ECONOMIC & INVESTMENT SUMMARY
MAY, 2006

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THE ECONOMY

CORPORATE PROFITS

During 2005, there was concern about inflation because of a weak dollar (makes imports more expensive) high oil prices, rising home prices, increasing labor costs and forecasts of a slowdown in productivity growth. These factors were worrisome because rising inflation taxes investment and causes higher interest rates. Did these fears have merit? Last year, the Consumer Price Index (CPI) increased +3.4% versus +2.7% in 2004 primarily because of higher energy prices. But the “core rate” (excluding food and energy) increased +2.4% versus +1.8% in 2004 with a strong economy. It was contained in 2005 because of strong competitive pressures from the internet, foreign competitors, greater globalization and improving productivity due to advances in technology. However, labor costs are rising and core inflation increased 2.8% in the first quarter of 2006 and +0.3% in March while productivity growth is slowing. For example, productivity – output per hour at non-farm businesses – grew +2.9% last year while wages increased +5.5% - the fastest rate in five years. Thus, unit labor costs and benefits – compensation costs not offset by productivity gains – increased +2.6% in 2005 – also the highest gain in five years. In addition, global labor markets are tighter as world growth causes upward wage pressures. This will cause higher inflation if productivity growth continues to moderate.

The fear of inflation due to rising energy prices and labor costs is beginning to be countered by a slowdown in the housing market. In addition, the Fed increased the federal funds rate 25 basis points (bp) to 4.75% on March 28th (the 15th 25 bp increase from 1% since June 2004) because of the rise in short-term inflation expectations and the economy’s strong rebound in the first quarter. The Fed stated that possible increases in resource utilization combined with strong job growth and high commodity and energy prices have the potential to add to inflationary pressures. Thus, it is likely that we will get another increase to 5% on May 10th followed by a pause as the Fed evaluates the future trends in core inflation, housing and unit labor costs. These trends increased the 10-year Treasury yield 22% to 5.09% over the past year. Economic theory states that it takes roughly nine months for interest rate increases to impact the economy. As a result, our economic growth should moderate somewhat as these effects take hold combined with moderating consumer spending caused by a declining wealth effect due to a slowing housing market. Then the Fed will be in position to cut rates in response to any unfavorable economic development or crisis. However, foreigners own 47% of the U.S. Treasury market and currency swings may impact our interest rate flexibility in the future. Today, it is expected that the Fed will “ease” or cut rates in the latter part of 2006 or early 2007 as our economy begins to moderate. The Fed’s job is to simultaneously keep the economy growing and inflation under control. The key questions today are the strength of our economy in the months ahead and how much the housing downdraft will slow consumer spending.

India has emerged as one of the world's fastest growing economies with GDP doubling to $700 billion over the last 10 years and similar projections for the future. It is the third largest economy in Asia with a population of one billion – 50% under the age of 19. Consumer spending accounts for 67% of GDP while services account for half the economy with a high savings rate and inflation under 5%. It is a vibrant democratic society. More importantly, India is friendly with the United States and we are India’s largest trading partner with joint trade over $18 billion in 2003 versus $5.5 billion in 1990. In addition, India represents a large opportunity because of its educated workforce, low wages and predominantly English speaking population. In a 2005 survey, over 70% of respondents had a favorable view of the U.S. This presents the U.S. with many opportunities for an economic, political and strategic partnership in trading, outsourcing and investment. Our relationship is strong and growing and we have recently initiated direct flights form the U.S. to India and joint military exercises. Today, India is a magnet for investment behind China and the U.S. It is projected to account for half of the world’s IT and outsourcing exports in less than five years and its private sector growth should continue to attract investments because of its well-regulated financial system and rule of law. However, India has major problems because of bureaucratic red tape, rigid labor laws and an underdeveloped infrastructure. It also has over 40% of the world’s poor, the second largest HIV population and a female illiteracy rate of 50%. While these factors hinder India’s progress, there is a strong desire for reform by both the government and people. The future growth of India will be explosive and it will rapidly become a major economic and political force in the world.

There are 1.3 billion Muslims in the world. The majority follow the teachings of Islam that preach leniency, tolerance and understanding. However, some radical Islamic groups are initiating a clash of civilizations by teaching intolerance, hatred and bloodshed. This clash is between the Modern Era of freedom and rationality and a Middle Age mentality of primitive barbarity and oppression that seeks to change our way of life and forced our “War on Terrorism.” Surrender is not in their vocabulary and retreat should not be in ours. Their degree of success will negatively impact the world’s economies and we need to discredit this dangerous ideology that threatens humanity with a global crisis of misunderstanding. How did this minority Muslim rage develop? The primary cause has been the failure of backward religious leaders and dictators to build economies and education systems that prepare young people for modernity. The lack of a balanced education has caused Muslims to lag in innovation, industry and science. For example, Pakistan registered only eight international patents over the past 57 years. In addition, a UN International Labor Office study found that the Middle East and North Africa had an unemployment rate of 13% - the highest in the world - and 60% of the Arab world is under the age of 25. GDP increased 5.5% annually in the region from 1993-2003, but productivity increased only 0.1% annually. This was the only world area where productivity did not equal GDP growth. The reason is because of increasing oil revenues and no diversified industrial base. Today, the internet has made the world flat and everyone knows where they stand. This has created a sense of frustration, helplessness and humiliation. It is time for Muslim and world leaders to join together and develop a plan of action to create a balanced education system, broaden the economic base of Muslim countries and discredit the ideology of fanatic radicals. This will help world growth and order over the longer term.

We continue to believe that the U.S. stock market provides the opportunity for above average returns over the longer term. Our economy is the “engine of growth” for the world economy and our stock market represents 50% of the world’s market. More importantly, the Sarbanes Oxley Act increased the accuracy of financial reporting and our public companies have the most reliable accounting in the world. Our stock market is the world’s best growth stock – an important factor for the safety of long-term investors. Since 2001, operating earnings for the S&P 500 increased almost 100% while the index increased 22%. Today, the S&P 500 is selling at 15.6 times estimated 2006 operating earnings of $84 per share, 21% less than the average of 19.8x over the past 18 years. The market is reasonably priced based upon the current level of inflation and interest rates and reflects the increased risks of today. In addition, there are other positive signs. Since 1950, the stock market increased 90% of the time when the market gained in January and all the market indices were up this year. Since 1936, years ending in six increased 73% of the time with an average gain of +13%. This is also the Chinese “Year of the Dog” which increased 80% of the time since 1946 with an average gain of +12%. The “Fire Dog” is a natural leader that generates a positive influence whose traits are adventurous, confident, strong and vibrant. Looking ahead, we are approaching the third Presidential year, which is historically the best for stock prices with an average gain of +14% since 1929. Also, corporations have over $2 billion in cash, dividends are up 40% since 2000, individuals owning stocks increased 14% since 1999 and stock buybacks are at a high level causing a net reduction in shares outstanding. Finally, the “Urge to Merge” is on a roll with mergers and acquisitions at a high level. These are positive signs!

However, we are in a period where investors should be somewhat cautious. The major averages are near five-year highs, our economic expansion is five years old, long bond yields are at four-year peaks and margin debt of $237 billion is near the 2000 peak of $251 billion. Also, since 1962, the market has experienced cycle lows every fours years with a 50% probability of decline and an average gain of +1%. From a technical perspective, the intermediate term outlook appears overbought with bearish signals as the market continues to strengthen. Accordingly, we are likely to get a pause or correction at some point with the key question being its length and depth. We expect more volatility, so fasten your seatbelt. As our economy begins a decelerating phase, we expect some earnings disappointments and a gradual stock market transition from value to growth. It will be important to own quality companies with above average growth prospects that are reasonably priced. The key to building wealth is to maintain a consistent investment strategy with patience and perseverance. We remain alert to take advantage of opportunities that may arise from market disruptions to enhance portfolio diversification and performance.