

Many large mutual fund managers have remarked that these companies, although being sold at a current premium, are still not properly valued and that management, who are often involved in the negotiations, is selling out for a quick immediate gain. Those same members of management and private investors stand to make many times more when the company is brought back to the public, which is generally the ultimate goal. Corporations themselves think their stocks are good investments evidenced by the fact that record amounts of stock buyback are being authorized. Much like the private equity groups, corporations willing to invest so heavily in their own stock must be confident that their businesses are undervalued.

Confidence in the equity markets is also sustained by relatively low interest rates. There is substantial incentive for an investor to buy stocks when a government bond is only paying a return of 4.75%. Corporations will also be able to raise capital for investments in their respective businesses using debt at these low rates. As managers gain confidence in stable interest rates, they will be more willing to invest in their companies. Individuals will behave in much the same manner as a business – borrowing at low rates and investing (spending) in their own lives.

The Federal Reserve and interest rates also strikes to the heart of the obstacles facing the market this year. The housing slump has been worse than many experts predicted. It is no secret that one of the ambitions of the Fed has been to pop the housing bubble. If negative effects of the housing slump eventually materialize and spread into other areas of the economy, this could hurt the consumer and the economy overall.

One thesis is that individuals who entered into variable loans or ARMs are now having to refinance or will begin paying higher interest rates on their loans. Banks have tightened their lending practices and it may be difficult for some of these borrowers to qualify for refinanced loans. Obviously, as consumers are forced into paying more for their homes or selling them at a loss, their spending habits will be adversely affected.

Inflation is another issue to be followed closely. The Federal Reserve continues to insist that their main concern when evaluating whether they should adjust interest rates is inflation. If commodity prices continue their upward trajectory, then interest rates may be pushed higher in order to stifle demand and rising prices. The consequences of such actions could be upsetting to an economy largely dependent on consumers and their confidence.

One last thought is that the stock market rally has been almost too consistent since 2003. Corrections in stock prices are a very healthy and ordinary event, although for investors they can be uncomfortable. Several market technicians have commented that a real correction is on the horizon because that’s what is customary. We can argue about what exactly constitutes a correction, but there are those who think the 7% drop in the S&P during the end of May and into June did not qualify. Looking back, it seems that timeframe was a great buying opportunity, as would be true for most corrections.

Rest assured that there will be ups and downs throughout the year, although we do expect the broader indices to show gains by the end of the year. We will be observing these aforementioned issues closely and adjusting portfolios appropriately. Wherever the market leads us this year, at Rollins Financial we will be investing in great opportunities here in the United States as well as in markets around the globe.

Thank you again for visiting We hope this update has been useful to you. Please email us and provide us with your thoughts and comments.

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