Welcome to 2006! January was a good month for most markets.

Several waves are propping a general tide of positive sentiment:

  • Market Optimism over the swearing in of Bernanke as the new Fed chief on February 1
  • Positive corporate earnings reports

Simultaneously, however, investor optimism is being tempered by:

  • Weak fourth-quarter GDP growth of 1.1%
  • Thought that the cumulative impact of the interest rate cycle – thanks to 18 months of Fed rate hikes – may now begin to weaken the earnings outlook

Most sectors should exhibit strength in 2006, however, we expect volatility to increase.

The end of Fed interest rate increases is on everyone’s horizon:  The Federal Reserve again signaled the beginning of the end of its extended streak of raising interest rates when it indicated that further increases would increasingly depend on concrete evidence of inflationary pressure. As Fed policy makers prepare to meet this week, Wall Street is wondering whether the interest rate run-up is almost over. None-the-less, another 2 or 3 rate hikes (½% to ¾%) would not surprise us.

There is a changing of the guard at the Federal Reserve.

  • The end of Alan Greenspan:  January 31 saw the last FOMC meeting that Alan Greenspan would lead. As expected, the Fed increased rates by another 0.25% to 4.5%, the fourteenth consecutive increase.
  • The beginning of Ben Bernanke:  Bernanke takes the Fed’s reins in February and has expressed a willingness to maintain Fed policies. Over time, most observers expect him to target inflation while allowing GDP to expand.

Although Greenspan is a popular hero to many, Wall Street seems unabashedly happy with Bernanke taking the helm.

TIPs vs. US Treasuries suggest rising inflation concerns:  The yield gap between 10-year Treasuries and TIPs widened 0.20% in January as investors sought inflation protection from high oil prices, strong US wage growth, low unemployment, high commodity prices, and possible further increases in the Fed rate. The difference is near current highs. TIPs are relatively cheap, and this low valuation may persist.

Mergers and acquisitions (M&A) were big in 2005:  Plentiful liquidity fueled active M&A last year, with volume nearly 40% higher than 2004. Major deals included Proctor & Gamble’s $55Billion acquisition of Gillette, BofA’s $36B purchase of MBNA, and ChevronTexaco’s $17B takeover of Unocal, as well as $1.3 trillion of European deals and $358 billion of Asian deals. Because access to capital remains easy for corporations, countries, private equity funds and hedge funds, we expect M&A momentum in 2006.


Greg P. Pellizzon
Managing Director

Michael Ashley Schulman, CFA

Hollencrest Capital Management