4th Quarter 2006 Review

From the Desk of Ron Rowland

Most people consider year-end as a time for reflection. As I look back on our performance in 2006, I must say I am disappointed - but probably not for the reasons you might think.

Last year, our flagship Single Sector program failed to achieve double-digit returns and underperformed its Nasdaq benchmark by nearly three percentage points in the process. Does this disappoint me? No.

Why does this not disappoint me? I have been investing some of my personal assets in this strategy for nearly 20 years. I have a long history with this strategy, and it has rewarded me extremely well. I also understand this strategy. I know that it has extremely low correlation to the stock market, and I accept that it is more volatile than the stock market. Most important, I have the right expectations.

What does "low correlation" mean? It means the stock market and the Single Sector strategy do not tend to move together. While both have attractive long-term growth, there are many times when one goes up while the other goes down. This is an attractive characteristic from a diversification point of view.

Many of our clients invest with us for precisely this reason - they want to have part of their portfolio in something that can zig when the market zags. Inevitably, however, it works the other way around. Sometimes Single Sector trails the market. Does this mean our strategy is broken? No, quite the opposite. It means our strategy is doing exactly what it is supposed to do.

The Single Sector strategy has double-digit returns on average, so from that perspective 2006 was a below average year. It is important to understand that volatile investments seldom, if ever, have an "average" year. Most years are either above average or below average. Aggressive strategies like Single Sector are likely to be far above average or far below average. I understand this and accept this.

The returns of the Single Sector strategy are completely different from the returns of its benchmark, even while it has delivered very attractive long-term results. The best way to use this strategy is in combination with other asset classes to create a portfolio with attractive returns at manageable risk.

One thing I am not satisfied with is our risk management techniques. While we have succeeded in avoiding major capital losses, I believe our methods may be costing us too much in terms of reduced gains. One of my goals for 2007 is to enhance the risk management techniques we use within each of our strategies.

Diversification among non-correlated asset classes (or strategies) is still one of the best risk management techniques available for your overall portfolio. We have a variety of ways to accomplish this. I encourage you to speak with your representative to see if there are any adjustments that would help you meet your objectives.

The Quarter in Review

While 2006 had more than its fair share of ups and downs, the stock market in general finished up nicely to close out the year. This means the market was higher on Dec 31, 2006 than it was on Dec 31, 2005. Although just a snapshot in time, the year-end performance numbers are always very important to investors.

Nevertheless, the year-end numbers rarely tell the full story of what actually transpired during the year. In 2006 we saw a huge rally early in the year, a major market correction over the spring and summer months, then a smart rebound in the last quarter. In some ways, 2006 was one of the more volatile years in memory.

Hidden within the annual results is the fact that 2006 was a year we saw many shifts in major economic and political trends. The biggest change happened early in the year with Benjamin Bernanke taking over for Alan Greenspan as the head of the Federal Reserve Board. The year 2006 also brought a big change in the fast-growing real estate market. Many economists have long been calling for the "bursting of the housing bubble", but 2006 was the year we saw the first signs of actual housing weakness. This happened in part because of the upward move in short-term interest rates introduced by Mr. Bernanke. Many market analysts feared over the summer that this would send the U.S. economy into a recession. This is a real possibility, and it hasn't gone away.

The year 2006 may also be remembered as the year commodities took center stage. Prices for oil, gasoline, steel, copper, gold and most other commodities were in the headlines frequently. All made several big price spikes and reversals throughout the year, which even caused the collapse of a large commodity hedge fund.

Another big change came late in the year with the results of the U.S. elections. While the immediate financial impact was minor, the election signaled a major change in mindset of some Americans and led to the shift in our foreign policy that we're seeing today.

There is a seasonal tendency for the fourth quarter to provide major rallies, and that seems to be a likely scenario for this year as well. January could, as it often does, bring a change of pace. We will continue striving to capitalize on the current trend, while watching carefully for signs of change.