Commentary and Articles

1st Quarter 2006 Quarterly Synopsis

“Keeping a Steady Pace”

Continuing the upward trend of the previous quarter, equities surged ahead in the first quarter with the major stock indexes reaching five year highs. Despite economic uncertainty and concerns over slowdowns in the housing market, investors moved to capture relatively attractive valuations and markets moved higher.

Adding to the concerns that were largely ignored; the yield on the 10-year U.S. Treasury note rose to the highest level since 2004 and the Federal Reserve raised the short-term interest rate target for the 15th consecutive iteration. Newly sworn-in Federal Reserve Chairman Ben Bernanke gave no indication that the central bank is inclined to stop raising short-term rates in the foreseeable future.

Part of the Fed’s concern stems from the high rate of growth in U.S. Gross Domestic Product which was revised upward for 4th quarter 2005 to an annualized rate of 1.7%. The continuing growth came despite the upward march of commodity prices, most notably oil and natural gas. U.S. corporate profits rose as well in the 4th quarter growing at 13.8% according to the Commerce Department. This shows a significant rebound from the 4% drop in profits after Katrina. Productivity gains continue to drive corporate profits although wage pressures appear to be heating up.

Even though these inflationary pressures led to increases in rates, the low relative value of stocks given these earnings attracted investors sufficiently to drive markets upward. How much upside is left in the U.S. equity markets at this point? We continue to be concerned about overconfidence in the prospects for near term growth at the same pace. The Core Consumer Price Index, which takes out the inflationary effects of food and oil, increased 2.4% year-over-year. This is higher than many economists believe the Fed will tolerate and more interest rates are likely. This risk, coupled with the slowdown in housing could present problems in consumer spending. In addition, higher interest rates will mean more expensive borrowing costs for corporations. Both of these potentially hamper growth in corporate earnings.

As we have looked to offset these risks, our portfolios have benefited from shifts to international market investments. In particular, we have seen gains from investments in Asia as the Japanese economy returns to health. Emerging markets have been a small but beneficial part of our allocation strategy, as well.

In our U.S. Large company holdings, the Energy sector rose again. While many other companies in the Financials sector struggled in the 1st quarter, Goldman Sachs
(GS, NYSE) led the way with significant gains. UPS (UPS, NYSE), and General Dynamics (GD, NYSE) had solid gains for the quarter as well and recent focus list addition Sprint (S, NYSE) faired well in the Telecom sector.

In fixed income, we have taken advantage of maturing bonds to reinvest at the higher yields while still focusing on short durations to avoid price volatility as interest rates climb. The lack of spread between 2- and 10-year yields supports our approach.