In '06, stock market banked on a soft landing

2006 was, by most measures, an exceptionally strong year for the U.S. stock markets. The Dow Jones industrial average smashed through its record high, set in January 2000, and kept rising. The Standard & Poor's 500 approached its record close. Even the tech-heavy Nasdaq, though still well shy of record territory, gained nearly 10 percent.

All this despite the fact that for much of the year, economy-watchers were fretting that the end of the housing boom would send the nation's economy into recession — if the Federal Reserve's campaign of 17 straight interest-rate increases hadn't already done the job.

So why, if stock prices are supposed to reflect how investors think companies will fare in the future, did the markets have their best year since 2003?

"It all comes down to the Fed," said Ernest Ankrim, chief investment strategist at Russell Investment Group in Tacoma.

Once it became clear in August that the Fed had stopped raising rates, investors assumed inflation was under control and recession had been avoided — the oft-sought but seldom achieved "soft landing," with corporate profits growing more slowly but more sustainably.

Then, Wall Street being Wall Street, the markets immediately began anticipating the start of an easing cycle.

"There is this opinion — it's not unanimous, but there are a lot of supporters — that interest rates are going to start coming down at the tail end of the first half of next year," said Steven Rhone, chief executive of Wentworth Hauser Violich in Seattle.

The Dow set its record close, 12,510.57, on Wednesday, before dipping to close out the year at 12,463.15. That still was good enough to give the Dow a 6.7 percent gain for the fourth quarter and a 16.3 percent gain on the year.

The S&P 500, a broader market gauge, finished the year at 1,418.30, up 6.2 percent in the quarter and 13.6 percent for the year. The Nasdaq composite rose almost 7 percent in the quarter and 9.5 percent on the year, finishing 2006 at 2,415.29.

Idaho General Mines, a molybdenum and copper-mining company with properties throughout the West, was 2006's biggest Northwest gainer: up 154 percent. The Spokane-based company benefited from the worldwide bull market in metals and other basic industrial materials. Seattle-based Jones Soda was the best-performing Puget Sound-area company, up 128 percent for the year.

The stock markets dodged a number of bullets in 2006: Israel's war against Hamas didn't spread beyond Lebanon; hurricanes didn't ravage Gulf Coast oil facilities as they did last year; and oil — after peaking at more than $77 a barrel — fell back to the low $60s.

The major indexes moved higher early in the year, but stalled out around May after gross domestic product and job numbers came in stronger than expected. Investors feared the Fed would feel compelled to raise interest rates even higher than anticipated, increasing the risk the central bank would overtighten and send the economy into recession.

But the Fed's pause in August, along with continued healthy corporate profit growth, put investors in a buying mood.

"A lot of people may have expected corporate profits to really decelerate in the second half of the year, but when corporate profit numbers for the second and third quarters began coming in very strong, that gave the markets a lot of comfort," Rhone said.

Telecommunications, a beaten-down sector for more than five years, surged back to life on a wave of mergers and acquisitions — the biggest of which, AT&T's $86 billion purchase of BellSouth, closed Friday within minutes of winning approval from the Federal Communications Commission.

But Fred Dickson, chief market strategist for D.A. Davidson in suburban Portland, cautioned that "the deal flow from telecom is pretty much over."

"The economics of telecom are still tough," Dickson said. "I doubt it will be one of the top performers next year."

The M&A wave wasn't confined to telecom. It washed across corporate America, including the Northwest: Nine public companies in the region were bought out in 2006, including familiar names such as Albertsons, Shurgard Storage and Nextel Partners. Deals still pending at year's end stand to erase five more names from the roster of Northwest stocks in 2007.

Health care was the poorest-performing of the broad industrial sectors, though even it managed a small gain. Big drug makers were beset by product-liability issues and an acute shortage of new blockbuster drugs; health insurers and hospital companies fear the new Democratic-run Congress that takes office next week will move to rein in Medicare spending, cutting into their bottom lines.

Wentworth Hauser's Rhone said those fears may be overblown: "I think you're going to see some tweaking, but nothing that would impact the profitability of these companies."

So, 2007 should be smooth sailing for stocks, right? Hardly — with new economic data coming out almost daily, investors can always find something to fret about.

The biggest issues, once again, likely will be housing and inflation. The latest data seem to indicate the worst of the national housing downturn may be over: Scott Anderson, chief economist for Wells Fargo, said housing starts should bottom in the first quarter of 2007 and then start rising again. Sales activity should improve, too, he said, but prices will be flat at best, and more likely around 3 percent below 2006.

That could crimp consumer spending, but probably not enough to do more than trim corporate profits. Russell's Ankrim expects profit growth next year in the high single digits to low double digits, compared with the 20 percent or so annual growth posted the past few years.

But stronger-than-expected growth could, paradoxically, be bad for stocks. Core inflation, excluding volatile food and energy prices, already is above the Fed's comfort zone, Anderson said.

Higher inflation would take a Fed rate cut — which already has been priced into stocks — off the table, Rhone said, and possibly mean further new increases. That, he said, would slow consumption and have an "extremely deleterious" effect on the housing market.

Jim Paulson, chief investment strategist for Wells Capital Management, said he expects stocks to do well in the first half of 2007 but fall back in the second half, as interest rates move higher.

With most investors still expecting rate cuts, he said, "there could be quite a bit of portfolio adjustment if rates go the other way next year."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com