Q1 Overview (2005)

Following a strong 4th quarter in 2004, the equity markets entered the year looking for a still strong but slowing economy for direction. Preliminary indications show the first quarter will likely exceed consensus expectations with GDP growth coming in over 4%, corporate earnings looking up over 8% while inflation readings have so far remained at reasonably low and stable levels below 2.5% for the core CPI.

Still there appear many indications that the economy is slowing in the 2nd quarter as unemployment claims, consumer spending, income growth and industrial production are all decelerating from prior levels. Previously discussed concerns regarding the effects of rising interest rates and the potential impact on consumer spending are weighing on the markets with the heightened concerns of oil prices reversing their 4th quarter decline by rising over 30% to almost $56/barrel as of this writing.

For the quarter, the S&P 500 and Nasdaq declined 2.1% and 8.1% respectively. Energy was the top- performing sector returning over 17% while Technology and Financials declined 6.9% and 7.4% respectively as disappointing earnings and concerns regarding rising interest rates fueled selling pressure.

Some flight to quality could be found in the out-performance of the S&P 500 relative to the smaller cap Russell 2000 which declined over 5.3%. International stocks as measured by the EAFE index and Emerging Markets outperformed for the quarter despite suffering through a difficult month of March where declines of 2.5% and 6.6% were experienced.

Continued tightening by the Federal Reserve has increased short term interest rates 50 basis points to 2.75% while the 10-year Treasury yield rose to 4.49% bringing many consumer rates up with it and serving to further flatten the yield curve. The continued intentions of the Fed to take the necessary steps in controlling inflation may, if successful, serve to actually hold down longer-term rates. Credit spreads widened specifically during the month of March as concerns at General Motors affected many credits.

Moreover, the continued period of rising rates along with the costs of rising commodities should serve to alter the leadership of this market through the moderation of economic and corporate earnings growth. Previous leaders in the more volatile areas of small cap and economically sensitive stocks should find more challenged growth in this environment. Higher quality, demand-defensive issues present in our portfolios with lower valuations and premium yields should continue to provide excess returns with lower risk over the market cycle.

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