QUARTERLY COMMENTARY THIRD QUARTER 2006

corporate scandals led by Enron and WorldCom, the decline in interest rates to 50-year lows, the rise of oil The 3rd quarter produced sparkling returns for the from $28/bbl to $77/bbl, a housing boom, the growth markets with both U.S. Stocks and U.S. Bonds of hedge funds, and many mergers and acquisitions. posting positive returns. The Dow Jones Industrial Through it all, the U.S. consumer has continued to Average nearly closed at a new high on the last spend retail sales are up 25%, and businesses have rd trading day of the quarter, but settled instead for a 3 continued to grow corporate profits are up over quarter return of 4.74%, its biggest quarter since 100%. 1998. The index had an intraday high of 11,741 for 3RD QUARTER IN REVIEW the quarter, but could not close above the previous high of 11,722, set on January 14, 2000. While the The 3rd quarter started off weak as a number of 30 stocks in the Dow Jones are back near record company earnings reports disappointed market territory, the rest of investors resulting in the U.S. equity precipitous one-day Dow Jones Industrial markets are far stock price drops of 10January 2000 High from breaking 20%. Dow Jones records. The S&P components: 500 closed at 1,335 Minnesota, Mining & still 12.5% below Manufacturing (tkr: the high set on MMM) and Intel (tkr: March 24, 2000 at INTC) were among the 1,527. Even more names that exemplified 9/11/01 dramatic, the this action. The market NASDAQ closed also responded to the 3rd quarter at weakness in individual 2,258 55% below consumer-oriented Source: Bloomberg its high of 5,048 on companies, which have March 10, 2000. Small stocks, though still positive, been a source of strength for many consecutive posted a second consecutive weak quarter. The quarters. Companies like Tiffany (tkr: TIF), Whole Russell 2000 appreciated only 0.44% in the 3rd Foods (tkr: WFMI), Cheesecake Factory (tkr: quarter. After a strong start to the year, foreign CAKE), and Starbucks (tkr: SBUX) all had equities were up 3.99%, underperforming the U.S. exaggerated declines after disappointing earnings markets for the first time in two years. reports.
A NEW HIGH! (NEARLY) THAT WAS THEN

Much has changed since the markets last traded at these levels, most significantly is the optimism surrounding the equity markets. In January 2000, the S&P 500 was trading at a price earnings ratio (P/E) of 31.5. Todays P/E ratio of 17.5 is indicative of both the significant growth of corporate earnings over the last 6 years and the fact that investors are applying far more reasonable valuation metrics. The resilience of the financial markets since the Dow Jones last traded at this level has been impressive. In the years since the last high, investors have endured the experiences of 9/11, hurricanes Katrina and Rita, the Indonesian tsunami, the start of two wars,

The market rally began in mid-July in response to Fed Chairman Ben Bernankes July 17th speech to the Senate Banking Committee. He suggested that the Fed might end its two-year series of rate increases at their next meeting. Chairman Bernankes comments were buoyed further with earnings that beat analyst expectations, most notably Goldman Sachs (tkr: GS) and Oracle (tkr: ORCL). In our portfolios, the big winners in the quarter came from the technology sector. Oracle (tkr: ORCL), Motorola (tkr: MOT), and Cisco (tkr: CSCO) all posted stock gains in excess of 20%. The energy sector, after an extremely robust first half of 2006, contributed the biggest decliners in the quarter as

crude oil prices fell to $60/bbl. Marathon Oil (tkr: MRO) and Schlumberger (tkr: SLB) each fell just over 10%.
A CHANGE IN DIRECTION

On the heels of a strong 2005, commodity price gains continued in the first half of 2006, peaking in midMay. But after reaching these highs, gold, oil, Index Performance and natural gas, as well Dow Jones Industrials as the entire CRB index Standard & Poors 500 fell in the 3rd quarter. EAFE (international stocks) The CRB, having Russell 2000 (small stocks) reached a 25-year high Lehman Intermediate was down 12%. Gold, Lehman Municipal which peaked at $714.8/oz, was down 16.2%. Oil dropped from the July 14th high of $77/bbl to $62.9/bbl a decline of 18.3%. The decline in oil can be attributed to Chevrons (tkr: CVX) announcement regarding the discovery of the most significant new domestic oil find since Prudhoe Bay in 1968. Its Jack 2 Well in the deep water of the Gulf of Mexico is estimated to hold nine billion barrels. DEFICITS, THE DOLLAR, AND INTEREST RATES We highlighted the growing problem of the U.S. Current Account Balance in our last quarterly commentary. If the trade balance continues to widen, we believe the U.S. dollar will suffer further weakness. To hedge portfolio exposure to this risk, we established a position in an international bond fund during the quarter. The American Century International Bond Fund (Tkr: BEGBX) invests in non-U.S. sovereign debt and will appreciate in value if the U.S. dollar continues to weaken. The Federal Reserve raised rates at its June 29th meeting for the 17th time, and then made the difficult but very significant decision to leave rates unchanged at the August meeting. The central bankers are trying to walk the fine line between keeping inflation under control and pushing the economy into a downturn as we see signs of both accelerating inflation and moderating growth. Bond securities rallied on expectations of this pause and yields have continued to move lower. We think the bond market is ahead of itself, even if the Feds next move is to lower rates in the spring.
ETHICS IMPACTING THE MARKET

board of directors and CEO making news in connection with the companys investigation into boardroom leaks. Recently the F.B.I. announced they were aiding the Justice Department in its investigations into the options backdating scandal. We feel the escalation of this issue by the SEC and the FBI is a significant development. We Q3 06 YTD expect to see the more 5.34 10.85 egregious examples of 5.66 8.52 corporate fraud 3.99 14.97 punished with both 0.44 8.73 prison time and fines. After several examples over the last year of unethical or fraudulent behavior on the part of a few hedge funds, this quarter we have seen headlines driven by extremely large investment losses. For example, Amaranth, a fund with about $9.5 billion in assets, lost $6 billion over one weekend in early September, due in large part to erroneous speculation on the direction of natural gas prices. Though Amaranths investors suffered significant losses, the liquidation of the firms positions was orderly and did not cause a dramatic market reaction.
FALL EXPECTATIONS

3.19 3.41

3.01 3.69

With the equity markets posting solid returns through the first three quarters of 2006, our expectations for returns through the remainder of the year are muted. The economy is slowing, the current conflicts in the Middle East remain unresolved, and the mid-term elections will likely create more questions than answers. Corporate earnings growth will continue to drive the direction of the stock market. We have acted on expectations for a lackluster 4th quarter by increasing our cash holdings. As the market rallied in the 3rd quarter, we trimmed holdings in Pepsi (tkr: PEP), McGraw Hill (tkr: MHP), Oracle (tkr: ORCL), and our S&P small cap 600 iShare (tkr: IJR). Our attention is focused on the handoff between the individual and the corporate consumer and we look for opportunities to profit from that exchange.
SUSTAINABILITY: AN INVESTMENT THEME

The recalibration of the ethical landscape in corporate America continues. We have seen daily reminders of the focus on ethical behavior with Hewlett-Packards

Brooks Nelson recently presented on the investment topic of Sustainability. If you are interested in receiving a copy of the presentation slides, please contact Elizabeth Fannon at (650) 322-4000 or efannon@nelsonroberts.com.

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