Investment / Economic Review

Second Quarter Investment Summary
Values and Performance as of 6/30/06

Market Update
Fears of inflation and rising interest rates led to a market sell-off in the second quarter, and we witnessed increasing volatility for the first time since 2004. U.S. broad markets were down 2-5% but are still positive year-to-date, up 2-4%. Nasdaq, which is weighted toward technology companies, was down 7% for the quarter and down 1.5% for the year. The Dow was positive for the quarter as General Motor's stock rose in partial recovery of the stock's problems earlier in the year. Because of economic concerns, value stocks (up .6%) performed better than growth stocks (-3.9%). International stocks also declined during the quarter and were down 1-5%. Emerging markets showed the most volatility overseas and were down 5% for the quarter. For the year, international markets are still positive, up 5-8%. The dollar's 6-7% decline during the year has helped the returns of overseas investments.

Bond performance was slightly negative during the quarter as interest rates continued their gradual trend higher. Many corporate and government bonds issues are showing negative total returns for the year and some categories over the past twelve months. Bank loan funds, which aren't sensitive to interest rate trends, were up .96% for the quarter and are up close to 3% for the year.

2nd Qtr 2006 Market Returns

We are currently experience the fifth stock market correction since the spring of 2003. The four prior periods produced declines of 5-8.5%, before stock prices rebounded to new cyclical highs. The present correction, which began in early May, resulted in a 7.7% decline through mid-June, comparable to previous declines. While the risk of a slowdown is greater today, opportunities do exist for the markets to improve over the next couple of years.

Exhibit1 – Stock market corrections since 2003
(Price performance of the S&P 500 Index, daily, index=100
as of January 1, 2003)

Corporate America shows continued strength
The economy grew at a revised 5.6% annual rate in the first quarter, the fastest rate in nearly three years. While the economy is expected to grow at a slower rate in the coming quarters, overall GDP projections for 2006 and 2007 are in the solid 3.5% range.

Corporate earnings growth is expected to be very strong in 2006 and 2007. Earnings growth is expected to be close to 12% this year and almost 13% next year. Additionally earnings revisions still are raising or reaffirming the initial forecasts.

S&p 500 Stock Prices And Eamings

The accompanying chart shows the S&P 500's monthly price performance from 1989 to the present, as well as the earnings trend line. The gray areas show times when earnings fell. White areas show periods when earnings rose. This chart illustrates some interesting points. First, it demonstrates that ultimately the market, over time, will respond to earnings trends. It also shows the strength in earnings since the end of 2001 and if continued as projected can provide the catalyst for continued upward stock performance. This chart also demonstrates just how quickly earnings trends can change, as in 2000, which we will be closely monitoring in the upcoming quarters.

Salaries paid to employees of small U.S. businesses increased for the 10th straight month. Hiring also picked up in June, suggesting that the downturn some have predicted for the second half of 2006 may not be as dire as was initially thought. The average small business salary across the country now stands at $30,328, returning to levels not seen since June 2004. While increasing salaries can create inflationary pressures, overall productivity gains and global competition have kept wage increases in check thus far.

World GDP growth rates are expected to be around 4% for 2006 and 2007. If this forecast is accurate, it would mark five consecutive years of above-average world growth, the longest stretch of global growth since the late 1980s. Additionally, worldwide fiscal policy is still stimulative. U.S. interest rates are close to neutral. The euro zone's real interest rate is still near zero. Japan has not begun to tighten. As a result, global money supply remains accommodative.

Concerns for 2006
Investors have been fixated on interest rate news because rising rates often have been a key factor in stopping bull markets. Higher rates are bad for stocks because they raise business costs and squeeze profits. They make alternative investments, such as money market funds, more attractive. Even if the Fed manages to pause in its rate increases, central banks in Europe and Asia have indicated they are going to continue raising rates in response to their growing economies. Even though interest rates in the U.S. and overseas are still more accommodative than restrictive, there is growing uneasiness about inflation and our deficits. Both of which could put pressure to force interest rates to accelerate higher rather than to gradually rise in response to growing economies. The higher costs of oil and gasoline have made it more difficult to factor in what are temporary or speculative cost increases vs. real and inflationary ones. Inflation has been increasing gradually since 2002, and still remains moderate and much lower than the 1970s. A comparison of the two periods is illustrated in the chart below:

Comparative Inflation Rates
1970 vs. 2000s
© 2005 Financial Frend Forecaster
Prepared by Timothy McMahon
Updated 4/21/06

Oil prices continue to impact consumer spending patterns. The uncertainty of the upcoming hurricane season will undoubtedly cause additional speculation through the fall, and global tensions in North Korea, Iraq and Iran will likely keep costs high throughout most of this year. Oil prices jumped to a record above $75 a barrel recently and gasoline prices remain close to the $3 a gallon. Fortunately crude oil supplies are at their highest level in 8 years, and gasoline inventories are at relatively high levels. This may allow prices to fall quickly when the primary focus in the sector is more correlated with supply and demand issues rather than speculation and geopolitical uncertainty.

The rate of economic growth is expected to slow later in 2006 or early 2007 and the concerns are already being directed towards a stalling economy. Fortunately, corporate earnings growth rates are still expected to be double-digit in 2006 and at similar levels in 2007. This is well above the 7% average profit-growth rates that have prevailed since the 1980s. Consumer spending is the primary concern as economists weigh the impact of higher costs compared to increasing incomes. Concerns have ranged from low savings rates to real estate bubbles to debt levels. Fortunately we have witnessed a leveling of spending overall by consumers, not major declines. And it appears that will continue to be the case unless the economy falters suddenly or inflationary trends accelerate.

We will be watching these concerns closely. Fortunately it does not appear this economy is headed toward a major slowdown or recession in 2006. But it is difficult to predict the timing of changing economic trends and we'll continue to look for deterioration in the earnings forecasts or consumer spending patterns.

Jim Evens
Investment Director