The stock market looped through 2006. A strong first quarter was followed by a second that gave back all the gains. The second half went up as the balance of the year unfolded. My take is that a good part of the 2007 potential gain was pulled into 2006.

Our performance was about average, with our holdings in risk adverse strategies and energy limiting our growth. We believe that it is more important then ever to remain cautious entering 2007.

The underlying pins supporting the second half advance were more emotional than rational.

Fast money, fueled by the Fed’s printing campaign and the continued explosion in hedge funds pulled the market higher.

This “ animal spirit “ was evident in the merger and acquisition activity and in the type of stocks that were advancing. By and large the stocks with the poorest fundamentals were the leaders …. with high quality companies in the rear.

Retail sales were “ ok “ for the important Christmas season as consumers continued to add to their credit card balances.

Trucking and railcar tonnage reports indicate a slowing in the economy is in place as truck tonnage in November fell to its lowest level since 2003.

Housing continued to downshift with home sales flat to slightly down. The inventory of unsold homes has stabilized as it appears many homes have been taken off the market by sellers who were testing the waters. Home builders have cut back on new construction as well. The combination of the two could get us to a bottom in the market by the fall.

There is almost universal agreement that Fed has handled the rate increases perfectly and that we will see a slightly slower economy in 2007….I am always a contrarian when we have almost unanimous agreement on anything.

Core inflation has continued above the 2 % level that the Fed is targeting. There is hope that the decline in oil prices will filter through the supply chain and restrain the current too high inflation trend.

Corporate profits continued to increase at slower rates of growth as the year progressed. The energy complex was a substantial contributor to these numbers and, with the price of oil backing up will not be a support in the fourth quarter or in 2007.

The mortgage market has turned down with late payments on the increase and walk aways starting. Banks are reporting increases in credit card defaults.

Auto and light truck sales are flat to down.

Billions of dollars in ARM mortgages issued three years ago are due for large resets this spring.

The international arena is fraught with potential problems, with the war of terrorism front and center.

The number of “ bullish “ market analysts are at 1999 and early 2000 levels. The volatility index is near its low, indicating pretty much a zero “ fear “ factor for market losses.

The bull market cycle has run longer than most do…..and, unlike normal bull cycles, there has not been any meaningful correction ( 10 % range ).

Sounds like the glass is empty, maybe leaking profusely

The confluence of all these factors, point the way to a potentially very volatile 2007.

The divided political scene is a plus for 2007. I expect Bush to finally start to wield the veto pen and the Democrats will step up the rhetoric. Inaction by Congress has never been a bad thing for either the economy or the stock market.

With both housing and autos in a funk, I expect to see GDP growth slow substantially…from the 2.5 rate in 2006 to a 1.0 rate in 2007. The risks of a recession are in the 50 % range given the factors in place.

The overseas economies have been growing faster than the US and this trend will continue in 2007. With the cheap dollar, exports will strengthen and this will be a benefit for the economy.

All told, it is easier to list the potential negatives than the positives.

We will need a vibrant consumer and a return to capital spending on a large scale by corporations who have thus far spent more on share buybacks than on additional investments in their companies.

All in all, I expect to see a volatile first quarter with more potential to the downside and we are positioned for this scenario.

The US is resilient and will weather the storm weather ahead.

But, short term investors and hedge funds will be in for a scare when the 10 % correction hits them. The hedge funds, with their rapid trading modus, will make any move down more pronounced by their quick exits at the signs of trouble.

I hope that everyone had a great holiday season. Please call if you have any questions.