Q3 Commentary (2005)

Recent quarterly commentaries have seen us discuss many challenges facing the economy. The greatest concerns centered on rising oil and gas prices combined with continued short-term interest rate increases and the eventual impact this might have on the consumer. Despite these headwinds consumer spending has continued at a fairly robust pace as employment and housing continued to provide stimulus. GDP grew at a still solid 3.3% in the 2 nd quarter on the heels of a 3.8% first quarter and 4.2% in 2004.

While there are signs that the economy was already slowing, the 3 rd quarter of 2005 may represent an inflection point in our economy. Two unprecedented natural disasters in our Gulf Coast region have helped propel oil prices to over $66 per barrel. Over the past year the U.S. retail price of gasoline has risen to $2.94 a gallon from $1.93, similar in percentage increase to the rise in heating oil. Natural gas has soared over 100% during this period from $6.73 per mBtu to $14.02. Additionally during the 3 rd quarter, the Federal Reserve increased interest rates 2 more times leaving the short-term Fed Funds rate at 3.75%. While market participants have hoped the cycle is almost over, Fed officials have indicated that inflation is at the "upper end" of the central bank's comfort zone thus pointing towards more increases in the offing and gold at 17-year highs seems to corroborate this concern.

While unemployment moved to a new 4 year low at 4.9% and corporate earnings growth continued strong increasing 13% in Q2, it is the consumer that has propelled our economy. As consumer spending represents an astounding 71% of US GDP and the personal savings rate has moved into negative territory, the continuation of this recovery is at risk. Moderation in job growth along with flat real income growth are now joining energy costs as additional headwinds facing the household sector. In turn we are seeing unmistakable signs of a "cooling" in a previously "red-hot" real estate market with inventories of homes rising and days on market increasing. Despite year-over-year price gains of over 30% in the dollar value of existing home sales, inventory levels and affordability indices are approaching recession levels.

The impact of rising short-term rates is manifested in the reduction of demand in the Adjustable Rate Mortgage (ARM) market and mortgage refinancing areas which have long supported the indebted consumer. While long-term rates remain very attractive, adjustable and interest only mortgages are tied to short term rates and have been the loan of choice for many buyers who have entered the markets for second homes or aggressive investments.

In spite of the above concerns, the major averages enjoyed their best quarter of the year as the S&P 500 and Nasdaq raced ahead 3.6% and 4.6% respectively. The strong quarter moved the S&P into positive territory for the year at 2.77% despite yields on 10-year Treasuries increasing to 4.33% from 3.94% at the end of the 2 nd quarter. As in the 2 nd quarter, higher beta areas such as Small Cap stocks continued to outperform with the Russell 2000 enjoying a 4.4% return.

The real story in performance attribution however is to be found at the sector level both for the quarter and YTD. Energy returns continue to dominate the indices as the sector returned 17.77% for the quarter and 39.96% for the year. The S&P 500 returns of 3.60% for the quarter and 2.77% for the year would be 1.61% and -1.90% respectively ex-Energy crystallizing the narrowness of the market returns.

The major markets have now spent the better part of the last 2 years in a narrow trading range rising about 12% since the beginning of 2004. Corporate profits, however, have increased over 40% during this period compressing valuations to levels of about 16x current earnings and potentially providing a floor to support decelerating earnings. With dividend payout ratios still near 40-year lows and corporations flush with cash, accelerating dividend increases, share buybacks, and increased M&A activity can continue and help propel the markets. A slowing economy should reward the owner of high quality, stable-growth companies that possess attractive valuations and strong yields with shareholder focus.

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