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The third quarter was characterized by falling oil prices due to a benign hurricane season and to a perceived cooling of geopolitical tensions over Iran and Lebanon. Gasoline prices have now come down a full ten percent relative to one year ago, and although we believe that a long term bull market for commodities and oil is still intact, a short term pullback may continue until the November elections.

Despite the negative wealth effect due to a moderating housing market, higher interest rates, and still elevated energy prices, a downturn in consumer spending has so far been lower than expected, although there is a shift taking place in the pattern of spending. While consumers are still focusing on items for their homes and on electronics, they are spending much less on new cars (which is why the “big three” automakers have drastically curtailed production for Q4). Retail sales growth (excluding automobiles) is still around 7.5%, having peaked in January at 10%. The average growth in retail sales for the past ten years has been around 6%, demonstrating that American consumers are slowing from an “extremely high” level of spending to simply “reasonably high” levels. While auto manufacturers and homebuilders have suffered this year, there is no drought in the consumer’s garden. Wages are still growing in the U.S. as average weekly earnings were up 4.2% year-on-year in the month of August. Headline inflation is still high at 3.8% but should be coming down due to moderating commodity costs, and lower housing prices. September 28 marked the second consecutive meeting of the Federal Reserve Board in which policy-makers decided leave rates unchanged after 17 straight hikes from mid-2004 to June of this year.

As a result of all of these effects, the third quarter was sanguine for the stock market. Traditionally, September and October are turbulent months for stocks, and so far, this has not been the case. The risks going forward remain tied to consumer spending, as the full effects of adjustable rate mortgages ratcheting up have not yet been fully built into the economy (most ARM’s have annual resets, so many mortgage holders face higher mortgage bills next year). Also, as the savings rate has been negative for 16 consecutive months, we question how long consumers will continue spending at current rates. For the moment we continue to watch the market climb in the face of pessimism, taking comfort in the fact that for the past three years, earnings growth of the S+P has exceeded the stock market’s actual performance. The potential effect of a Democratic victory in November on the stock market remains uncertain as the U.S. commitment to an ongoing military effort in Iraq will likely continue regardless of which party takes control of the house, which will lead to further increases in the alarmingly high national debt, and a lower U.S. dollar. For the first three quarters of 2006, the Dow gained 8.9%, the S&P rose 7.0%, and the Nasdaq gained 2.4%.

Grant Rogers Elizabeth Allen

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