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QUARTERLY COMMENTARY FOURTH QUARTER 2004

THE YEAR OF BIG NON-EVENTS


Though the Presidential election stole many of the headlines in 2004, in many ways the events that did not happen were even more significant. Long-term interest rates, widely expected to increase in 2004 (and 2003 AND 2002), remained stable despite the Fed increasing short-term rates five times. Fears of terrorism loomed over the Summer Olympics in Greece and the Democratic and Republican National Conventions, but each were held without Index Performance event. Deflation did not materialize. Dow Jones Industrials Consumer spending S&P 500 did not decline. Oil, EAFE (international stocks) after barreling through Russell 2000 (small stocks) the $40 and $50 price Lehman Intermediate levels, peaked in the Lehman Municipal mid $50s and has since settled down around $43.00/barrel. The presidential election did not end with an uncertain victor or a contested vote, as it did four years ago, but instead with a President that received the majority of the popular vote for the first time in 16 years. The stock market responded positively to the development, or lack thereof, of each of these events. Heading into 2004, we anticipated the market would have below average returns in the high single digits. With a stellar 4th Quarter the broader indices, like the S&P 500 and the Nasdaq, did not disappoint, but the narrower Dow Jones Industrials lagged due to disappointing returns from Merck & Co (-29.4%) and General Motors (-25.2%). See the table on this page. To our surprise, the bond market did not punish investors on the longer end of the yield curve. The Lehman Brothers Aggregate Index was up despite the fed funds rate rising from 1.00% to 2.25% over the course of 2005. Interest rate stability on the longer end of the yield curve allowed for mortgage rates to remain attractive and the housing market, as measured by new home starts, remained strong.

BUSH AGENDA, TAKE II


As we toast 2004, we turn a watchful eye to Washington D.C. and President Bushs second term agenda. Emboldened by the increased Republican representation in congress we expect him to first address the growing concern surrounding Social Security. President Bush campaigned on the notion of a Personal Savings Account (PSA), which would separate a guaranteed portion of a taxpayers Social Security benefit from an optional PSA that Q4 04 YTD could be invested at +7.56 +5.20 the direction of the +9.21 +10.74 beneficiary. It remains +15.34 +20.35 to be determined how +14.14 +18.29 the PSAs will be -0.98 +1.53 administered, what +0.46 +3.65 investment options are available and what the effect participation will have on the guaranteed benefit, but each of the issues will be heatedly discussed by congress. The short-term effects on the market would appear to be positive, as a greater number of dollars will be allocated toward market investments. The administration has promised an overhaul to the outdated tax code. Will the estate tax code be revised or repealed together? The key will be how well congress can focus on modifications that make the code simpler while promoting economic growth. Any revision to the tax code, the nations primary source of income, will need to consider the increasing deficit. Addressing the deficit will require the government to exercise fiscal restraint. Marginal reduction in government spending will have to be offset by increased spending activity on the part of consumers and businesses to maintain GDP growth. We forecast 2005 GDP to be a solid 4.0%, less than the 6.9% growth of 2004 as higher interest rates impact retail spending and the housing market.

RISING INTEREST RATES


Interest rates will rise as a result of increased inflationary pressures. There are two significant

reasons why we feel that 2005 will be the year interest rates rise. The first reason is the dollar. After ending 2002 at near parity relative to the Euro ($1 / 1), the dollar has declined to its current level of $1.32/. The decline of the dollar has two major repercussions. Foreign goods become more expensive in dollar terms causing inflation for U.S. manufacturers and consumers and dollar denominated assets, specifically U.S. Treasury securities, become less attractive to foreign investors. To get foreigners to continue to hold the dollars they receive from our burgeoning trade deficit, U.S. interest rates must rise.

what to do with these increased cash reserves. Microsoft made the decision to return cash to their shareholders, implementing a special one-time dividend of $3.00/share in December. Oracle made the decision to purchase a competitor completing a hostile bid to acquire Peoplesoft for over $10 billion in cash. We see both these actions as indications that 2005 will see improved levels of spending from the corporate sector.

7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1999

With capital spending driving the economy both the Industrial and Material sectors will lead the market. Paychex (PAYX) and Automatic Data Processing (ADP) will benefit from both increased corporate spending and rising interest rates. Merger and acquisition activity Fed Funds Target Rate and Inflation will increase fees to Goldman Sachs (GS) and Morgan Stanley CPI YOY % Change (MWD). Interest rate sensitive Fed Funds Target Rate retail oriented banks will suffer.
Negative real cost of funds

2000

2001

2002

2003

The second reason is the relative level of Fed Funds to inflation. Despite five consecutive rate hikes, the current Fed Funds rate at 2.25% is still significantly below the current inflation level (CPI) of 3.5%. (See the chart above). This results in a negative real cost of funds. Historically, the Fed Funds level runs at positive real rate of return, averaging 1.0%-2.0%. This suggests the Fed will continue to tighten until Fed Funds is greater than the inflation rate. Over the last two years we have been diligently positioning portfolios in anticipation of a rising interest rate environment and believe that rising longterm rates will vindicate these actions in 2005.

The Healthcare sector has recently made headlines, first with the healthcare reform platforms of Presidential candidates and more recently with the findings of the heart risk associated with Cox-II inhibitors Vioxx and Celebrex. The negative publicity has created a value 2004 sector from one that has historically been associated with growth. We feel that these concerns will continue to plague the sector in 2004 leading to just market returns for the Healthcare sector. The energy sector will come under pressure as oil continues to fall off its recent high and consumer discretionary stocks will take a breath after two years of great returns. International stocks underperformed their U.S. peers on an absolute basis, but continued pressure on the dollar allows them to outperform after adjusting for exchange rates. We expect 2005 to reap the benefits of the catalysts put in place during the last two years of economic recovery. Though corporate earnings will be stellar, the current valuation level will keep market returns more moderate. Whether or not inflation can be kept at bay will determine if the economy will enter a new growth phase.

INCREASED CORPORATE SPENDING


As the economy recovered over the last two years, corporations have focused on streamlining businesses and increasing cash reserves. Now, as their businesses have stabilized executives must decide