• The strong stock market rally from the closing months of 2004 failed to carry over into 2005 as the equity markets generally pulled back during the first quarter.o The Fed raised short-term rates twice during the quarter, bringing the Fed Funds rate to 2.75%, and marking the sixth and seventh increases in less than nine months. The bond market responded negatively, although the longer end of the yield curve remained less volatile than short-term rates. The 10-year Treasury rose about one quarter point to 4.5%.o Oil prices surged again, easily pushing through previous record prices set last fall. Suggestions from OPEC and various market analysts that prices could go much higher further unsettled the investment markets.
  
  
• Inflation stabilized somewhat during the quarter; the trailing 12-month CPI receded fractionally to a 3.0% annual rate. The core rate ticked upward to 2.4%, however, excluding more volatile food and energy prices.o The U.S. dollar strengthened nominally relative to major foreign currencies, gaining 2.5% – 5.6% against the EU’s Euro, Japanese Yen, and British Pound during the quarter, at least briefly reversing a multi-year trend.
  
  
• Unemployment improved fractionally to 5.2% through March, although employment growth for the month at 110,000 new jobs was weaker than anticipated.o Equity P/E ratios continued to ease during the quarter, led by decreases in small cap valuations. Other valuation measures have been mixed depending on market cap and style. Given the expectation that interest rates will continue to rise, this trend may continue in the near term.o Stocks, both foreign and domestic, lost ground during the quarter, with small caps suffering the greatest decline of 5.3%. The S & P 500 slipped 2.2%, while mid caps and international stocks lost only 0.3% and 0.2%, respectively.o Defensive and broad fixed income returns were both fractionally lower for the quarter. The Lehman Aggregate Bond Index lost 0.5% during the period.

The market enthusiasm that carried investors to strong fourth quarter returns for 2004 failed to carry through into the New Year. Profit takers cashed in prior gains in the first quarter, sending stocks lower across the board. The concern that inflationary pressures not only refuse to abate, but might even be gaining momentum, have unquestionably contributed to the market’s jitters.  Increasing inflation accompanied by a slowdown in domestic growth would place the Federal Reserve in a difficult position relative to its current strategy of gradually ratcheting up short-term interest rates. Some economists consider low level inflation to be a structural byproduct of a growing economy and, to the extent it remains temperate, a benign result not worthy of concern. The greater fear rests in the potential for inflation to resist the efforts of the Federal Reserve to keep it in check, requiring more aggressive means that could have the unwanted effect of stalling the economy.

During the quarter, the S & P 500 index fell 2.2%, giving up a portion of its post-election gains. Mid caps fared better than the other segments of the domestic market, losing a comparatively small 0.3%. Smaller cap stocks were the biggest losers, however, posting a quarterly loss of 5.3%. With the U.S. market under pressure, international stocks slipped fractionally as well, losing 0.2% during the quarter, but maintaining its position as the best performing equity asset class as in 2004.

Rising short-term rates continued to weigh heavily on the fixed income markets. The Federal Reserve’s decision to raise its benchmark overnight lending rate by a half percent during the quarter pushed the short end of the curve upward. Longer term bond yields also came under pressure as a result. The ten-year Treasury yield, which began the year at about 4.2%, bottomed out at around the 4.0% level before spiking to close the quarter at about 4.5%.

The Lehman Aggregate Bond Index lost 0.5% for the quarter, although even short-term bonds came under fire as demonstrated by the 0.3% loss of the Lehman Aggregate 1-3 Year Government Index. Municipal bonds were hit harder as the Lehman Muni Bond Index 3- year and 5-year lost 0.8% and 1.2%, respectively. Generally, the modest yields received by holders of high quality bonds were insufficient to offset principal losses in bond values as the market began to price in higher inflation and the prospect for further action by the Fed. International bond markets were perhaps the lone bright spot as the Citi World Government Bond Index Hedged posted a comparatively strong 0.9% gain for the quarter.

Despite this mild pullback in the markets, the economy itself appears to continue to stay on course. Prevailing economic thought currently projects that U.S. economic growth will diminish from its strong rate of growth of 4.4% in 2004. The nation’s unemployment rate, long mired in the 5.4% – 6% range, has quietly crept downward to 5.2%. Job creation appears to remain solid, albeit not spectacular. Although the March new jobs report came in much lower than anticipated, preliminary results suggest that about 475,000 new jobs were created in the first quarter.

While stronger job growth would be generally preferable, this tepid result should bolster the Fed’s ability to continue to gradually raise short-term rates. Strong job growth coupled with flaring oil prices and the threat of increasing core inflation may move the Fed to assume a more aggressive posture in raising rates. Such a change in the Fed’s stance could continue to weigh negatively on Wall Street. All else being equal, in the face of an otherwise growing economy and increasingly reasonable valuations, it seems unlikely, however, that any such pullback would be severe or lengthy.

As we outlined in our research paper 2005: The Road Ahead, our immediate outlook for the capital markets remains cautiously optimistic. (If you did not receive a copy of this research paper, please contact us.) Equity valuations continue to trend downward, primarily as measured by P/E ratios, which are generally more volatile than other measures based on book value or cash flow. Given the upward surge in interest rates, downward pressure on P/E’s was to be expected; the long-term inverse relationship between bond yields and P/E ratios is well-documented. Also working in favor of lower P/E’s has been corporate earnings growth that has outpaced appreciation in stock values. Combined, these dynamics have contributed to the compression of P/E’s down toward long-term historical averages over the past year.

Although some bond pundits argue that certain segments of the bond market remain relatively unattractive due to stubbornly low yields on intermediate to longer term treasuries and corporates, rising rates also present problems for not only corporations, but individual borrowers as well. Over the past twenty years, mortgage rates have gradually receded from historically high levels to low points not seen in over a generation. For home purchasers utilizing substantial leverage to finance the transaction, the decline significantly reduced the cost of housing. The accompanying boom in re-financing also provided fuel for the economy as lower housing  payments allowed funds to be diverted to other spending. With the Fed beginning to ramp up rates, mortgage rates bottomed and began forging higher, dampening activity in the refinancing market.

Just as higher borrowing costs can weigh heavily on corporate earnings and, consequently, stock prices, consumer spending may not be able to maintain its current pace if previously discretionary cash flow is sapped to cover increased housing costs. Excessive consumer debt that is typically subject to higher interest rates would also become more costly to carry. Borrowers are left with the difficult and costly choice of either redirecting funds to pay off their debt or subject themselves to higher interest costs. Either would result in an increase in borrowing costs and a decrease in discretionary cash flow. Given that consumer spending represents the largest component of GDP, a large scale reduction in consumer discretionary income, and ultimately spending, could be detrimental to the rate of domestic economic growth.

Also symptomatic of the preference within the U.S. toward consumption over savings, the dollar remains generally weak against world currencies. Although it strengthened 2.5% – 5.6% against the Euro, Yen, and British Pound during the quarter, this represents only a small gain relative to the much greater decline over the past couple of years. Further, some are making a well-reasoned case that any substantial strengthening in the dollar is likely to be a short-term trend that is unlikely to be sustained. Given the ongoing structural trade and federal deficits, the deck remains stacked against a meaningfully stronger dollar for the foreseeable future.

We continue to seek opportunities to add value beyond a traditional portfolio of blue chip stocks and high quality bonds. In recent years, significant allocations to small cap stocks, Treasury Inflation Protected Securities (TIPS), and high yield bonds added meaningfully to portfolio returns. Today, we believe that the economic cycle and market valuations are more likely to favor large cap stocks and international stocks and bonds. While current valuations in these areas do not suggest the same degree of potential relative benefit that was realized through our prior tactical allocations noted above, we believe that the current positioning of your portfolio is appropriate given relative values and the current macroeconomic outlook.

You may recall from our last report that the Securities Exchange Commission (SEC) announced in November that it was investigating the trading methods employed by a number of the largest brokerage firms, including Charles Schwab. The investigation related to allegedly inappropriate trade routing of certain Nasdaq stocks which may have created a conflict of interest for the brokerage firms involved.

As we noted in our previous correspondence, the investigation does not relate to mutual fund, fixed income, and most individual stock trades. Consequently, we believe that the ultimate resolution of these matters will have no effect on most, if any, of our clients. We remain unaware of any client that was adversely affected by these alleged practices. Since that initial announcement, there have been no changes in the status of the investigation that have been publicly disclosed. Although Schwab has declined to comment on ongoing SEC investigations, they have stated that they remain confident that the investigation will show their  ommitment to providing best execution for client trades. We will continue to monitor the situation and keep you apprised of any significant developments.

On an unrelated note, effective March 1, the American Advantage family of mutual funds was renamed as American Beacon funds. Included in this change was the American Aadvantage International Equity Fund, in which a large number of you are invested. The name of the fund is now the American Beacon International Equity fund. Please note that we have reflected this name change  accordingly in our reports to you. We have been in communication with American Beacon and they confirmed that the fund itself remains intact with no current or anticipated changes in the fund’s management or cost structure.

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.

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