12.31.2006Fourth Quarter Client Newsletter Economic Update: Not Too Hot, Not Too Cold, Just Right The economy is growing, but growing more slowly. Real GDP, net of inflation, increased at an annual rate of 2.0% in Q3 2006. If the economy grows too fast, then investors worry about rising interest rates. If the economy doesn’t grow or grows too slow, then investors worry about lower earnings. Well, at this moment, the economy is growing just right. Though it never seems to be a perfect economic environment as someone is always complaining about something, the economy is growing, corporate profits are soaring, and the unemployment rate is only 4.5% as depicted by the chart below. US Unemployment Rate The last difficult employment market was 1982 when the unemployment rate was 10.8%. Since that time the unemployment rate has steadily dropped. Low unemployment is causing wage growth of about 7%-8% year-over-year. This indicates that the U.S. economy is in a sweet spot--growing neither too quickly nor too slowly. Market Update: International Markets are Red Hot Riskier asset classes, led by emerging market and international equities, continue to outperform US equities. A reason for the tremendous gains in the international equities is that 77% of all US investor equity mutual funds inflows were invested in international mutual funds. Trim Tabs, a market research firm, calculates, in 2007, that US investors have taken out $21 million from US equity mutual funds, while international mutual funds have received $7 billion. The US market is staying true to form. During the 3rd year of a US Presidential term, the market typically out-performs; the S&P500 was up 6.5% in 4Q 2006. The Dow Jones Industrial Average (DJIA) is hitting new highs although US investors are net sellers of US equities. The persistent lack of interest in US equities could be positive for the US stock market. Portfolio Update: Reduce Portfolio Risk Last quarter, we began increasing our US large company holdings. This shift from US small companies to US large companies appears to be a common theme in the market. I like to be a contrarian, but there are so many investment firms telling their clients to buy US large companies that it will cause US large company stocks to outperform. Not only that, but there are now many reasons to own US large companies instead of US small companies: (1) small companies outperform large companies in rising interest rate environments. The Federal Reserve stopped raising interest rates in June 2006. Coincidentally, large companies began to out perform small in July 2006; (2) if the market were to sell off, US large companies typically go down less than US small as large companies are more predictable and safer; (3) US large companies are cheap. Since 2000, S&P500 earnings have risen 57% from $52.00 to $81.96. In the meantime, the S&P500 index has risen only 7%. In the same timeframe small companies, depicted by the S&P600, are up 116%. For the last few years, we have owned more international equities than domestic. It is time to pare these positions back, realize some of the gains, and re-invest in the US stock market. We believe it is time to begin easing out of some of your international equities in anticipation of the US market being the safe haven for investors. Thank you for your continued trust and support. Trevor K. Holsinger, CFP