Stock markets end year in strong position

Smith Barney's U.S. Investment Policy Committee, a group of the firm's senior investment strategists meets weekly to review developments in the U.S. capital markets.

The committee has summarized its current view on the markets through fourth-quarter 2006, which I have provided some key points I believe investors may find useful.

Overall financial conditions were favorable through most of 2006. Bond yields, while rising, remained historically low in real (after-inflation) terms. Credit was both plentiful and relatively easy to obtain. Ample liquidity helped fuel a boom in mergers, acquisitions and private equity deals, increasing the demand for equities.

One dark lining to the economic sliver cloud: Housing markets slumped in many U.S. regions in 2006, pushing home prices lower and threatening to curb consumer spending. However, by year's end analysts were pointing to emerging signs of stability in some regional real estate markets, and consumer demand still appeared healthy.

The U.S. Stock Market

The end product of these generally favorable trends was a solidly positive year for equities, with lower levels of market volatility. Except for a brief rough patch in late spring and early summer, most major benchmarks rose gradually but steadily for most of the year, with those gains accelerating in the second half.

The S&P 500 Index returned 15.80 percent for the year and 6.70 percent in the fourth quarter, posting its largest annual gain since 2003. The Dow Jones Industrial Average set a new record high in late December, completing its long recovery from the deep 2001-'02 bear market. The Dow ended the year at 12,463.15, up from 10,717.50 at the end of 2005.

The small capitalization sector narrowly outperformed the large capitalization universe in 2006, reversing last year's relative performance trend. The value style of equity investing continued to outperform the growth style for 2006.

Telecommunications Services and Energy were the clear sector winners in 2006. The former benefited from a wave of industry mergers and rising optimism about the market for broadband services. The latter sector was lifted by high oil and gas prices and increased drilling and exploration activity.

The Health Care sector underperformed, at least on a relative basis, in 2006.

Nervousness about new regulation or government price-controls initiatives hit some major pharmaceutical and medical device companies hard in the fourth quarter, while financial problems continued to dog the hospital industry.

All 10 economic sectors in the S&P 500 Index posted positive returns, both for the year and for the fourth quarter.

Equity market gains were distributed broadly in 2006. Of the 495 stocks in the S&P 500 Index with full performance track records for the year, 386 posted positive returns while only 109 returns were negative.

The U.S. Bond Market

Treasury yields rose and prices fell in the first half of 2006 as signs of rising inflation and a strong economy led the Fed to continue pushing short-term interest rates higher. However, after lifting rates four times in the first half, the Fed signaled in August that it would pause and assess its policy. That, coupled with slowing economic growth, triggered a bond market rally that stretched into early December before hints of an economic growth revival caused yields to reverse direction in the closing weeks of 2006.

The yield on the 10-year Treasury bond ended the year at 4.71 percent, up from 4.39 percent at the end of 2005. The yield curve - the difference between long-term and short-term interest rates - remained inverted. The two-year Treasury Note ended the year yielding 4.82 or 0.11 percentage points below the yield on the 10-year note.

A healthy stock market and strong investor appetite for riskier asset classes boosted high-yield bonds.

The U.S. Economy

Economic growth downshifted in the second half of 2006, as the Fed's previous interest-rate hikes and the higher energy prices both acted as brakes on business and consumer demand.

Softness in the housing sector took a large toll on home construction, and the expansion in manufacturing slowed to a near standstill.

However, gross domestic product (GDP) continued to rise, although at a reduced rate. According to the Commerce Department the economy expanded at a 2 percent annualized pace in the third quarter, down from the 2.6 percent rate seen in the second quarter. Citigroup analysts estimate the economy grew at a 2.3 percent rate in the fourth quarter.

Despite the economic slowdown, earnings growth remained robust and labor market conditions remained favorable in 2006, as the economy added over 1.8 million net new jobs.

Inflation pressures also eased over the course of 2006, as a summer spike in oil prices was largely reversed later in the year.

International Markets

Most international equity markets performed as well or better than the S&P 500 Index in local currency terms in 2006. Currency changes, however, turned those gains into even higher returns for U.S.-based investors. The U.S. dollar lost ground against the euro and a number of other major currencies, although not the Japanese yen.

Morgan Stanley Capital International's Europe, Australasia and the Far East (EAFE) Index, a widely used benchmark for the international developed markets, returned 26.86 percent for the year in U.S. dollar terms - with nearly 10 percentage points of that annual return coming from exchange rate effects.

For more information on market and economic updates, call 689-8704 or e-mail william.a.creekbaum@smithbarney.com.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas St., Ste. 200 Reno, NV 89509.