US equities advanced solidly in 2006 as corporate profits continued to surge, investors overcame fears that the Federal Reserve would trigger a recession through continued increases in overnight interest rates, and crude oil prices declined $18 a barrel from a summer high of just over $78. The Standard and Poor’s 500 index returned 13.6% (before dividends), advancing from 1248 to 1418. Looking forward, we see some weakness in stocks for the first half of the year followed by gains in the second. Our year-end target for the S&P500 is 1525.

We foresee a correction in stocks for the first half of the year for multiple reasons. The main reason is that stocks are working off a heavily overbought condition since rallying almost nonstop since late July into early December. By overbought we mean that buyers have exhausted themselves in the medium-term. The majority of investors have bought into this rally, and there are few remaining to buy in and drive the rally higher. Symptomatic of the overbought condition is the pervasive bullishness among investment advisers and Wall Street strategists. For the first time since 2001, all major Wall Street strategists are predicting gains for the year. This overbought condition can take several months to correct itself, requiring lower prices in the interim. We see ultimate downside support in the S&P500 at 1275. Once the selling has run its course with the liquidity of potential buyers restored, the market can resume its advance.

Fundamentally, we believe earnings will decelerate, giving impetus to the first half correction. Economic growth has already begun to slow and earnings will not likely maintain the rapid pace of growth that investors have become accustomed to. Much of the economic slowdown has been driven by weakness in the housing and auto sectors. Housing experienced a bubble over the past five years and has begun to substantially correct since the summer of 2005. The weakness in housing has multiple impacts on the broader economy. Directly, it decreases demand for materials, transportation and labor. Indirectly, it weakens consumers by depreciating their largest asset making them feel less wealthy and therefore less likely to spend, and it lowers the consumers’ ability to extract cash from their homes in the form of a home equity loan or mortgage refinancing. The auto sector faces high levels of overcapacity as it deals with the hangover from many years of heavy rebating and zero percent financing, and the continued loss of market share to Japanese competitors, especially Toyota. This retrenching by the auto industry is leading to further lessening in demand for material, transportation and labor.

We believe that the recessions in the housing and auto sectors of the economy will not spread to the wider business world, and this gives us confidence in our forecast that US stocks will still have positive returns for 2007. We believe that booms cause busts, as they have to substantial effect in the housing market. Business generally, however, has not been driven to such excess. Learning from the boom-bust cycle of the late 1990s-early 2000s, corporate managers have been extremely disciplined in adding capacity to their businesses, and have essentially been running their businesses to generate cash, which they have widely returned to shareholders in the form of increased dividends and stock buybacks. This reluctance to add capacity has precluded the excesses which have traditionally driven down corporate profits and stock prices. Therefore, while we believe corporate profits will decelerate as stated above, we also believe they will continue to grow at a healthy, albeit slower rate.

On the interest rate front, yields on the benchmark ten-year US Treasury note increased from 4.39% to 4.71%. The Federal Funds overnight interest rate rose from 4.25% to 5.25%. As you can see from the above figures, the overnight rate is currently 54 basis points above the ten-year rate. This is known as an inversion, and as we have discussed in previous reviews, it is typically an indicator of future economic weakness, if not outright recession. Some believe that the current inversion is not so much a forecast of future weakness, but rather a manifestation of the massive amount of dollars being reinvested by foreign exporters into the US Treasury market. This massive buying by foreigners is supposedly artificially lowering long-term US rates below where they would otherwise be given the economic environment. As we have stated above, we believe the economy will slow, profits will decelerate, but we do not see recession. If the economic weakness begins to impact employment, we believe the Federal Reserve will begin to cut overnight interest rates. The Federal Reserve has claimed to be focused on the possibility of further tightening to forestall inflation, but we believe this is largely rhetoric, as inflation has already rolled over in the data since peaking this summer, and should continue to moderate as the economy slows further. We believe the Fed’s next move is a rate cut rather than an increase. Such a cut may act as a catalyst to get the market moving on our predicted second half stock rally.

To recap, we are bullish on stocks for 2007, with a year end target for the S&P500 of 1525. We see significant downside support for the index at 1275. We foresee weakness in the first half as the market relieves its current overbought status and comes to grips with slower corporate profit growth. Once it realizes that profits will stabilize and continue to grow, the market, having shed its overbought condition, may continue its advance. A possible Federal Reserve rate cut could prompt a second half rally, just as their August pause helped ignite the rally this past summer.

As always, our focus continues to be on developing a diversified portfolio of shares in high quality companies at a reasonable price. We may contract and expand your overall equity exposure based on our general market forecast. Please feel free to contact us at anytime to discuss your individual investment position. Because Patrick Mauro Investment Advisor, Inc. is regulated by the state of Illinois, these state regulations require that you be offered a disclosure document (ADV-Part II). This form is on file with the Secretary of State’s office (Securities Department) and is available to you by merely writing a request to this firm. We appreciate the confidence you have shown in our firm, and will endeavor to continue to earn that confidence.

Patrick Mauro, Daniel Mauro, Henry Criz