Commentary and Articles

4th Quarter 2005 Quarterly Synopsis

“Room to Grow”

2005 presented many challenges for investors, including major hurricanes in the Gulf of Mexico region and the continued unsure political and military outcome in Iraq. Despite the recent news about the Dow Jones Industrial Average finishing the year at a small loss, and the U.S. Treasury Yield Curve inverting briefly on December 27th when short-term interest rates rose above long-term, the U.S. Economy shows signs indicating that it still has plenty of steam.

The inversion of the yield curve has been a concern in the past and has signaled the onset of the last five recessions. However, it did invert in 1995 and 1998 with no recession following. The inversion of the yield curve in this case is probably a sign that inflation expectations are lower for the distant future compared to the present rather than a scare of a slowdown in the U.S. economy. The long-term yield on bonds is still below that of a year ago even as short-term yield have risen sharply. Of note; retiring Federal Reserve Chairman Alan Greenspan has warned that the yield curve may not be as good a gauge of economic patterns as some believe it to be.

Indeed, economic indicators are stronger than the equity markets currently reflect. Manufacturers currently report that factories are at 80% of capacity, higher than at any point since mid-2000. Unemployment is at a relatively low 5%, and wages are rising at the fastest annualized pace since 2003. In order to keep up with demand for goods and services, we expect to see companies increase capital investment in 2006.

In addition, corporate balance sheets remain strong, with companies piling up cash. Even as Energy sector companies garnered all the attention with annual earnings growth on track to reach 65%, the other economic sectors show average projected annual earnings growth of 10.5%. Consumer prices have grown at a faster pace in the last quarter than producer prices which has helped the earnings trends even as labor costs have grown with the rise in wages. Corporations are using cash to buyback stock at double the rate of 2004, and venture capital firms are raising record levels of cash to take companies private. These factors should help drive stock prices.

Why, then, the doldrums in U.S. equity markets? The bull market looks tired as investors appear skittish about equity investments in spite of good earnings and cash flows. Concerns over impending weakness in housing seem to be causing investors to worry about U.S. consumers’ ability to weather higher rates while maintaining spending patterns which have helped the economy in recent years. Investor reluctance seems to be caused by the great unknown of whether corporate capital expenditures will help U.S. economic growth enough to make up for the anticipated slowdown in consumer spending. The bright spots seem to be in small-cap and international equities. The increases in M&A and private equity will continue to help small company stocks and continued U.S. money flows to overseas financial markets will spur foreign equities.

We believe the economy will have a strong 2006 and we have continued to diversify across asset classes and sectors to provide good risk-return tradeoff. Over the last quarter we have benefited from exposure to the international equity markets particularly in Pacific and Emerging Markets holdings. In individual equities, long-term core focus list holdings PepsiCo (PEP, NYSE) and Teva Pharmaceuticals ADR (TEVA, NASDAQ) performed extremely well. However, the pull back in Energy and Utilities as well as under performance in Apollo Group (APOL, NASDAQ) and Dell (DELL, NASDAQ) hurt our portfolio performance for the quarter.

In fixed income, we experienced a flat quarter overall as portfolios were structured to provide a sufficient yield to income sensitive clients. Our bond portfolio performed well for the year. We will continue to balance income needs with interest rate risk.