• For the first quarter of 2006, returns for equities were their strongest since the fourth quarter of 2004. Bonds struggled under the weight of rising short-term and long-term interest rates.
• After a tenure that lasted nearly two decades, Alan Greenspan relinquished the reins to Ben Bernanke as the Chairman of the Federal Reserve. Greenspan ended his tenure with another quarter point rate hike, which was followed by a second increase of the same amount by the new Bernanke Fed, bringing the fed funds rate to 4.75%.
• The yield curve steepened slightly as long-term rates finally began to respond to increases in short-term rates and the belief that the slowdown in GDP growth was temporary. The benchmark ten-year Treasury yield finished the quarter at 4.85%, up from 4.39% to end 2005. Yields for both the 10-year and 30-year treasury remain fractionally higher than all shorter maturities along the curve.
• Inflation concerns appear to be dissipating somewhat, although headline CPI ticked up slightly to 3.6% for the trailing 12 months ended February. Core CPI, which removes volatile food and energy costs, remained unchanged at a moderate 2.1% annualized.
• During the past three months, the U.S. Dollar weakened slightly against major foreign currencies, reversing gains against the Euro, Yen, and Pound in 2005. With the largest decline being just under 2%, however, the pullback was not of particular concern
• Unemployment receded to 4.7% in March back to its January level and matching its lowest point since July 2001. Job growth remains relatively strong, suggesting that the increase results from an increase in job seekers rather than a net loss in job creation.
• Equity P/E ratios moved in opposite directions during the quarter, but increasingly favor large caps. The P/E for the Russell 200 Index declined, while P/Es for both the Russell Mid Cap and 2000 Indices moved higher. International P/Es also increased. Relative to one year ago, large cap stock valuations continue to trend most favorably.
• Small cap stocks led the markets for the quarter; the Russell 2000 Index sizzling gain of 13.9% led very strong results for stocks. The S & P 500 gained 4.2%, while the MSCI EAFE Index of international stocks gained 9.4%.
• A diversified portfolio including mid cap, small cap, and international stocks provided substantial value beyond a traditional blue chip portfolio.
  

April 2006

Capital Markets

Thus far, 2006 has been “a tale of two asset classes”, with strong results for stock investors providing a stark contrast to generally disappointing returns in bonds. Investors who have waited patiently through sometimes sideways markets over the past few years witnessed the strongest single quarter returns in stocks since the fourth quarter of 2004. It also marked the best first quarter results for the broad equity markets since 1998.

Not coincidentally, the equity rally followed the slowest quarter of GDP growth since the first quarter of 2003. As anticipated, the relatively brief but significant surge in oil prices early last fall negatively impacted consumer spending. With discretionary income eroded by higher gasoline and heating costs, U.S. consumers modified their spending habits enough to reduce growth to a below trend 1.7% annualized rate for the quarter. The primary fear was that energy price increases might not pull back and, more critically, might begin to flow through to core inflation. With energy prices subsequently stabilizing, the feared impact on core consumer inflation did not materialize.

While official first quarter GDP growth estimates have not yet been released, the prevailing expectation is for a sharp rebound from the fourth quarter. Some economists are calling for the strongest quarter of growth since 2003, perhaps topping 4.5%. Increased government spending and private sector capital investment appear to be leading contributors as consumer spending may be peaking at least temporarily. The rate of real (inflation-adjusted) consumer spending has been declining steadily since November, reaching just 0.1% in February. For the twelve months ended February, real disposable income rose just 2.2%. Personal savings rates have been negative since the second quarter of 2005, further limiting aggregate consumer ability to increase spending without increases in income.

Since the unemployment rate peaked in June 2003 at 6.3%, over 5 million jobs have been created, sufficient to push that rate down to 4.7% in March. As the economy moves closer to capacity in labor markets, wage growth rates could begin to accelerate. As long as wage growth remains moderate, this should provide further support for consumer spending and, ultimately, GDP growth as well. Excessive pressure on labor costs could also push inflation higher. Nonetheless, at this point, we believe that wage growth should remain contained.

As is often the case, much of the improving economic news that has generated strong equity returns was cause for pessimism in the fixed income markets. Long-term rates surged during the quarter, as the yield on the benchmark ten-year Treasury increased almost a half percent since December 31. As expectations shifted toward a more optimistic outlook for the economy and fourth quarter results increasingly appeared to be a short-term phenomenon, the market began pricing in further Fed rate hikes.

Early in 2006, short-term rates were briefly higher than long-term rates, a trigger that has historically often signaled a recession in the near term. While the yield curve remains relatively flat, long-term rates finally responded to the Fed’s persistent tightening. The reversal of this inversion reflects increasing optimism that the U.S. should experience economic growth in 2006 that is stronger than that of the fourth quarter of 2005. To be certain, this is generally good news – just what the fixed income markets did not want to hear.

For the quarter ended March 31, the S & P 500 Index gained a solid 4.2%, only 0.7% less than its return for the entire 2005 calendar year. Mid-cap stocks, which paced the U.S. markets in 2005, continued to perform well; the Russell Mid Cap Index returned 7.6% for the quarter. Market leadership clearly belonged to small cap stocks, which easily outdistanced larger companies. The Russell 2000 Index gained 13.9%, its strongest quarterly results to begin a year since 1990.

Conversely, bond returns for the quarter were mediocre at best. The Lehman Aggregate Bond Index lost 0.7% during the three months ended March 31. Municipal bonds fared slightly better; the Lehman Muni Bond Index 5 Year basically broke even for the quarter. As would be expected given the uptick in long-term bond rates, short-term bonds held up better. The Lehman 1-3 Year Government Index provided a fractionally

positive return of 0.4%, outpacing the Lehman Muni Bond Index 3 Year return of 0.1% for the quarter.

Returns in international bonds were mixed; the Citi World Government Bond Index Hedged lost 1.0% for the quarter. Certain segments of the international bond market, including emerging markets bonds, performed reasonably well for the quarter.

Influences and Strategy

It is not unusual for our clients to contact us with questions about industry news, market events, or new investment opportunities that may be receiving a great deal of attention in the popular press. Not surprisingly, the spike in oil prices last fall generated renewed interest in natural resource and commodity related investments. Within just weeks after Hurricanes Katrina and Rita devastated the Gulf Coast region and prices for crude oil, gasoline, and natural gas spiked, many were trumpeting the merits of investments tied to the prices of those commodities.

Unfortunately, once an investment “opportunity” is highlighted in the mainstream press, it is often no longer an “opportunity”. Such has been the case for commodities in the intervening period. Since peaking in mid-December, the Dow Jones AIG Commodity Index has lost over 7.0% through March 31. For the first quarter, it has lost over 2.0% during a period in which the equity markets have performed very well. While the preceding period provided a brief spurt of strongly positive performance, the returns of the Dow Jones AIG Commodity Index over the past year clearly illustrate the significant volatility associated with investing in commodities.

We continue to evaluate commodities as an asset class and believe that there may be strategic merit for an allocation to commodities for many investors. However, we believe that prudence dictates that even an investment that may represent an attractive long-term, strategic opportunity should not be made if it may be overvalued. Clearly, the immediate prospects for commodities at the time were much bleaker than much of the popular press indicated when oil prices were peaking last fall. For investors who bought into commodities after their furious rally, the subsequent pullback was a reminder that the recent performance of any investment isn’t necessarily indicative of its future attractiveness.

While an extended period of good performance by an asset class can be a signal of greater downside risk due to overvaluation, that is not always the case. After a multi-year period of strong performance, some money managers are starting to be wary of investments in emerging markets (EM) debt. While their argument is far from universally accepted, it has gained some traction. Their conclusion is based primarily on the currently low yield spreads between EM bond yields and U.S. Treasuries compared to their historical levels. Yield spread represents the premium that an investor receives for investing in higher risk bonds, which can also include high quality corporate bonds, high yield bonds, foreign bonds, or, in this instance, emerging debt.

Clearly, EM spreads are at historically low levels. However, we continue to believe in the performance and diversification merits of considering EM debt and other foreign bonds in a well-diversified bond portfolio. The correlation of such bonds to both traditional high quality U.S. bonds and both U.S. and international equities remains low, suggesting that EM bonds provide diversification benefit. The current yields provided by EM debt remain higher than those generally available in high quality domestic bonds.

Perhaps most importantly, we believe that the fundamental rationale for owning those bonds remains intact. The long-term, secular trend of improving liquidity and currency reserves in the emerging market countries is still underway. Economic growth throughout most of the developing world remains strong, and the continued reliance of the U.S. on foreign central banks to finance our ballooning trade deficit should continue to improve the economic stability and reserve positions for the emerging market countries that are profiting from our domestic spending. We believe that, while spreads are much lower than was the case even a few years ago, EM debt remains an attractive option for many investors, subject to consideration of their overall portfolio structure and tax circumstances.

Both commodities and EM debt represent distinct investment strategies and asset classes that we continue to evaluate on an ongoing basis. Each has strategic benefits for use in individual client portfolios in certain circumstances. Each has been the subject of discussion in the press over the past several months and, in both cases, we have reached our conclusions based on our independent evaluations of their relative attractiveness both tactically and strategically. We believe that our independent analysis will continue to contribute to positive results in your portfolio through improved performance, reduced risk, or a combination thereof. Sometimes, that requires that we not follow the herd.

In addition to our evaluation of emerging asset classes, mutual funds, and money managers, we are also continually evaluating the relative attractiveness of traditional asset classes. As part of this analysis, we continually evaluate their respective current valuations and outlook to implement appropriate allocations to each.

Increasingly, independent academic studies have concluded that traditional allocations to international stocks in a diversified equity portfolio have been lower than would optimally be the case. Put simply, the actual risk, return, and correlation statistics for international and domestic stocks indicate that “conventional thinking” among investors and advisors has resulted in an allocation to international stocks that should have been higher to fully realize the diversification benefits. The results of our internal quantitative research also support this same thesis.

Relative to most investment advisors, our typical international equity allocations have historically been higher than the industry norm. Over time, our clients have reaped the benefit of this higher allocation – a reduction in portfolio volatility and improved risk-adjusted returns. Based on these recent findings and below average returns in blue chip stocks over the past several years, the investment advisory industry has begun to increase their recommended allocation to international equity. As a result of our quantitative research and increasing acceptance of larger commitments to international stocks, we will be evaluating the merits of further increasing the international equity allocation in your portfolio in the near future.

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.