The Federal Reserve’s (the Fed’s) decision to pause in its interest rate-hiking campaign, on August 8^th, sparked a rally across almost all major equity indices. The Dow Jones Industrial Average returned 12.72 percent, including dividends, to close at 12,080, as of the end of October. The more broadly based Standard & Poor’s (S&P) 500 Index also fared well, with a total return of 10.39 percent, closing at 1,378. The Nasdaq Composite Index, heavily weighted with technology stocks, bounced back from a poor second quarter showing to close at 2,367, leaving it up 7.32 percent, as of the end of October.

Value stocks surged ahead of growth, extending their leadership position for the year. The Russell 1000 Value Index increased 16.89 percent, while the Russell 1000 Growth Index only achieved a 6.59 percent return. These year-to-date returns illustrate the reward for overweighting value instead of growth. Value also outpaced growth among small capitalization companies through October, as the Russell 2000 Value Index finished up 19.02 percent, while the Russell 2000 Growth Index was up 10.96 percent.

Foreign markets also performed well, which is especially encouraging given their relatively weak second quarter. The MSCI EAFE Index for developed markets delivered a gain of 16.51 percent, while the MSCI Emerging Markets Index returned 15.28 percent, both in U.S. dollar terms.

A cease-fire between Israel and Hezbollah, as well as an end to the summer driving season, helped send oil prices below $60 per barrel, a significant decrease from their $77-per-barrel high in July. The resulting drop in gasoline prices translated into extra money in consumers’ pockets, which could help spur spending in the months ahead.

Inflation Data Mixed

There appear to be varying opinions on the outlook for inflation. The camp that believes inflation is still a concern cite the 2.5-percent year-over-year increase in the core Personal Consumption Expenditure deflator – a number that is above the Fed’s stated one to two percent comfort zone. High wages as measured by unit labor costs, also have the potential to add to inflation pressures. In September, the Department of Labor revised both first and second quarter unit labor costs up to 9 percent (from 2.5 percent) and 4.9 percent (from 4.2 percent), respectively. Inflation doves, meanwhile, believe the lagged effect of prior rate hikes, as well as a decline in home prices, should help to ease inflation pressures in the months ahead. (Note: The sharp decline in oil and natural gas prices has little impact on core inflation readings, which exclude food and energy prices.)

The Fed left its target federal funds rate unchanged at 5.25 percent for the third straight meeting, in October, and appears to be satisfied that its 17 prior rate hikes have achieved their goal of containing inflation. The market is currently pricing in no additional rate hikes, with a high probability of a rate cut during early 2007.

Interest Rate Outlook Fuels Bond Market Rally

Bond investors finally got some relief from the Fed and sent prices markedly higher. Yields, which move inversely to price, fell across the U.S. Treasury curve, with the benchmark 10-year Treasury note closing out October at 4.55 percent. Other maturities are offering similar yields; the 5-year and 2-year notes are at 4.51 percent and 4.63 percent, respectively, and the 30-year bond yield is at 4.67 percent.

The current difference in bond yields indicate and inversion of the yield curve – a condition in which short-term bond yield are higher than longer-term maturities. This occurs when the market believes that the pace of economic growth will start to decline, thereby prompting the Fed to cut short-term rates to help stimulate the economy. Anticipating these rate cuts, investors attempt to lock in current yields by purchasing intermediate to long-term bonds and sending their yields lower.

The Lehman Brothers Aggregate Bond Index enjoyed a total return of 3.74 percent, as of the end of October, after finishing each of the first two quarters of 2006 in negative territory. Lower-rated and typically riskier high-yield bonds also performed well, as the Lehman Brothers U.S. Corporate High-Yield Index advanced 8.80 percent. Bond default rates are currently less than 2 percent-very low by historical standards-but could increase with signs of economic weakness.

Is the Stock Market Rally Sustainable?

An inverted yield curve typically predicts that the economy will weaken, yet stock market valuations remain elevated, due to strong profit growth. In the meantime, the possible continued decline in the housing market has the potential to hurt the job market and corporate profits. Investor optimism, therefore, may be tempered if earnings start to fall short of estimates. In addition, there are several other issues that threaten the sustainability of the U.S. stock market’s recent upward trend. Government policy, the war in Iraq, and the global geopolitical picture, are momentum busters.

During October, when the Dow Jones Industrial Average broke its previous record of 11,722, investors began to feel a great deal of excitement. The media created a lot of hype about the new "bull" market for stocks. Somehow, my feelings were much different. The last time the Dow was at these levels was in January of 2000. It took us seven years to regain what has been lost during the recession of 2000 to 2002. Although I am a believer in long-term investing, seven years is a long time to get back to even. One of the most important lessons investors should learn from this seven-year journey back to 12,000 is that diversification into other asset classes is essential in attempting to achieve consist, positive results. Investors need to stop obsessing about the "Dow" and become better educated about other investment sectors such as bond, real estate, commodities, and international opportunities.

Definitions & Disclosures: All indices are unmanaged and investors cannot actually invest directly into an index. Past performance is not indicative of future results. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures all Nasdaq domestic and non-U.S.-based common stocks listed on the Nasdaq Stock Market. The Russell 1000^AE Value Index measures the performance of Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000^AE Growth Index measures the performance of Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000^AE Value Index measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000^AE Growth Index measures the performance of Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. The Lehman Brothers Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated, including government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Lehman Brothers U.S. Corporate High-Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market, excluding emerging markets debt.