• On the strength of solid November returns, bonds and stocks rallied in the fourth quarter to post positive returns in most major indices.
• The Fed announced two .25% increases in the Fed Funds rate in the fourth quarter, raising the discount rate to 4.25%. The yield curve continued to flatten as longer term bonds did not respond significantly to the hikes. The benchmark 10-year Treasury yield finished the year at 4.39%, only .06% higher than at September 30. Relative to the 2-year Treasury, the yield curve actually inverted slightly in the closing days of 2005.
• Oil prices pulled back after peaking at over $70 per barrel in the third quarter. The resulting fears of rapidly increasing inflation or even another potential oil crisis appear to have subsided.
• Despite receding oil prices, inflation remained a concern. The CPI moved down to 3.5% annualized from its 4.7% peak in September. Core CPI, which removes volatile food and energy costs, remained at a moderate 2.1% annualized.
• The U.S. dollar extended its gains against major foreign currencies, capping a year of gains of 11 - 15% against the EU’s Euro, Japanese Yen, and British Pound during 2005.
• Unemployment dipped back to 4.9% in November after rising briefly in the wake of Hurricanes Katrina and Rita. The economy is estimated to have created over two million new jobs in 2005.
• The direction of equity P/E ratios was mixed during the quarter, as the S&P 500 and Russell 2000 P/E ratios declined. The Russell MidCap Index P/E moved higher, continuing the same trend from the trailing twelve months. Growth stocks generally continue to appear more favorable relative to value stocks.
• International equities led the markets for the quarter; the MSCI EAFE Index performance of 4.1% easily outpaced the best performing domestic segment. The S & P 500 gained 2.0%, trailing the Russell MidCap by a slim margin, but outdistancing the Russell 2000 by 0.9%.
• A diversified portfolio of mid cap, small cap, and international stocks provided substantial value beyond a traditional blue chip portfolio. International fixed income also enhanced the returns of a core portfolio of either high quality taxable or municipal bonds.
  

January 2006

Capital Markets

Happy New Year!

Despite a November rally that gave hope to investors for a strong close to the year similar to that in 2004, the markets faltered in the closing days of December. Although stocks again outperformed bonds in 2005, domestic equity performance across all sub-asset classes was lower than in the preceding two years.

The economy continued its steady advance through the year and the outlook for 2006 remains relatively upbeat. The efforts by the Fed to nominally cool the rate of growth and contain inflation risks showed some signs of effectiveness. Consensus GDP expectations for 2006 are for growth in excess of 3 percent, but slightly slower than that in 2005. Inflation concerns remain elevated as a result of the sharp uptick in energy costs due to growing global demand and tight supplies.

The surge in petroleum and natural gas costs in the third quarter partially receded in the fourth quarter, but fundamental supply/demand dynamics remain a concern. As we noted in our oil market commentary in October, the hurricanes brought oil prices back into the headlines, but were not the sole contributor to increasing prices. Uncertainty about the potential long-term economic effects of higher energy costs weighed on the market in the fourth quarter and represented the greatest single source of concern for equity investors.

For the quarter ended December 31, the S & P 500 Index gained 2.0%, raising its return for the year to a modest 4.9%. This gain came despite the market’s October selloff on inflation worries. Investors also reacted to the declaration of bankruptcy by Delphi and increasing difficulties faced by the U.S. automotive industry. The subsequent easing of oil and gasoline prices helped to alleviate the immediacy of those concerns, in addition to providing relief to consumers and brightening the outlook for consumer spending. Ultimately, that easing also likely sparked the November rally that carried stocks higher.

Mid Cap stocks continued to pace the U.S. markets, with the Russell MidCap Index tallying a return of 2.4% for the quarter and 12.7% for the year. Small Cap stocks lagged other domestic indices with the Russell 2000 gaining 1.1% for the quarter. The Index’s gain of 4.6% for the year trailed the S & P 500, showing signs of potentially reaching the end of their dominance of the last few years.

International stocks fared much better. The MSCI EAFE Index of developed markets was up 4.1% for the quarter, building on its prior year-to-date gains to finish the year up 13.5%. Equity markets internationally generally posted substantially higher local currency gains. The strength of the dollar against the Euro and Yen in particular negated a portion of those gains for U.S. investors. Nonetheless, international diversification provided substantial value in 2005.

Since the Fed began its series of rate hikes in June 2004, the U.S. bond market has been under pressure. Rising interest rates erode bond prices, with longer term bonds subjected to greater risk of loss. The Fed’s cycle of rate hikes progressed unabated throughout the year, including two additional quarter point increases announced during the fourth quarter. A total of eight rate increases lifted the Fed Funds rate from 2.25% at the outset of 2005 to 4.25% at the end of the year. The Lehman Aggregate Bond Index returned just 0.6% for the quarter. However, that return would have been lower had not the yield curve flattened further. Municipal bonds lagged further behind; the Lehman Muni Bond Index 5 Year returned 0.3% to close out a mediocre 2005 with a total return of just under 1.0%.






Despite the 0.5% increase in short-term rates, the benchmark 10-year Treasury yield rose only .06% for the quarter to end 2005 at 4.39%. In the closing days of December, the 10-year yield was actually lower than that of the 2-Year Treasury, creating a mild inversion of the curve and sparking a brief selloff in stocks. Historically, an inverted yield curve has usually been a leading indicator of an expected economic slowdown or recession. In this case, the inversion was short-lived and stocks rallied early in 2006. At this point, evidence suggests that structural supply/demand issues were the cause of the inversion, and that the economy is not likely to become recessionary in the next year.

The performance of foreign bonds was moderately better than that of the Lehman Aggregate. The Citi World Government Bond Index Hedged advanced 0.8% for the quarter. For the year, its return of 5.1% easily surpassed the 2.4% return of the Lehman Aggregate.

Despite the obstacles presented to the markets, a well-diversified portfolio of stocks and bonds performed reasonably well, particularly when compared to a traditional portfolio of blue chip stocks and high quality bonds. As noted previously herein, portfolio allocations to mid cap stocks and international stocks and bonds significantly outperformed a traditional blue chip stock / high quality bond portfolio. Further, this was accomplished without substantially altering the risk of the portfolio. In short, 2005 was a poignant example of the benefits of broad diversification across a range of sub-asset classes.

Influences and Strategy

While we give consideration to the major themes that we expect to influence the markets or impact investors throughout the year, the start of a new year always provides an opportunity to communicate some of our thoughts in an expanded format. In the coming weeks, we will be publishing our economic and capital market outlook for 2006. This research paper will be sent to you upon completion. We will also plan on discussing the themes and conclusions outlined therein as we consult with you regarding your investment portfolio.

As always, our goal is to provide you with the highest level of service accompanied by meaningful insights to assist you in achieving your financial goals.

Industry Matters

We continue to monitor the status of the investigation by the Securities Exchange Commission (SEC) into the trading methods employed by a number of the largest brokerage firms, including Charles Schwab. The investigation relates to allegedly inappropriate trade routing of certain NASDAQ stocks, which may have created a conflict of interest for the brokerage firms involved.

As is typically the case during an investigation such as this, the parties involved are unlikely to comment on its status until the SEC decides on a course of action. There have been no publicly disclosed developments related to the Schwab investigation in the past quarter. Schwab continues to state that they remain confident that the investigation will show their commitment to providing best execution for client trades. We will continue to monitor the situation and keep you apprised of any significant developments.

As always, if you have any comments, questions or suggestions on the report, please do not hesitate to call.

This report is prepared solely to help you with your investment planning. Accordingly, it may be incomplete or contain other departures from generally accepted accounting principals and should not be used to obtain credit or for any purposes other than your investment planning. We have not performed an audit, review or compilation engagement in accordance with standards established by the American Institute of Certified Public Accountants.