4 Great Years in a Row...Uh...Oh!

The final quarter of 2006 produced exceptionally good quarterly results in a nearly relentless march upwards for virtually all key asset classes.

This put full-year 2006 returns well into the teens or higher for every equity asset class.  This was consistent with our view that 2006 was likely to yield a fourth consecutive year of positive results, but well beyond the level of our expectations at this point last year.

We know that some commentators…and at least a few clients…fear that these results have been too good.  Four very strong years in a row are, maybe, a once in an investing lifetime expectation, but it’s happened twice now in the past 10 years or so…and look what happened last time!  While we caution our clients to not expect this level of appreciation to continue into 2007, we believe that there are several good reasons to believe that, this time, no equity market crash is in store.

Valuations are now much more tame than at this point in late 1999, early 2000.  Today’s P/E ratio for the S&P 500 is 17 (well within the range of long term averages); in early 2000, it was over 30.  Inflation has not emerged as a significant threat (perhaps precisely because the Fed announced that it would instantly quell it if it did arise).  And energy prices are well off their peak, despite severe tensions in the Mid-East and strident anti-American rhetoric from Iran and Venezuela.  Further, no-one now expects interest rates to rise; in fact most expect short-rates to be lowered sometime in 2007.  The much bemoaned real estate bubble bursting seems to have already hit its nadir without significantly detracting from overall economic activity or crimping consumer spending.  That last factor probably stems from the very low unemployment rate and increases in real (after inflation) average earnings.  While we hesitate to appear too bullish, we have a hard time not continuing to feel reasonably optimistic about what lies ahead.

With the current exception of commodities (see the comments to follow by Jason Thomas, Karen Blodgett, and Monica Ma), we feel very good about the changes we encouraged in clients’ portfolios over this past year.  While our purpose was to improve client portfolios for long term results, we are very happy to see immediate and unexpectedly large rewards for our clients.  Leaving “absolute return” funds avoided the generally only modest results that that asset class was able to produce this year; and the heightened exposure to broadly diversified real estate was a real winner.  Similarly, in part due to the (expected) deterioration of the dollar (the Euro was up 11.5% over the course of 2006), increased exposure to overseas equities, generally, produced excellent results for clients’ portfolios.

As we did last year at this time, we present graphs below showing the performance of our clients’ portfolios over the 1, 3, and 5 years ending 10/31/06.  When we have complete data through year-end 2006, we will provide more detailed analyses of these results in a separate communication.

We are extremely pleased to be able to show that not only have clients been able to achieve excellent absolute levels of return but also that those results compare very favorably, by return and risk, to the S&P 500.

As we observed last year, these results are attributable, mostly, to our clients’ willingness to adopt our coaching on the major investment decision: the asset class architecture of their portfolios.  Less so, but still important, these good outcomes stem from the general outperformance of the specific investment vehicles we have chosen to implement those asset allocations.  If we had to succeed on only one of those dimensions, we’d pick the first; but we’re very happy to have been able to deliver good results on both.  We are confident that these two levels of decisions are likely to continue to serve our clients well as we move into this new year.

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Tom Tracy and Sandi Bragar comment below on how possible tax law changes might affect our clients.  Responding to those possibilities may be among our most significant areas of service to  you in the coming year or two.  In any event, we look forward to doing all we can to develop effective strategies for you, whether in the realm of tax, estate planning ,and/or investment, and to manage their implementation to successful results.

Happy New Year!

Tim Kochis, Editor