We believe that 2007 will be an interest rate story. An increase in 10 year bond yields above 5% will prove negative for stocks while a non-Fed induced 10 year yield that has a 4 handle on it will prove to be positive. While there has been increased speculation that the Fed will be cutting interest rates in early 2007, we believe that given current economic indicators, the Fed will be on the sidelines till at least the third quarter of 2007. GDP growth in the fourth quarter of 2006 will give us a better idea on the health of the economy and our belief is that it will probably come in at a rate that is greater than the adjusted annual rate of 2% we saw in the third quarter of 2006. This, along with a healthy employment picture and relatively stable inflation will give the stock market the confidence needed for a healthy run, at least, in the first half of 2007.  While a slowing economy will push the Fed to cut interest rates, we believe that the Fed will not take any action until the first batch of negative economic data arrives and then it is confirmed by any revisions and then reconfirmed by subsequent data in the same direction. Thus, we do not see any Fed action till the third quarter of the year and even then it is currently a toss up whether it will be a rate cut or a rate increase.

 

Sector Outlook

 

Looking ahead into 2007, we favor Technology, Healthcare, and Consumer staples stocks. While an economic slowdown is on the horizon we do not see a doom and gloom scenario for the stock market. Hence, we are positioning our portfolio into overweight positions in the defensive Healthcare and Consumer Staples stocks. We are also overweight Technology stocks in order to take advantage of what we see as a secular shift in the Technology industry. While we favored small cap stocks in 2006, we are moving up the capitalization scale with increased holdings in midcaps (2-10 Billion) in order to have almost equal holdings among the three size categories.

As we did in our 2006 outlook, we are recommending an overweight position in Technology stocks in 2007. While the technological changes we talked about in our 2006 outlook started to take shape this year, we admit that the stock price of technology shares did not respond appropriately until the second half of the year primarily due to various product delays that have been resolved already or will be resolved in 2007. Thus we continue to see increased spending in the areas of broadband video, semiconductors, RFID, interactive gaming, and payment systems. We are adding one more theme this year and it is Mobile broadband and commerce. We continue to maintain the same logic as last year and invest in companies that are enablers of these technologies. Furthermore, we predict a reasonable amount of consolidation in the technology sector and we will favor companies who we consider to be takeover targets based on their technology and their valuations. As for Healthcare and Consumer Staples, we believe these stocks will act as a hedge against a slowing economy and will provide a solid anchor to any portfolio. However, we see valuations a bit stretched in large cap stocks in these sectors and we are focusing more on mid and small cap stocks particularly in those two sectors.