2006 Stock Market Year In Review

With the last trading day of 2006 under our belts, it is time to take a look back at how the markets and my 401(k) portfolio performed this year.

Overall, it was a fantastic year for the markets, across almost every asset class. In fact, it would have been difficult to show a negative return in your portfolio this year. This was very upsetting to me. I'll explain why after I walk through some of the details.

70% of my retirement portfolio is invested in Large Cap stocks, with 50% in a S&P 500 Index fund, 10% in a large-cap growth fund, and 10% in a large-cap value fund.

According to Standard and Poor’s Website, the S&P 500 Index rose 13.62% in 2006 and showed a total return (factoring in both capital gains and dividends) of 15.8%. I use the S&P 500 Index as a proxy for the market as a whole, as do many other investors.

My S&P 500 fund showed a total return of 18% this year. I don’t exactly know why it outperformed the returns published on the S&P’s Website, since it is basically designed to track the S&P 500 and I would usually expect its returns to come out slightly lower than the S&Ps because of the fees the fund manager charges. The outperformance may be due to the fact that the fund managers were able to purchase securities at favorable prices, or some timing issue between when they added stocks and when the S&P officially added stocks to its index. Another reason could be that my plan’s Website has not yet completely updated its year-end figures.

Taking a closer look at the sectors that accounted for the S&P’s performance in 2006, the best performers were Telecommunications Services (+32.13%), Energy (+22.22%), and Consumer Discretionary (+17.23%). The weakest performing sectors were Health Care (+5.78%), Information Technology (+7.7%), and Industrials (+11.02%). When the third-worst performing sector in the S&P has double-digit returns for the year, you know it’s a good year for stocks.

2006 was a better year for value stocks than it was for growth stocks, as seen in the performance of my value stock fund (+18.5%) and my growth stock fund (+10%). Value and Growth stocks tend to perform differently as groups so I like to have exposure to both high P/E (growth) and low P/E (value) stocks in my portfolio.

As an aside here, the Wall Street Journal has another proxy for the market as a whole, and that is the Dow Jones Industrial average. I don’t think this is a great barometer for the market because it contains only 30 industrial stocks, but it is a popular gauge. Dow Jones publishes the Journal, so this is the index the paper focuses on the most. The DJIA was up 16% this year and closed near a new all-time high.

The biggest winners of the year were small cap and international stocks. Because I consider these two groups to be more risky than bigger, more well-established American companies, I have lower exposure to them. I keep 15% of my portfolio in small cap stocks, divided among two funds, one of which was up 15.5% on the year, and the other of which was up 7.9%.

12% of my portfolio is allocated to International stocks, with 7% in an international equity fund and 5% in an emerging markets fund. The emerging markets fund blew the doors off of the market this year, recording a 29.4% return. The international fund didn’t do too bad either, returning an even 21% on the year.

If you’ve been adding up my percentages along the way, you’ll discover that I have 3% left. I decided to put a small amount of my retirement money in a fixed income fund purely for the sake of diversification so that in the years when equities are in the red (and I know these years are coming!), I will be able to look at my portfolio and see that at least one of my investments is up. The fixed income fund underperformed my stock investments this year, returning 5%.

My combined rate of return on the entire portfolio this year was a solid 16.6%.

So, am I patting myself on the back for this 16.6%? Am I going to go out and have a party?

I most certainly am not. In fact, I'm pretty disappointed. To illustrate why, here’s a quote from Warren Buffett’s 1997 shareholder letter:

"If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

I'm definitely a net buyer, so I prefer sinking prices.

While it is a good idea to keep tabs on your investments and year-end provides a good time to take a deeper look at them, the only holding period return I care about is the time period between when I invested my money and when I cash it out. The market could be down 50% next year for all I know, but the reason I am putting my money into stocks is that I think they will end up as my best investment opportunity over the long haul. I hope to average 10% a year over the next 30-35 years, something I could probably never achieve with regular bank account interest, bonds, or other alternatives.

A few other random thoughts about the market this year:

-Most of the market’s gains came in the second half of the year, after the Fed stopped raising rates

-The price of a barrel of oil was up only a penny this year, closing at $61.05 vs. $61.04 at the end of last year. This compares with the $20 a barrel we had become comfortable with in the decade or so before 2004. I never thought I would live to see the day when people expressed relief that oil was “only” $61 a barrel. For most of my life (1986-1999), you could get a gallon of gas for $1.50 at the pumps. For the past few years we’ve been paying more like $2.50, which is a 67% increase that seems to my uneducated eyes like it’s here to stay. If you’re curious about gas prices, check out this website (zfacts.com).

-People seem to be looking for risk. One of the basic tenets of finance is that you get greater rewards if you take greater risks. Judging by how well the riskiest asset classes performed this year (emerging markets being the biggest illustration of this), investors are bidding up these risky assets in hopes of getting these big rewards. Don’t follow the crowd and throw a ton of money at these stellar performers. The other shoe will drop sometime.

-The housing market finally started getting some positive press towards the end of the year. A lot of it came from the National Association of Realtors (NAR), so that can be taken with a grain of salt, but some of the reports on housing starts and home prices have been downright rosy compared with what we had been hearing. Personally, I hope housing prices keep going lower, because I hope to be a buyer within the next few years.

That’s my year in review. I'll close with my wish for 2007:

LOWER SHARE PRICES!

Happy New Year!