Despite record high oil prices, instability in the Middle East, and economic uncertainty in the U.S., stocks have managed to continue their ascent. While many attribute the rise to improved earnings and an increase in merger activity, there are other, more indirect reasons that equities are defying Wall Street’s expectations for a sizable drop in valuation.

Consider the re-normalization of the yield curve, for example. As the difference between long- and short-term term rates continues to expand, investors are once more being compensated for taking risks in the bond market. This trading indicates that portfolio managers believe that recession is a less likely scenario, and that current economic growth is an ample reason to continue buying stocks.

And as stocks have continued rising, a growing number of stock options granted by companies are now “in the money.” As these options are being exercised, executives have more cash to spend, which is propelling the economy even further along.

Even so, many large-cap stocks are still relatively inexpensive. I suspect a primary reason for the uptick in equities is that, on the basis of valuation, few things are more attractive.

The state of the market is far from perfect, of course. As prices for precious and base metals continue to soar, inflation remains a concern. Domestic political pressures are also growing more intense. But by the time these issues resolve themselves, stock prices will be much higher.

The Monthly Index Report for May 2006

Index

Apr-06

QTD

YTD

Description
S&P 500 Index*

1.22%

1.22%

4.99%

Large-cap stocks
DJIA*

2.32%

2.32%

6.06%

Large-cap stocks
Nasdaq Comp.*

-0.74%

-0.74%

5.32%

Large-cap tech stocks
Russell 1000 Growth

-0.14%

-0.14%

2.95%

Large-cap growth stocks
Russell 1000 Value

2.54%

2.54%

8.63%

Large-cap value stocks
Russell 2000 Growth

-0.29%

-0.29%

14.03%

Small-cap growth stocks
Russell 2000 Value

0.27%

0.27%

13.81%

Small-cap value stocks
EAFE

4.85%

4.85%

14.78%

Europe, Australasia & Far East Index
Lehman Aggregate

-0.18%

-0.18%

-0.83%

U.S. Government Bonds
Lehman High Yield

0.62%

0.62%

3.52%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

2.45%

2.45%

5.58%

Managed Futures
3-month Treasury Bill

1.36%

All returns are estimates as of April 30, 2006. *Return numbers do not include dividends. ** Returns are estimates as of April 27, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.