Editor's note: The following review is based on the most recently available information as of September 30, 2006.

The third quarter of 2006 found the domestic economy enjoying relative tranquility. The Federal Reserve (the "Fed") cheered investors when it declined to raise interest rates at its August meeting, marking the first time in the last 18 Fed meetings that the rate, now at 5.25%, didn't increase.

Minutes of the August meeting indicated that the Fed might be willing to leave the rate alone for the foreseeable future to see how growth and inflation evolve. The Fed had been keen to the threat that inflation might pose to the economy's well-being, but recent indications of an economic slowdown have given rise to the fear that being overly vigilant on inflation by raising interest rates could push the economy into recession.

The fact the economy is slowing was borne out by figures showing that second quarter 2006 gross domestic product rose 2.6%, adjusted for inflation, whereas it had increased 5.6% in the previous quarter. Additionally, the much-anticipated decline in the housing market seems to have materialized. The U.S. Office of Federal Housing Enterprise Oversight (the "Office") reported that average home prices rose just 1.17% during the second quarter of 2006, the lowest such quarterly increase in the 31 years that the Office has kept records. Furthermore, average prices actually declined in five northern states and in more than a quarter of the nation's metropolitan areas. The Office attributed this slowdown to higher interest rates, rising inventories of houses for sale and declining speculative activity. The National Association of Realtors released figures showing existing-home sales falling 4.1% from the June-to-July period of 2006, while the Commerce Department chimed in with the news that sales of newly constructed houses dropped 4.3% in the same period.

Housing is now a buyer's market in many demographic areas, a turnaround from the situation that has prevailed for most of this decade. Buyers in a number of areas appear to expect prices to continue falling and seem emboldened by their strong position to force sellers to meet them more than halfway. We believe the shakeout in the housing market will strongly affect consumers' attitudes in the months ahead as measures of their wealth and home equity as a source of cash fluctuate with housing price movements.

In another potential indication of slackening demand, as well as positive news on the inflation front, the price of crude oil crested above $78 per barrel during the summer, then steadily declined to around $60 per barrel in late September, which has been reflected in lower retail prices for petroleum products. The announcement that Chevron had successfully tapped new oil reserves in the Gulf of Mexico provided a dose of good news at a time when this country's petroleum supply is increasingly derived from unstable and potentially hostile, foreign sources. Other factors behind the recent decline in energy prices include the absence (so far this season) of major hurricanes, as well as some perceived reduction in Middle East tensions as Israeli troops withdrew from Lebanon, and Iran has given at least some signs of willingness to negotiate on the issue of their nuclear intentions.

In response to these signs of slowing growth and reduced inflationary pressure, the Fed decided once again at its September meeting to leave rates unchanged. Future actions by the Fed will be determined by the economic data as it is revealed. In the meantime, the issue remains whether growth of the overall economy, despite some weakness in certain sectors, will be strong enough to keep upward pressure on prices, or if the economy is slowing too much, threatening a recession.

Data are likely to remain mixed. For instance, some recent statistics on wages suggest that compensation levels have been rising, at least in nominal terms, although not necessarily in real terms (that is, ahead of inflation). Retail sales also remain strong, especially as reflected in the sales reports of major retailers. At the same time, The Conference Board's Consumer Confidence Index, a representative sample of 5,000 U.S. households, registered a sharp decline in August 2006, based on respondents' pessimistic attitudes about both their current situation and future expectations. The Index then rebounded significantly in September.

Corporate profits continue to grow but at a slower rate. The U.S. Commerce Department reported that pre-tax profits grew 1.4% in the second quarter of 2006 from the previous three-month period. Increases for the two previous quarters both exceeded 10%. Nevertheless, profits in the second quarter of 2006 were nearly 20% higher than they were over the same quarter a year earlier, reflecting record profit margins despite large price increases in many raw materials inputs. While further improvement in margins will be difficult, we believe continued profit growth in line with corporate revenue growth in the 5-7% range will continue to generate tremendous amounts of cash to fund dividends, share repurchases, capital expenditures, and mergers and acquisitions. Corporate America remains quite healthy.

So does the stock market. After trading within a narrow range throughout much of the third quarter of 2006, the market began a rally as investors shook off the summer doldrums and seemed to accept that the economy's health would endure for the near future. Large-cap stocks finally began to narrow the performance gap with their smaller counterparts, as they outpaced small-caps and mid-caps during the third quarter, and have reduced the spread in performance from almost 10% in May to less than 2% at Sept. 30. Health care, telecom services and technology were the most prosperous sectors during the third quarter, with energy, industrials and materials declining. All sectors are up for 2006 through the third quarter, led by telecom services and energy.

THIRD QUARTER INDEX COMPARISONS

Source: The Wall Street Journal

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The above article is for general information only and is not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax adviser with regard to your individual situation.

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