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Economic and Market Comments

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Note from Professor Vitaliy: The writer of this piece, Michael Conn, is a president and founder of Investment Management Associates, Inc. He is a Chartered Financial Analyst and has been in the investment industry since 1968. Michael and I work side by side and look at the world in a similar way, the only difference is he's been doing this a bit longer (ok, he has ties older than me).

As expected, 2005 was not a banner year for the stock market. At least the fourth quarter closed the year on a positive note in spite of concern by some of what an inversion of the yield curve might portend.

In the past, an inverted yield curve, with short term rates higher than long term rates, has often preceded a recession as the bond market expects the Fed to cut rates to shore up the economy. The inversions of 1995 and 1998 didn't signal anything much. The current curve is better described as flat, and the low long term rates may have more to do with a build-up of dollars overseas than expectations that the Fed will begin a policy of lowering short-term rates. On the contrary, the speculation is whether the strength of the economy will induce the Fed to keep raising interest rates. Probably the biggest surprise of 2005 was the ability of the economy to maintain a solid rate of growth in the face of the sharp rise in oil prices. We expect housing and the consumer to pass the baton to business spending as the driver for economic growth in 2006. Corporations are flush with cash and have postponed expansion and hiring while demand has grown. Employment growth should help mitigate any slowdown in consumer spending, and we expect real growth of three to three and one-half percent in the coming year.

Core inflation has remained at 2% or below and so far has reflected little push in overall prices from the increase in oil prices. While oil and other commodity prices may not decline significantly as Japan and the European economies begin to recover, these prices have likely reached their highs. While the payroll and unemployment numbers have strengthened, the increase in wages has been matched or exceeded by productivity gains keeping labor units in check. These unit labor costs are likely to be the canary in the mine that the Fed, under Mr. Bernanke, will be watching to head off inflationary pressures. The most likely scenario is for the Fed to increase short-term rates only one or two more times and then be alert to the condition of the aging economic recovery.

Corporate profit growth is likely to decline from 2005's 13% to a still above average 10% this year. This has brought overall market valuations in line with historical averages. The problem is that the market has very seldom stayed at average valuations for any length of time, but usually has just briefly visited average on its way to very undervalued or very overvalued. As the economy seems to be in a sustainable growth mode with, as of yet, few signs of real inflation pressures, it is difficult to see what would cause the Fed to adopt a more restrictive policy placing downward pressure on the market. Likewise, it does not appear necessary for the Fed to stimulate the economy and thus the market. We are left with no conviction in a significant move in the overall market either up or down. The market is most likely to be bound in a fairly narrow range, and in this environment containing risk levels becomes as important as potential up side. We believe momentum investing will be hazardous in 2006, and that rigorous discipline on the fundamentals of earnings, cash flow, and balance sheets will once again reduce risks and produce positive returns.

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No positions in stocks mentioned.

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