Commentary and Articles

3rd Quarter 2005 Quarterly Synopsis

“Uncertainty Abounds”

In the aftermath of Hurricane Katrina, the U.S. Economy shows plenty of reasons for concern, although markets have not reacted as negatively as one might think.

In spite of the anticipated slowdown from a significant spike in energy prices, the Federal Reserve continued to raise short-term interest rates, fearing the potential for inflation more than the potential for a slowdown. The federal government is showing a willingness to provide economic stimulus following Katrina and Rita and this will help to keep the U.S. expansion on track.

However, along with increasing fuel prices, consumer confidence dropped to its lowest level in 13 months, and consumer spending dropped in August by $47.2 billion. Credit card delinquencies hit an all-time high according to the American Bankers Association. Other loan delinquencies rose as well. The increase in interest rates adds to the stress on the American consumer who has pulled the weight of the economic growth in recent years by spending when corporations closed their wallets.

As an interesting backdrop to the concerns in the U.S. economy, America’s trade deficit has grown in the 3rd quarter to 6.4% of GDP. Foreign investors have so far been willing to finance the gap and their willingness to invest shows both their confidence in the prospects for the U.S. economy and their need to keep the U.S. economy vibrant for trade. Even as U.S. consumers are seen as a boon for foreign companies, overseas economies have grown more slowly than that of the U.S. and this creates less demand for U.S. goods and services in those markets. As the dollar has strengthened relative to the euro and the yen, U.S. exports have continued to slow. A decline in the dollar as a result of the continued deficit expansion could lead to further inflation fears and increases in interest rates.

We continue to believe that energy prices will be a key in economic growth. Also a factor; U.S. corporations will increase spending in response to post-hurricane rebuilding efforts. In addition, we see favorable conditions in overseas markets as reports show greater internal demand in Japan and other developed countries. Thus, we are allocating an increased percentage to foreign opportunities. However, we continue to weight the bulk of our equity allocation to the U.S., and believe that foreign investment in the U.S. will continue to buoy the American consumer-driven economy and provide for growth in spite of increased energy prices and other concerns in the wake of Katrina.

In the past quarter, we took advantage of continued increases in the energy sector as long-time focus list holding, Burlington Resources (BR, NYSE) rose above our price targets immediately following Katrina. Utilities sector holding Dominion Resources (D, NYSE) also rose significantly in light of concerns over natural gas supply. We maintain our belief that the relatively high levels of cash and low levels of debt on large corporate balance sheets give a margin of safety in uncertain times and we persist in screening for highly profitable companies that are likely to outperform their industry peers over extended periods. We are also allocating to the broad small-cap asset class in light of our research showing a favorable risk/return tradeoff for these companies. As in the past, we continue to seek diversification opportunities which we believe will enhance portfolio returns and mitigate potential risks.

In the light of the almost certain increase in interest rates, we are cautiously positioning our fixed income investments with shorter durations. We continue to review credit spreads for increased opportunities in yield.