ECONOMIC & INVESTMENT SUMMARY
MAY, 2005

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THE ECONOMY

CORPORATE PROFITS

In late 2003, there was much speculation that the US economy was entering a deflationary environment. Now, we have fear of inflation. Today’s economy has rising commodity prices (oil especially), a weak dollar, slower productivity growth and rising labor costs. These factors usually create inflation worries in a strong economy. Should we be worried? Over the last 13 years, inflation has been over 3% only once. In 2004, inflation increased +2.7% while the “core” rate (excluding food and energy) rose +1.8%. This year the CPI and “core rate” are expected to increase +2.8% and +2.5%, respectively. The Fed has been worried about the “upward creep” in inflationary pressures and the March increases were greater than expected. But, we expect the recent strength to be contained because of productivity gains and moderating growth worldwide. The rise of China and India as evolving industrial nations has created fierce global competition. We are in a low inflation, low interest rate global environment. In addition, inflation is likely to moderate over the intermediate term because energy prices may stabilize, producer price increases are mild and the consumer is becoming a better shopper because of the internet. Competitive forces combined with improved technologies that suppress unit labor costs should keep inflation in check. The main question is how long can this last and what are the implications if corporations pass price increases on to the consumer?

In late 1999, the Fed believed that our economy was growing at an unsustainable rate and began to increase the federal funds rate (charged on overnight loans between banks) and the discount rate (the Fed rate on loans to banks). In 2001, we experienced a recession and the Fed rapidly reduced interest rates from 6.5% to 1% in 2002 to improve liquidity, stimulate our economy and prevent deflation. Now, our economy has been expanding for over three years and inflationary pressures are strengthening. As a result, the Fed increased the federal funds rate eight times since last June to 3% on May 3. The goal is to increase rates to a more normal level of 3.5% - 4.0% at a “measured pace” since our economy’s strength does not need low rates. As the Fed raises rates, it becomes more expensive to borrow money – a policy called “tightening” to slow growth. Thus, we expect the Fed to continue raising rates if the economy grows at an above average rate or take a neutral position if growth eases. The objective is to maintain sufficient liquidity for modest growth while restraining future inflationary pressures. We believe the Fed will be successful. This policy is likely to produce higher short and intermediate term interest rates. But, rising cash levels worldwide looking for fixed income investments should keep an upper lid on long-term rates. The wild card is much higher energy prices, inflation and interest rates which would slow our economy more than expected. Another key problem would be higher food and medical costs, which account for 31% of consumer spending versus 6% for energy costs. We need to be vigilant and watch these sectors closely. Finally, Chairman Greenspan retires in January and will not want to leave a legacy of rising inflation.

Over the past two years, job growth and outsourcing have been key topics. For perspective, corporate America embarked on a technology capital-spending boom in 1998-99 primarily because of the Y2K problem, followed by a recession beginning in late 2000. When our economy began to recover in November 2001, productivity increased sharply enabling companies to increase sales without adding new equipment or personnel. In addition, there was a lack of confidence in the sustainability of our economic recovery because of the uncertainties caused by corporate scandals, higher oil prices, Iraq and terrorism. These issues combined with rising health care costs - 27% of total compensation – created a goal to increase productivity, cash flow and reduce employee expenses. Some companies outsourced jobs to low wage countries and this became a major news topic. We lost 2.7 million jobs during and after the last recession, but added 3.1 million jobs since May 2003. Job growth has been somewhat less after each of the last three recessions because of these trends. Our job market has historically shown great resiliency because of our education level, hard work, innovation and risk-taking – our formula for success. We have consistently led the world in productivity improvement and innovation. For example, the World Wide Web was invented in Switzerland, but we developed the technology and market.

Offshore outsourcing has been underway for decades and is gaining momentum because of the intense worldwide competitive environment. This reality is a key issue for all companies in developed countries. The major negative is that domestic job growth will be somewhat slower than the past. We need to adjust to this reality and focus our efforts on our strengths to generate new industries and jobs in the future. The positives are that it allows companies to cut costs, improve cash flow, and direct financial resources to new innovative technology that help our companies remain competitive in worldwide markets. This strategy helps our companies survive, save jobs and create new jobs in the future. A secondary benefit is insourcing, which increases foreign demand for domestic accounting and legal services, IT hardware, software, etc. We also benefit from insourcing by foreign companies in energy, financial services, motor vehicle manufacturing and pharmaceuticals. For example, over the last five years, we were the beneficiary of over $1 trillion of direct investments from overseas – which created jobs in the U.S. Now, we need the next new industry, similar to the automobile in the 20’s, airlines in the 50’s and information technology in the 90’s. Today, the candidates are biotechnology, nanotechnology and telecommunications.

We believe that the U.S. stock market provides an excellent opportunity for above average returns over the intermediate term. There are risks, but there is too much frustration and pessimism. Our economy has sound fundamental strengths with flexibility, innovation and a strong entrepreneurial spirit. The U.S. will continue to be the engine of growth for the world’s economy over the foreseeable future with rising cash flow and profits. In addition, the U.S. represents 50% of the world’s equity market with greater liquidity and safety. And, taxes on dividend income and long term realized gains are only 15%. While stock prices may decline further, we expect the market to gradually climb a “wall of worry” with modest gains as we continue to experience a “tug of war” between earnings growth, inflation and interest rates.

In our opinion, the stock market appears relatively attractive. Historically, the S&P 500 has sold at an average multiple of 15x estimated earnings. Today, it is selling at 15.7 times this year’s estimated operating earnings of $73 per share and 14.5 times projected 2006 earnings of $79 per share. A realistic market multiple should be around 18x based upon the outlook for earnings growth, inflation and interest rates. This would provide a return of +25% through next year and could be greater if inflation and interest rates remain at current levels or decline somewhat. In addition, there is plenty of firepower with $4.3 trillion in short term investments, $2 trillion in corporate cash and rising contributions for 401K and underfunded pension plans. Also, the corporate tax on repatriated foreign earnings was reduced from 35% to 5% and may return up to $500 billion to the U.S. Since the dollar appears to be stabilizing, this may generate foreign buying because of the reduced risk of currency loss, potential currency gains and excess liquidity worldwide. The demand/supply balance is also favorable with a net reduction in shares because of acquisitions, mergers and accelerating stock buybacks. And, this trend is continuing with the “Urge to Merge” as 2005 becomes the “Year of the Deal.” In addition, dividends are rising at an above average rate.

Technically, the stock market appears oversold based upon momentum and sentiment indicators and may be approaching the low end of its corrective trend. A survey of the American Association of Individual Investors indicates that only 14% of its members are bullish – the lowest since September, 1992. That is a positive sign! Looking ahead, we are “cautiously optimistic” and expect stock prices to gradually recover in the quarters ahead. We also believe that quality small and medium sized growth companies with reasonable valuations will produce above average returns because of their fundamental strength, flexibility and acquisition potential. It is important to have a consistent investment strategy with patience and perseverance and to own a diversified group of quality companies in an “all weather” portfolio that will stand the test of time. Time in the market is more important than timing the market. And, history tells us that wealth is created with long-term investments and to take advantage of opportunities to add to the depressed shares of quality companies. We believe that we have one of those opportunities!