CPI Runs Hot

After all the positive news over the past several weeks, today's report on the CPI was just a bit disappointing. Both the "headline" number of +0.2% and the "core" gain of +0.3% were above expectations and the prior three months levels. Of note, healthcare costs took a big jump - +0.8% - in January.

While not we're not happy with these numbers, we're not really concerned as one month does not make a trend break. We still believe inflationary pressures remain relatively mild and at a level the Fed can tolerate. Indeed it seems to us that we've entered a period of interest rate stability across the yield curve which should provide a favorable backdrop for the stockmarket.

2006 - A Quick Review

The new market year got underway yesterday with some interesting stock market action. More on 2007 in a later post. For now, let's step back for a brief review of 2006's market action.

Here are the latest twelve month returns (thru 12/29/06) for various asset classes:

S&P 500: 15.80%
3-Month T-Bill: 4.85%
LT Treas. Bonds: 1.40%
Gold (US$): 23.92%
CPI (1 Month lag): 1.97%

A couple of comments:

Most market participants were not expecting a double digit gain in the stock market at the start of 2006. But thanks to several key factors including better than expected corporate earnings, the end of Fed rate hikes, stable long term interest rates, the impact of private equity players, and perhaps the better than expected news on weather, oil, etc. Oh, by the way, the residential real estate bubble was finally pricked in 2006. Housing related equities suffered unsurprisingly, however, the economy and the rest of the stock market took the real estate troubles in stride.

Long term treasury bonds were up slightly for the year leaving long term interest rates essentially unchanged for the year. And interestingly, the CPI is running right around 2%, hardly a level for serious concern.

All-in-all, 2006 was a great year for the stock market. But that's history. We're looking forward to 2007.

Slow Growth in 2007

Over the past ten days we've seen some interesting economic reports. Last week's report on the CPI was surprisingly good - almost unbelievable. This good news was offset earlier this week by the PPI report which was much worse than expected. Today, the final report on third quarter GDP was released. It was down from the last revision to 2.0% vs 2.2% but up from the initially reported 1.7%. And also today, the Conference Board released its Leading Economic Indicators index for November, showing a gain of 0.1% - the third increase in a row - pointing to further growth in the economy.

What should we make of all these mixed reports? Simple. The economy has slowed but is still growing. Inflation is not accelerating out of control. We think that the Fed can stand pat on short term interest rates, perhaps cutting in 2007.

We're expecting more of the same economic action in 2007. That is slow GDP growth, controlled inflation, stable interest rates and rising corporate profits and cash flows. We believe that this will be a favorable environment for stocks and bonds (although our preference is for stocks) and we would tend to focus on companies with solid top line growth, stable/rising margins, and positive free cash flow generation. We expect more M&A activity across a number of sectors of the economy. And, at the risk of sounding like lemmings, our bet is that larger cap stocks will be the better play in 2007.

The risks to our scenario are the same ones we faced this year and include energy supply disruptions, terrorism, a worsening Middle East situation, N. Korea, storms etc. The new unknown is the impact of a Democrat controlled Congress. Watch taxes, particularly the talk on dividends and cap gains - as the impact would be certainly negative for stocks.

All-in-all, we think being cautiously optimistic on the economy and market in 2007 is the correct stance for now. So, don't worry, be happy and have a very. . .

Merry Christmas!