QUARTERLY COMMENTARY THIRD QUARTER 2004

The quarter that ended September 30th produced several surprises. After showing greater than expected strength in the spring, the economy sputtered over the summer. Long-term interest rates, which rose a full 1% to 4.8% through June, declined back to near their 45-year lows. The election campaigns of both parties waxed and waned with their conventions and we still dont have a clear leader. The stock market was fickle and bonds were the best performing asset class (see table below). Meanwhile, oil tested $50 per barrel, steel and other industrial metals continued their ascent Index Performance and in the midst of all Dow Jones Industrials of this the Federal S&P 500 Reserve raised interest EAFE (international stocks) rates three times. All Russell 2000 (small stocks) of this points to a fundamental paradox: Lehman Intermediate interest rates are Lehman Municipal falling in the face of the build up of many forces that would normally be considered inflationary. Additionally, we see a fundamental lack of market leadership. Who will win the election? Which is right oil or bonds? Will the economy continue growing or will it decline? POLITICS Early in the quarter the government reported that the budget deficit for the year ending June 30, 2004 (FY 04) was $588 billion. While this is a new record for the size of the deficit in nominal terms, as a percent of Gross Domestic Product (GDP) at 3.7% its far shy of the 6.0 % of GDP that we saw in 1983 and a decline from fiscal 2003s 5.0%. The political conventions and campaigns to date have not established an obvious winner. About 80% of the electorate is split evenly between staunchly supporting George Bush or John Kerry. The remaining 20% seem to be very undecided and, if you believe the polls, appear to sway with the varying reports that are blowing about. The campaigning has again reached new lows of polarized mudslinging. Fervent Republicans maintain that President Bush is the only one capable of leading the war on terrorism and seem certain that another Bin Laden attack is imminent. Fervent Democrats lament the loss of jobs and the decline of the welfare of the poor and middle classes during the last four years. There is a lot for the Republicans to overcome. During the last 4 years weve seen job losses, rising deficits, expanded government regulation, and a quagmire develop in Iraq. The Democrats have John Kerrys questionable charisma and his record of flip-flopping on the issues. The outcome of the election will have significant effect on our policy towards Q3 04 YTD the deficit and towards healthcare in the U.S. -3.40 -3.57 THE FEDERAL RESERVE On 9/21/04 the Fed increased the benchmark target for the Fed Funds rate for the third time to 1.75%. The bond market took this as a sign of Fed making a preemptive move against the potential for inflation to pick up. Bond prices rose and the yield on the 10year Treasury note fell to just under 4% on 9/27. This increase in short term and decrease in long-term rates produced the flattening of the yield curve as shown in the chart below: The Feds actions have only begun to offset the numerous rate cuts from 6% to 1% between November 2001 and April 2004. -1.88 -0.20 -2.87 +2.70 +3.88 +1.51 +4.65 +3.44 +2.53 +3.18

OIL In our second quarter commentary we highlighted the rise in the price of oil and included a chart showing the increase to $32/bbl. Below is a chart from the 8/23/04 Weekly Market Monitor which shows the annual percentage change in the price of oil over the post World War II period.
Oil Prices and Recessions 180 150 120 90 60 30 0 -30 -60 Jan-45 Recession crude oil, y/y % ch.

Jan-55

Jan-65

Jan-75

Jan-85

Jan-95

The shaded vertical bars represent periods of recession. Observe that whenever the price of oil increases over 100% year over year, the economy subsequently goes into recession. The oil embargo of 73 and the Iranian revolution in late 79 caused the price of oil to increase more than 100% and both were followed by recessions. The Iraqi invasion of Kuwait in 90 caused oil to rise some 60% and also caused a recession. Some will claim that this time is different because the prior price increases were due to supply constraints whereas this time it would appear that increased worldwide demand is the culprit. Based on the bond markets reaction to date one would presume that it believes that the rise in the price of oil isnt inflationary but rather, as the Monitor argues, just detrimental to growth. The rationale is that as the cost of gasoline, heating oil and electricity goes up, consumers, whose average incomes move only very slowly, will pay more and more for these basic necessities, leaving less for discretionary spending. To believe this we have to assume that demand is not sufficient enough for companies to be able to pass along their higher costs to their customers.

MARKETS There is an old Wall Street saying: three steps and a stumble. It means that when the Fed raises interest rates a third time the stock market usually falls. The stock markets fickleness was demonstrated by the three sets of lower highs and lower lows we experienced during the quarter. This continues to be a very difficult environment in which to make money. Florida saw a record four hurricanes but the total cost was not as bad 180 as initially feared. The Google IPO was 150 successful in raising $2 billion but the offering size was scaled back, preventing 120 the venture capitalists and insiders from selling as much as they would have liked. 90 So far, Google has not sparked another IPO frenzy. The increased burden of 60 complying with Sarbannes-Oxley regulation 30 on public companies is effectively increasing hurdles for smaller companies to 0 access the public capital markets. The majority of corporate earnings reports were -30 positive due to management generally under promising and over delivering. Generally, -60 there were more positive earnings reports Jan-05 than negative ones. However, there were some ominous reports from companies with significant exposure to raw or intermediate materials costs. General Mills predicted lower earnings due to higher commodity costs, while Colgate and Unilever forecast lower earnings due to higher labor and marketing costs. Contrast the fortunes of Hewlett Packard with that of IBMLouis Gerstner turned IBM around by focusing on becoming the premier technology consultant rather than simply a manufacturer, and services now account for 48% of IBMs revenues. Hewlett Packard moved in the opposite direction when they chose to buy Compaq Computer rather than PriceWaterhouse Consulting. They have become a focused manufacturer of commoditized computers, and since then their margins have eroded. This does not auger well for manufacturers of low added-value products. In conclusion, our answers to the questions we raised above are: The election outcome is highly uncertain; Regarding the apparent disconnect between interest rates and inflation, we think the bond market is wrong and inflation is a growing problem; And lastly, the economy will continue to grow, albeit at a lower pace, as long as the price of oil stabilizes in the high 40s.