Before sticking my neck out with predictions for the upcoming year, I thought I would take a look at my forecast for 2006 and see how accurate my predictions were.

Prediction #1 - “Mergers and Acquisitions will accelerate and become the driving force for a healthy equity market.” The total amount of Mergers and Acquisition activity so far in 2006 has been approximately $1.3 trillion, the highest level since 2000. In the prediction department that makes me one for one.

Prediction #2 – “The fears of accelerating inflation will subside paving the way for an end to Fed tightening.” Despite the huge run-up in the price of oil and other commodities, consumer inflation remained relatively sanguine and the Fed did indeed end its tightening cycle by holding rates steady since August. So, I’m two for two.

Prediction #3 - “The Big Kahuna. We think stock prices are poised to move higher in 2006. …stocks could advance 8-10%, with a double digit gain not out of the realm of possibility.” If the markets hold at current levels for the final month of the year, then we will have our low double digit return, which would make me a perfect three for three.

Which only makes me nervous going into 2007... What is different this year? For starters, the political scene is different. The bumbling Republicans lost control of both houses. Fortunately, gridlock in Washington is a good thing. Typically, as far as the markets are concerned, the less accomplished in Washington the better. My sense is that we’ll have plenty of rhetoric as candidates position themselves for the 2008 presidential election, but legislative accomplishments will be few and far between. I think it is also important to realize that the U.S. is becoming a smaller percentage of the global economy, a trend that will continue for the foreseeable future. What this means is that many of the economic issues at the center of the political debate are driven by global factors that Congress cannot control.

The housing market is also different this year, and it could emerge as a catalyst to move the stock prices in either direction. Should the slowdown in housing continue long enough to suppress consumer spending then this might have a negative affect on investor psychology. Conversely, if the consumer proves resilient once again, the market rally that began in July might have more room to run. Meanwhile, there is substantial evidence that the economy is slowing which should allow the Fed to remain on the sidelines as consumer inflation remains within an acceptable range.

What is the same?... The Middle East is still a big mess and it is becoming harder to see the light at the end of the tunnel. It is clear from the polls that our country is becoming more frustrated and less supportive of the President’s foreign policy. While this is discouraging, especially to the families of those in harm’s way, my sense is that it won’t have much of an impact on the markets in 2007. I hope I am wrong and that a political breakthrough will occur, but I’m not betting on it.

I think it is possible that 2007 could be another very strong year for merger and acquisition activity. It would not surprise me to see several mega deals as corporations, flush with cash, struggle to find organic sources of earnings growth. While this is positive in an overall sense, it does raise the risk that some deals are poorly valued or just plain dumb. Think AOL and Time Warner, which was both.

So what could happen in 2007 that would change the investment landscape?... That is really the question, because in my experience, when you’re three for three the next pitch isn’t as easy to hit.

First of all, I continue to be concerned that China is an environmental disaster waiting to happen. While the government has begun to address the situation, my sense is that it will get worse before it gets better. As evidence, the International Energy Agency issued a report in November that predicted that China will soon over take the U.S. as the biggest emitter of carbon dioxide, the main greenhouse gas responsible for global warming according to many scientists. Already over 20% of China’s population lives in severely polluted areas, while nearly 70% of China’s rivers and lakes are polluted.

Thus, we enter 2007 cautiously optimistic. Benign inflation, stable interest rates, solid earnings, solid corporate balance sheets, M&A activity, and global growth should all positively influence stocks in 2007. Within this positive backdrop we continue to feel that individual stock selection will drive portfolio performance as it did in 2006. Performance within the two largest sectors of the S&P 500 illustrates this stock picker’s environment:

In summation, our strategy going into 2007 will be to have a well-diversified portfolio of undervalued, high quality stocks. We look forward to sharing our views on the market and other topical issues throughout the New Year. In the meantime, we would like to thank all of you for your support and we wish you a joyful holiday season.