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What to learn from 2006 and use in 2007

January 10, 2007

Before we can look forward I think that it is smart to review what happened in 2006:

Domestic Stock Markets:
* The 2006 market was interesting in the fact that the first half was pretty flat as everyone tried to figure out what the Federal Reserve was going to do with interest rates.

* The second half was El Fuego (“ON FIRE” for my spanish challenged listeners). The Fed decided to take a break with interest rates, oil prices dropped, everybody and their brother decided it was a good time to merge with other businesses, corporate profits were better than anticipated, unemployment was lower than expected, and interest rates came down.

* All of this was the perfect mix of optimism and lower inflationairy news that allowed patient long-term investors to be rewarded.

* Actual numbers for 2006 (with dividends reinvested):
S&P 500 Gained 16%
Dow Jones Industrial Average returned 19% (at an all time high)
NASDAQ was up 10% (still more than 50% below 2000 levels)

Currencies:
* The US dollar was hammered in 2006 with two heavy drops. One around May and another in November. This was attributed to countries spreading out their foreign-exchange holdings. The euro was the primary winner in this adjustment of the dollar

Commodities:

* Gold had a great run in 2006 hitting a peak of $750 an ounce in May, but has settled back below $600. A large part of this is attributable to inflation concerns for the first part of 2006.
* Oil surged near $80/barrel when their was unrest concerning Lebanon and Israel, but that hot spot has settled down and oil has dropped below $55/barrel.

Weather:

* There were predictions from weather experts that nine or more hurricanes, including at least five with rooflifting winds of 111 to 130 miles per hour, would batter the Caribbean and US this fall (“Fair Weather’s Friend,” July 10, 2006).
* 2006 hurricane season proved to be one of the mildest on record, with just five storms, none of which made landfall in the US.

So What Can We Learn from 2006 and Use in 2007?

* First a word of caution… It concerns me that the markets have started to attract the attention of the media. It is not a good indicator for the financial markets when the evening news programs focus on record stock prices and opportunities for the average investor. As many of you are aware, there are financial rewards for being a contrarian and moving away from the actions of the masses. Remember what the Oracle from Omaha Warren Buffet said in his 2005 Berkshire Hathaway annual report, “investors should try to be fearful when others are greedy and greedy only when others are fearful”.

* However, there is enough pessimism in the marketplace to not be overly concerned and still feel that there is opportunity in 2007. Tax rates remain low, monetary policy is not too tight, valuations of US companies are not at unreasonable levels, corporate balance sheets are in their best shape in more than 50 years, and GDP growth should continue to be healthy.

* Make 2007 the year that you get your financial house in order by making sure that your Wills are up to date, Life Insurance is adequate to replace your income for your family, and to finally diversify your investment holdings.

* Let’s get into the numbers a little and speak about the opportunity that large US multinational Corporations have in 2007, especially those who derive a large percentage of their profits from overseas. According to Barron’s the following companies could take advantage of the dollar’s 10% value decrease and the slowing US economy with their foreign operations: Intel receives 85% of its revenue from outside the US, Coca-Cola – 71%, McDonald’s – 66%, IBM – 62%, and ExxonMobil – 69%. Remember that I am not a big fan of picking individual stocks. I think that average long-term investor would be better served by buying large cap index funds and Exchange Traded Funds (lower risk through diversification, and dirt cheap access to stocks).

Quick and Dirty 2007 Predictions (if I am wrong we can review my errors next year, but if I am right I can brag about my pontification skills):

Domestic Equity = Large-cap stocks are better valued and positioned better than small-cap stocks to do well in 2007.
International Equity = The decline of the dollar provides some momentum for international stocks, and let’s not forget that one of the driving factors of economic globilization is the high skill/low wage factor that many areas like Asia/South America provide to the world economy. Void of an American recession, International holdings should do well, but please recognize the added return comes with risk of volatility.
Debt Securities (Bonds) = The Fed raised interest rates 17 consecutive times because they are trying to control the core inflation rate (if inflation moderates to the desired 1% to 2% level, look for the Fed to start reversing the increases). As many of you are aware when interest rates are lowered it increases the value of existing bonds that were issued at higher rates.
Hedged Securities = Hedge Funds seek to make money by using the inefficiencies in the investment markets. Their returns have been positive in the last year, but those returns have significantly trailed traditional market returns. This is to be expected becuase Hedge Funds have the added flexibility to make money by selling investments that they believe will fall in price and value. Because there is some risk that the economy will slow down or have volatility due to world events I am using Hedge Funds to do just as their name implies… Hedge against downward risk.
Real Estate = Valuations on real estate, especially REITS, are still sky high. I have been calling for a pullback in this asset class for the last two years, and yet somehow it continues to outperform. I will make another call to be careful with REIT investments in 2007. Historic valuations show that they trade at prices much higher than traditionally paid for such investments.
Commodities = I think the recent drop in oil is probably short lived. There is just too much volatility in the world to think that prices will stay settled. Oil demand will be up in 2007 and supply may be tighter if some of the controlling organizations have their way (OPEC). Probably some opportunity in this asset class (but please do not bet the farm, house, and everything else on this volatile asset class).

Disclosure:

Brian Preston is a Partner with Preston & Cleveland Wealth Management, LLC. Preston & Cleveland Wealth Management, LLC is a Registered Investment Advisory Firm regulated by the SEC in accordance and compliance with applicable securities laws and regulations. Preston & Cleveland Wealth Management, LLC does not render or offer to render personalized investment or tax advice through this program. This program is limited to dissemination of general information about financial topics. The information provided is for informational purposes only and does not constitute financial, investment or legal advice. Investment advisory services can only be rendered after delivery of the firm’s disclosure statement (Form ADV Part II) by Preston & Cleveland Wealth Management, LLC and execution of an investment advisory agreement between the client and Preston & Cleveland Wealth Management, LLC.

General investment, financial planning or other information discussed here are for illustration purposes only. Investment and financial planning is long-term oriented. Any strategies that you consider implementing, or changes in your financial situation should be brought to the attention of your professional Investment Advisor. The information available in this program is general in nature and should not be construed as personalized investment or financial advice. Please contact your professional Registered Investment Adviser regarding your specific investment planning needs.

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