December 2006 Investment Report

The Markets End 2006 on a Positive Note

Declining oil prices, hopes of a strong holiday season, and generally favorable economic data boosted the markets during December. Oil prices eased in December due to mild winter temperatures, resulting in above normal supplies of crude and heating oil; oil fell to $62.38 a barrel, down from $65.56 a barrel in November. As oil prices dropped, there appeared to be a trickle down effect on the economy, reducing the trade deficit and providing consumers with more discretionary dollars as a result of lower gas prices.

Jobless claims drop during December …

… reviving investors' confidence and suggesting that the economy won't cool as quickly as some investors feared. Many economists believe if consumers are working, they are spending—and that's fuel for the economy's engine.

New housing starts improved …

… in November, sparking some to believe that the bursting of the housing bubble may not be as pronounced as some have been expecting. Throughout the year, the housing situation has adversely impacted the economy and has been a concern for investors and the Federal Reserve.

The trade deficit falls to the lowest level in 14 months …

… driven by plunging oil prices. The $58.9 billion deficit was far lower than economists had been expecting, substantially below the all-time monthly high of $68.5 billion in August. The sharp decline reflected a record drop in oil prices that sent America's foreign oil bill down by 17.1% to $21.8 billion, the lowest monthly oil total since July 2005.

The Federal Reserve leaves rates unchanged at 5.25% …

… though indicating it still has some concerns about inflation. The funds rate, the interest that banks charge each other, has been at 5.25% since June, when the Fed raised rates for the 17th consecutive time in a two-year effort to combat rising inflation. The decision means that banks' prime lending rate, the benchmark for millions of consumer and business loans, will remain unchanged at 8.25%. Economists believe the central bank may hold rates steady through the first half of 2007, watching to see if its previous rate hikes are effective in slowing economic growth enough to keep inflation under control.

Retail Sales Surge in November …

… the largest amount in four months, after three straight months of lackluster performance. The November gain, which was the best showing since a 1.4% increase in July, came at a critical time at the start of the holiday shopping season. Still, it was unclear whether the boom seen in November would carry over through the entire Christmas shopping season. Consumer spending slowed dramatically in the spring and summer as Americans faced surging gasoline prices and rising interest rates. Consumer spending is closely watched because it accounts for two-thirds of total economic activity. The markets will closely watch and react to final holiday sales numbers released in January.

Fund Performance

December was a mixed month in terms of performance for the General Board's funds. Three of the funds advanced in price while three funds declined. Three funds performed better than their benchmarks while three funds underperformed. For the year, however, all funds produced a positive investment return. Net of all management and operating fees, three funds surpassed performance benchmarks and three funds fell short of their performance benchmarks. Overall, however, 2007 was a very good year for the General Board's investment funds.

The Inflation Protection Fund (IPF) declined 2.3% for the month and slightly exceeded its benchmark return of -2.4%. Two market related factors were responsible for the decline of the fund. First, bond prices generally declined as a result of positive economic news signaling stronger growth. Investors tend to prefer more risky assets during periods of economic growth. This preference tends to drive up interest rates as investors sell bonds and invest capital in stocks. Second, investments linked to inflation further declined as investors became more optimistic over the future direction of inflation as a result of declining energy prices. The difference in the interest rates between traditional bonds and bonds linked to inflation represents investor expectations for the future of inflation. If investors believe that future inflation will be lower, inflation-linked bonds will perform worse than traditional bonds. Conversely, if investors change their expectations anticipating higher inflation, inflation-linked bonds will perform better than traditional bonds. During December, the fund's active manager held cash in lieu of inflation-linked bonds for a significant portion of the assets it invests on behalf of the fund. The value this manager added, however, was partially offset by losses on the fund's investments in commodity futures contracts. Declining energy prices in December contributed to losses in the value of the fund's commodity investments.

For the year, the Inflation Protection Fund produced a meager return of 0.7% but surpassed the 0.5% return of the performance benchmark. This was the lowest performing fund offered by the General Board. As indicated above, during 2006, investor expectations for future inflation declined and this had an adverse impact on investments linked to inflation and ultimately the fund. The fund was able to beat its performance benchmark even after the payment of fund administration and management expenses because of the fund's 10% exposure to commodities and because of value added by the fund's active manager which chose to hold cash in lieu of inflation-linked assets for a significant portion of the assets it manages on behalf of the fund.

The Domestic Bond Fund (DBF) declined 0.3% in December as a result of increasing market interest rates due to a stronger economic outlook. This fund, however, did outperform its benchmark return of -0.5%. The fund benefited from its exposure to bonds from lesser developed countries. Emerging market bonds continued to produce excellent performance as a result of continued improvement in the economies of these countries. This in turn has led to improved investor confidence in these countries' ability to repay their debt obligations. The gains from these bonds, however, were slightly offset from losses on bonds from developed countries due to strength in the U.S. dollar. Bonds denominated in currencies other than the U.S. dollar will decline in value as the U.S. dollar strengthens.

For the year, the Domestic Bond Fund produced a return of 6.8% and substantially exceeded its performance benchmark return of 4.7%. The two biggest factors contributing to this excess performance is the fund's exposure to international bonds. For the year, the fund's emerging market debt portfolio climbed 20.5% because of increased confidence that investors have in the economic outlook for these countries. Additionally, for the year, the U.S. dollar declined in value against most of the world's currencies. Bonds denominated in currencies other than the U.S. dollar will gain in value when the dollar weakens, which it did over the course of the entire year.

The Domestic Stock Fund gained 0.5% in December, but meaningfully underperformed the benchmark Russell 3000 return of 1.2%. Stocks continued to advance due to investor optimism regarding economic growth. The fund underperformed its benchmark, however, due to its larger concentration in stocks from small and mid-sized companies. Stocks from small and mid-sized companies declined during the month. Additionally, the investment managers in the fund collectively and presently have a preference for stocks that exhibit characteristics of earnings growth. These "growth" stocks also underperformed the broad market averages. Finally, the fund's exposure to stocks of real estate investment trusts (REITs) hurt performance as these types of stocks declined in December after a long period of outstanding returns.

For the year, the Domestic Stock Fund gained a very respectable 15.3% as the robust U.S. and world economies continued to fuel investor optimism. Net of fund administration and management expenses, the fund slightly under performed its benchmark return of 15.7%. A positive factor influencing the 2006 results were the fund's exposure to real estate. The fund's real estate investment trust portfolio gained 41.4%. However, the fund's real estate gains were more than offset by the impact of fees and the overall performance of the fund's active investment managers. Generally, the fund's managers focused on high quality companies that are expected to grow earnings at a rate higher than the overall economy. These types of companies did not produce investment returns comparable to the overall market.

In December, the International Stock Fund was once again the best performing fund on an absolute return basis for the month and advanced 3.6%, which was 0.5% better compared to its performance benchmark. The fund benefited from its exposure to the stocks of companies from lesser developed countries and also from added value from the fund's investment managers. December once again added to a recent string of months with excess performance compared to the performance benchmark.

For the year, the International Stock also had the best performance for all of the General Board's funds and advanced 25.4%, though the fund lagged its performance benchmark return of 26.7%. The fund benefited from its exposure to stocks from lesser developed countries. The fund's emerging market investments returned approximately 34% during 2006. However, this was more than offset by generally poor performance of the fund's investment managers compared to their respective performance benchmarks. Four of the fund's six managers underperformed their respective benchmarks. This is primarily due to a less-than-market weighting in energy stocks, which have performed well and a greater-than-market weighting in technology stocks, which have performed poorly.

The Multiple Asset Fund advanced 0.7% during December and slightly underperformed its performance benchmark return of 0.8%. The worse than benchmark performance is attributable to below market performance from the Domestic Stock Fund, though this was mostly offset by better than market performance from the other three funds that comprise the Multiple Asset Fund (Inflation Protection Fund, Domestic Bond Fund, and International Stock Fund).

In 2006, the Multiple Asset Fund produced a return of 13.8% net of all fund administration and management fees. This return was 0.4% better than the benchmark. The relative performance of the Domestic Bond Fund is primarily responsible for the fund's excess performance, although this has been partially offset by the less than benchmark performance of the International Stock Fund and the impact of fund management and administration expenses.

The Balanced Social Values Plus Fund declined 0.2% in December and trailed its benchmark return by 0.9%. As reported previously, the fund has significant exposure to stocks that are expected to grow earnings at a rate higher than the overall economy. These "growth" stocks performed significantly worse than the overall market. The fund completed 2006 with a return of 6.4%, which very substantially trailed the 11.4% return of the benchmark. Again, this was attributable to the fund's exposure to stocks with higher rates of earnings growth. For the year 2006, a popular growth stock index posted an investment return of about 9% compared to a return of approximately 22% for an index representing "value" stocks. This extends to seven the number of years in which value stocks have performed better than growth stocks. The General Board intends to continue to retain the investment manager employing a growth stock strategy in anticipation of a reversal of this unprecedented period in which value stocks have outperformed growth stocks.

Market Indices for December 2006

sp0612 The S&P 500 Index was up 1.2% in December and was up 13.6% for the year.
russ0612 The Russell 2000 Index was up 0.4% in December and was up 17.0% for the year.
msci0612 The MSCI EAFE Index was up 2.8% in December and was up 22.9% for the year.

The performance data for these charts is based on price changes only and do not include the impact of dividend payments.

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