2005 Scorecard
     As predicted, U.S. equity markets were range-bound throughout most of the year, with a year-end rally pushing most stock indexes into positive territory.  Despite higher oil prices, rising interest rates, and two devastating hurricanes, the consumer remained resilient.  This, combined with the hope that we are nearing the end of the Fed's restrictive monetary actions, resulted in a strong fourth quarter and first week of 2006.  With most major U.S. market indexes in the red for the first 10 months of the year, the S&P 500 managed to finish the year up about 3%, the Dow Jones Industrial Average ended down 0.6 %, and Nasdaq added about 2.5%.  Overseas markets did extremely well, with major European indexes up 14% and Japan's Nikkei index up a whopping 40%.
          Pundits agreed the Fed would raise rates throughout 2005, and those expectations held true.  The Federal Reserve upped the fed funds rate each time they met last year, with eight 25 basis point increases.  This raised the Fed Funds rate from a low of 2.25% in December 2004 to its current level of 4.25%.  Nonetheless, interest rates are still at historically low levels, with the 10-year note yield currently at 4.35% (roughly unchanged for the year) and the 30-year bond yield at 4.53% (actually down from last year's 4.9%).
     Crude oil prices continued to increase throughout 2005 from roughly $42/bbl to nearly $61/bbl at year-end.  Prices spiked considerably during the devastating hurricane season, reaching highs near $70/bbl in August and September.  The big difference for the economy in 2005 was that these increases were immediately passed along to the consumer, with pump prices approaching and even exceeding $3 per gallon in some areas, before settling to their current levels in the $2.30 to $2.50 range.  Miraculously, inflation remained subdued, with the CPI virtually unchanged from November to November at a level near 3.5%.  Going forward, the expectation is for a continued rise in inflation, albeit at a decelerating pace, indicating that inflation expectations may have peaked.

The Economy in 2006
     We are quite surprised that economic growth in 2005 repeatedly defied the aforementioned negative implications related to rates, oil, and hurricanes.  Consensus estimates for growth in 2006 hover around the 3.5% range, which is a drop from eight consecutive quarters of 4% growth that likely ended in the third quarter.  Fourth quarter estimates are now under 3%, leading many economists to re-evaluate 2006 projections due to concerns about the consumer and the still-pending Fed increases. 
     St. Nicholas had predicted last year that the economy would return to a more stabilized (and sustainable) level of economic growth, and it appears that the slowing fourth quarter growth puts that forecast right on target.  With oil prices again approaching all-time highs and natural gas prices sometimes in tow, a tightly-strapped consumer after a robust holiday shopping season, and mounting evidence of a slowing housing market, we are now looking for a continued pullback from recent higher growth levels and the possibility that we may even see a quarter or two of below consensus growth.  However, this is not necessarily a big negative given that business spending could boost employment, resulting in a lessening of the retrenchment effects of lower consumer activity.
     The biggest risk to this Goldilocks scenario of moderate but positive economic growth lies mainly in the duration of Fed rate increases.  If the Fed limits its actions to just one or two more rate hikes, we should be OK, but any further increases (or even the notion that they are not done), can bring figurative dark clouds well before the next hurricane season does it literally.  Risks are also inherent in continued energy price increases, the war in Iraq, and increased protectionist rhetoric.  All things considered, economic growth in 2006 should be stable and at a level high enough to allow earnings growth to accelerate and provide support for continued increases in equity prices.

The Stock Markets in 2006
     We began the stock market year with a bang -  major US indexes were up more in price the first two weeks than in all of 2005.  As a matter of fact, this year's rally marks the first time since 1987 that all three major indexes (DJIA, S&P 500, and NASDAQ) have gained in each trading day during the first full week of the year.  If you hold to the "as January goes, so goes the year" axiom, then 2006 is off to a great start.  If 1987 sticks out in your mind as a year to forget, then caution should be your mantra.  Here's another little tidbit of trivia:  Now that the DJIA has crossed 11,000, can you guess how many times this has happened since 1999?  If you answered 19, you are correct and probably follow the market as closely as any investment professional out there.  For the rest of us who may have had little clue, don't fret if it seems like 19 is an unbelievable number given where the market has come from - all 19 of those instances came between 1999 and 2001, so you should rightly feel like 11,000 is new territory.
     In spite of the fact that we have already hinted that the markets may be a little ahead of economic growth, there is still light at the end of the equity tunnel.  While the recent resurgence in stock prices is mainly a function of the purported end in the Fed's tightening cycle, we think there are other positives in place to support a better year for stocks.  We've already mentioned that consumer spending has room to slow as supports from job growth and capital spending step in.  We also feel that stock valuations are more definable with the settling of interest rates, the easing of inflation, the visibility of earnings, and the stabilization of economic growth.  Additionally, corporate activity in the form of rising dividends, stock buybacks, and mergers should be even stronger than last year.  We go against the grain a bit in our continued attraction to the energy sector, but also look for other sectors like technology, capital goods, health care, and even metals to emerge in leadership categories.
     There are some pitfalls that we will watch for that could stall any sustainable rallies.  Of greatest importance is the Fed - if Bernanke (Greenspan's successor) doesn't halt the rate increases shortly, the message to the markets will be largely negative and stock prices will halt in their tracks.  Also, even though we are positive on energy stocks, we still only look for oil prices to remain in the $55 - $65 range.  Any sustainable move outside the top of that range and consumers will again feel the need to further reduce spending.  We are looking for more of a soft landing in the housing sector, but severe price declines in too many regions will turn out to be another consumer spending decline catalyst.  Finally, the end of inflation is not always a great thing - if corporations do not have the ability to pass along still higher production and raw materials costs, earnings growth becomes more questionable.
     In summary, St. Nicholas looks for a better year in stocks.  2006 is both a mid-term election year and the second year of a presidential term, each of which generally brings only single-digit returns.  The rub, as pointed out by Schwab's Chief Investment Strategist, Liz Ann Sonders, is that we've already had two back-to-back years of single digit gains and never before has the S&P 500 had three consecutive years of single-digit gains.  We remain in the positive camp and think that there is better potential for a double-digit return year than a 2006 market decline.

Bonds and Inflation in 2006
     This will be our first Outlook Letter where the bond call has not been an easy one.  In the past, we simply listened to the Fed - they said they would continue to raise rates, so our forecast was for increasing rates.  Now we are looking for a cease-fire from the Fed sometime in the first quarter of this year.  If that occurs, look for bonds to produce returns that are pretty much in line with their coupons.  If the Fed tightens beyond Q1, bonds will remain flat to negative and should produce total returns somewhere between zero and four percent.  We support the former argument, and look for a better return year for bondholders than they experienced in 2005.
     In closing, we remain cautiously optimistic on all fronts - looking for slowing but moderate economic growth, a little better overall year for stocks with continued earnings growth potential, and an end in the Fed's restrictive policies.  However, our experience in the investment world has led us to believe strongly in the age-old adage that "forecasting is always a difficult endeavor - particularly when it involves the future."  All kidding aside, we again thank those that have remained confident in our management abilities, and welcome those who would like to enjoy a truly unique and successful financial management experience.