QUARTERLY COMMENTARY THIRD QUARTER 2005

HURRICANES AND THE ECONOMIC EFFECT OUTLOOK

During the third quarter hurricanes stole the headlines. As Katrina strengthened and ravaged the Louisiana coast, many prognosticators warned the significant damage, particularly to oil-refining capacity, would lead to an economic slowdown. The Consumer Index Performance Sentiment Index, taken Dow Jones Industrials just after the hurricane when looting was Standard & Poors 500 rampant and the death EAFE (international stocks) toll was expected to Russell 2000 (small stocks) surpass 10,000, Lehman Intermediate recorded the largest Lehman Municipal drop since 1990. The post-Katrina economic outlook now appears much less grim than initially feared. Recent data releases continue to point to a sound economy in the run-up to the storm. Before Katrina hit, GDP had risen, unemployment had fallen to 4.9%, retail spending was strong, and state tax revenues for the 2nd Quarter had increased by 13%. Interestingly, despite the economic uncertainty, the Dow Jones rose 215 points to 10,678 in the two weeks following Katrina. Economists generally are estimating that Katrina will lower 4th Quarter GDP by 0.4% to 0.5%. Katrina represents a supply shock, raising the risks of both higher inflation and lower economic growth. The well-reported short-term effect is reduced oil and natural gas production. The constraint on production will lead to higher oil and gas prices. Those higher prices will negatively impact consumers discretionary spending as more dollars are consumed by transportation and heating costs. While higher energy costs therefore hinder growth in the short term, longer-term companies have historically found a way to pass higher costs on to consumers. This will lead to further inflation. With their latest rate hike, the Fed has clearly indicated their concern about rising inflation, despite the economic dampening from the two hurricanes.

The odds of a recession in 2006-2007 are rising. Two historical indicators of recession apply today. Merrill Lynch points out one. When gasoline prices rise by more than 50% over a two-year span a recession has always followed. (See chart following page). Over the most recent two years gasoline has risen nearly 100%. Another indicator is the debt market. When the rate of return on short-term bonds is higher than long-term bonds (called an inverted yield curve), it implies that the demand for money is expected to decline in the future. Bond market participants, especially mortgage lenders, use the interest rate swap markets to hedge their interest rate risk. This market for swaps is presently indicating that the yield curve will invert. The last time the curve inverted was in August of 2000, one year prior to the beginning of the most recent economic recession.
FIXED INCOME

Q3 05 3.44 3.60 10.46 4.71 -0.52 -0.13

YTD -0.34 2.76 9.60 3.43 1.06 2.76

Bond yields rose during the quarter across the entire maturity spectrum. The 10-year Treasury was yielding a rate of 3.96% on June 30th and closed the latest quarter at a yield of 4.33%. Current bond prices suggest at least one more increase in the Fed Funds rate to 4.00% by year-end. Spread products, particularly corporate bonds, high yield bonds and asset-backed securities, are not attractive. We continue to maintain a low duration position with high credit quality issuers and believe we will be rewarded as rates rise.
HARD ASSETS

Gold, a safe haven in an inflationary environment, has moved to a 17-year high at more than $460 an ounce, and was up more than 7% in the 3rd quarter.

Golds price is typically driven by excess liquidity in the short term and its recent movement is seen as a precursor to inflation. Lawrence Kudlow, a wellknown market strategist, maintains that gold leads inflation by ten months. If true, then the Feds concerns about rising inflation are well founded.
EQUITIES

impact of the Japanese government. There is a good chance that the Japanese Postal Service, the largest holder of Japanese household savings will be taken public in the future. The highly publicized revaluation of Chinas currency, the Yuan/Renminbi, brought about a modest 2% adjustment relative to the U.S. Dollar and a switch to pegging the Yuan against a basket of other currencies rather than just to the Dollar. The U.S. Dollar rose marginally against the Euro and fell marginally against the Yen, Pound and Canadian Dollar. In July we increased our investments in the foreign equity markets with the purchase of the Matthews Pacific Tiger Fund.
HEDGE FUNDS

Our stock selection continues moving down the capitalization scale as exemplified by Symbion (SMBI), Avery Dennison (AVY), Stericycle (SRCL) and Fiserv (FISV). We are finding better values in mid-sized companies and do not foresee the negative headline risk that larger companies like AIG or Morgan Stanley have experienced. In the Healthcare sector, Biotech has been very positive. Amgen alone was up $20.00/share in July. Pharmaceutical companies continue to be under pressure as pricing power continues to move from the manufacturers to the managed care providers and pharmacy benefit managers (PBMs). Hospitals are seeing profit pressures as highly profitable ambulatory surgery is moving to specialized forprofit facilities. The technology sector had a great July but mid quarter updates and earnings releases caused many stocks to give up their gains. INTERNATIONAL In July the London terrorist bombings rocked the markets. Market participants, skittish about the threat of a coordinated terrorist attack, initially caused the market to decline but in subsequent days the markets recovered. Recent elections will have significant effects in key geographies. In Germany, we witnessed election stalemate. The stagnant German economy still awaits an outcome and leadership that will start its considerable economic engine. Perhaps more significant is Kozumis election win in Japan. The win provides him with a necessary vote of confidence to enact dramatic reforms to reduce the size and

As we predicted in our last commentary, the problems in select hedge funds are coming to light. The Bayou Capital saga is a sad tale of fraud and deceit. The degree of leverage in the overall market has risen due to the activity of hedge funds. The Counterparty Risk Management Group II (the revival of a group formed in 1999 following the implosion of Long Term Capital Management) reports that 40% to 80% of all market trading is done by hedge funds. The level of derivative exposure outstanding is staggering: JPM had $41 trillion of total exposure ($60 billion net of offsetting positions) at end of the 1st Quarter from facilitating hedge funds activities. LOOKING AHEAD As hurricane season ends, the market turns its attention to 3rd Quarter earnings announcements. We feel it is too early to begin discounting an economic recession and anticipate that corporations will largely meet or beat earnings expectations and oil prices will moderate as supply is normalized. Our focus will be on the consumer discretionary sector, expected to be the most affected by the run up in oil prices. Falling revenues and compressed margins in this sector will be a harbinger of declining consumer strength and a signal of recessionary storm clouds on the near horizon.

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