A Surprisingly Good Year for Stocks

Thanks to Kevin O'Keefe, CIMAR, AIFR for writing this commentary that originally appeared in First Affirmative Financial Network's Market Commentary. Kevin is the Chief Investment Officer of FAFN.

The booming stock markets of 2006 caught many by surprise. Of 62 categories of stock-focused mutual funds tracked by research firm Lipper Inc., 51 categories had double-digit returns for the year. The S&P 500-stock index gained 15.8%, and the Russell 2000, a widely followed index of small-company stocks, advanced 18.4%. The MSCI EAFE Index, which represents international stocks, gained 26.3%. All 18 broad sectors tracked by Dow Jones Indexes, finished up for the year.

Value-oriented mutual funds continued their dominance over growth-oriented funds, gaining 17.9%, on average, versus 5.6% for growth funds. The average small-cap core fund also continued to outperform the average large-cap core fund, 14.9% vs. 13.5%.

International stocks were especially rewarding in 2006, with healthy earnings overseas and a weakening dollar. Europe continued to reap benefits from corporate restructuring and improved export margins. For U.S. investors, the dollar's weakness against the Euro provided an added lift to returns, but even in local terms, it was a good year for the Continent, Germany in particular.

China's and India's economies continued on the fast-growth track. In late spring, the MSCI Emerging Markets Index dropped 25% and then rallied later in the year, not only to recover, but to finish the year 29% higher in dollar terms.

Most of gains realized by investors in stocks came in the second half of the year. Oil prices fell from July's record highs, and the Federal Reserve stopped raising short-term rates after more than two years of increases, which stimulated consumer spending. In addition, excess liquidity (lots of cash) drove merger activity, dividend increases and stock buybacks.

A year ago, investors fretted over prospects of slower economic growth, inflation and higher interest rates, but these pessimistic scenarios failed to materialize. The Fed managed to curb inflation without tipping the economy into recession, and the dollar weakened without going into free-fall.

Expectations for stocks are high at the moment. The "Goldilocks" economy (not too hot, not too cold) is a good environment for stocks. However, Fed Chairman Bernanke is not nearly so confident that inflation will remain low enough to preclude further rate increases.

Seasoned investors know better than to get overly bullish when expectations are generally high. So, even as we are grateful for the above-average returns that 2006 we resolve to be patient and maintain reasonable expectations about the future.