Fed Concerns Lead Markets to a Lackluster First Half

At the start of 2006, Financial-Watch put together a portfolio of stocks we believe would significantly outperform the overall market during the course of the upcoming year. We expected cyclical stocks that had seen their values remain stagnant over the last couple years despite improving business conditions would finally fully realize their value once the Federal Reserve completed their interest rate hikes. Financial-Watch underestimated incoming FOMC Chairman Ben Bernanke’s concern about rising inflationary pressures. We firmly believed the Fed would stop raising rates during the first quarter of this year to fully evaluate the future course of the U.S. economy prior to tightening further. Much to our dismay we continue to be in a cycle of rising interest rates midway through the year.

In the first half of 2006, the overall stock market moved up by 1.8%. Aerospace and investment banks turned in solid performances in the first half. To most people’s surprise General Motors led the Dow, as investors believed GM’s successful voluntary buyout package would bring in enough savings to return to the company to profitability next year. Here at Financial Watch we do not believe most analysts rosy forecast for GM. Tech stocks and homebuilders took a big hit in the first half of 2006. Financial Watch’s expectance for tech stocks to outperform the market severely cut into our portfolio’s profits from other sectors. However, we believe great values in the tech sector will lead to modest gains in the second half.

Overall, Financial Watch’s portfolio rose by 1.7% in the first half of 2006. Our slight underperformance is largely attributed to positions in Intel, Microsoft, and AIG. Intel took the biggest hit as concerns about pricing pressures from rival AMD forced analysts to cut the company’s estimated EPS from $1.62 to $1.05. Intel’s long-term outlook was severely damaged in the first half of 2006, but it is trading at less than 16 times earnings. It is nearly impossible to accurately predict the future for Intel, but Financial Watch believes it has more upside potential than downside risks at this time. Microsoft turned in a disappointing first half due to a delay in its long awaited new Windows operating system. Unlike Intel, this is a temporary setback. Microsoft is extremely undervalued at its present price.

Financial Watch’s portfolio also turned in some bright spots early in 2006. Seagate had a torrid start to the year rising by 30% in January. Financial Watch dropped Seagate from our picks of recommended stock holdings in late January and the stock has since pulled back. Deere, Kohl’s and Goldman Sachs also turned in a stellar first half. Kohl’s appears to be almost fully valued at this point and Financial Watch will consider dropping it from our portfolio should it move much higher. Deere and Goldman Sachs are a different story. Both companies, particularly Goldman Sachs, have substantial upside potential.

Our slight underperformance (0.1%) in the first half should not discourage investors. Financial Watch’s portfolio is presently trading at 12 times projected 2006 earnings. Going into the year, we would not believe such under valuation would even be possible. Fear dominated the markets in the first half of this year. Once the Fed is done, we will move into a period where cyclical stocks are viewed more favorably.

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