Commentary and Articles

2nd Quarter 2007 Quarterly Synopsis

“Resilient Optimism”

Equity markets shook off concerns over high energy prices and increased defaults in the sub-prime mortgage sector to post substantial gains in the second quarter. As inflation indicators showed relatively tame price increases on goods and services, investors bid up prices on stocks in anticipation of a continued strong economy with no increase in interest rates.

In the most recent quarters, this commentary has discussed the risks in the continued upward movement in stock prices. This quarter we will do the same. Oil prices have stayed above $60 per barrel and U.S. markets have risen without any significant correction. However, it does appear that the risks posed by higher fuel prices and declining demand in housing are being absorbed by the U.S. economy with little immediate effect. Consumers continue to spend and businesses are rebuilding inventories; both are good signs of potential future growth.

Inflation, as measured by the core Consumer Price Index, is down from a year ago to 2.2% from 2.9%. Even including food and energy prices, which have seen more dramatic increases, the CPI is showing inflation at 2.7%. Strong job markets seem to have helped the U.S. consumer absorb higher prices passed along by producers. Household income in the U.S. increased 5.6% from the prior year and according to the Federal Reserve, household wealth continues to grow despite downward pressure on housing prices.

The strength in consumer spending is negative as well in that this strength can lead to increased inflationary pressure. The higher prices being passed along by producers come from increased energy costs, but also from the wage pressure caused by tight job markets. As the economy picks up steam, this demand for labor will continue the spiral of higher inflation as long as consumers continue to spend. This labor market pressure will also impact businesses’ ability to increase earnings to meet investor expectations.

The belief that inflation will continue to be a concern in the U.S. economy is seen in the divergence in stock and bond prices. Clearly, stock markets have benefited from the lowered inflation fears, but the bond markets are looking over the horizon and seeing the potential for higher long-term inflation. Bond prices have fallen sharply over the last quarter. Yields, particularly long-term yields, have risen, indicating anticipated inflation increases.

The other pricing concern that continues to have a double edge is the increase in energy costs. This increase stems from the demand for energy because of global economic growth. We have sought to capitalize on the global growth spurring that demand by increasing exposure to overseas investments.

This past quarter we benefited from a posture of conservatism and stability. In measuring the various economic factors, we continue to believe that volatility will increase and that a well constructed portfolio will prevent downside surprises. Focus List holding Ingersoll-Rand (IR, NYSE) appreciated significantly as did its fellow industrial sector holding 3M (MMM, NYSE). Energy sector names such as Occidental Petroleum (OXY, NYSE) did well overall, and financial sector holdings Aflac (AFL, NYSE) and Goldman Sachs (GS, NYSE) repeated their strong first quarter 2007 performances. Technology sector holding Maxim Integrated Products (MXIM, NASDAQ) turned the corner after lagging over the past year to lead the sector for second quarter. We continue to pay close attention to fundamentals and review holdings that have reached our target price. In addition, we continue to diversify to asset classes that we believe will perform well in volatile conditions with minimized downside risks.

Fixed income fared poorly over the second quarter as bond prices fell. We continue to seek short durations in order to minimize these downside movements. We believe that our prudence in management will payoff given the inflationary pressures that currently exist.