“The Other S&P”

Summer 2006

What a difference a day makes, or at least three months! Prior to writing this letter I reviewed last quarter’s newsletter and the reports of the very good returns that we had realized to that point. I also read with a certain degree of relief, my cautionary tale that, while the returns in the first quarter of 2006 had been very good, strange things can, and do, sometimes occur in investing. The second quarter of 2006 was proof that, to quote a line from The Phantom of the Opera, “These things do happen!” Strange things did indeed happen in the most recent quarter.

For the quarter, the Dow Jones Industrial Average rose a meager 0.4% and now is up 4.4% for the first six months of 2006. The NASDAQ was down 7.2 % for the quarter and is now down 1.51% for 2006. The S&P 500 Index, probably the best measure of performance, was down 1.9% for the quarter and is up 1.76% for the year. The very good returns from the first quarter of 2006 were erased basically by the losses in the second quarter.

What happened, and more importantly, what are we going to do in response? The cause for the drop in the world markets in the last quarter can be summed up in one word, inflation. Several of the inflation measures crept up more than the experts envisioned that they would in April and May. Prior to that point, the general opinion was that the Federal Reserve Board was just about finished raising interest rates in their attempt to contain or control inflation. As the higher inflation numbers were announced, the markets shuddered and sold off in anticipation of interest rate hikes in the future. The Federal Reserve responded appropriately and raised interest rates ¼% last week for the seventeenth consecutive time. The question remains, will the Fed continue to raise interest rates?

To further stoke the fears of inflation, the appointment of a new Federal Reserve Chairman, Ben Bernanke, was confirmed last January. Mr. Bernanke has all the appropriate credentials and education to be qualified for the post. The problem is that he is not Alan Greenspan. By this we do not mean to infer that Mr. Bernanke will not be successful in the position. Alan Greenspan held the post of Federal Reserve Chairman for 18 years. He was the longest serving Chairman of the Federal Reserve Board. That kind of longevity brings to the mix a certain degree of comfort on the part of investors. After 18 years on the job, investors knew exactly how Mr. Greenspan would react to a financial crisis. If X happened, Mr. Greenspan would do Y and investors could react by doing Z and everyone would make money.

Mr. Bernanke is the new sheriff in town. Investors do not know how he will react to inflation or the perceived fear of inflation. Will he continue to raise interest rates aggressively? Will he raise rates too much and push the economy into a recession? The markets hate uncertainty. Much of the current sell-off is as much a function of uncertainty as to what Mr. Bernanke will do as it is a response to the fundamental issues.

We also have enjoyed an incredibly long string of good fortune in the markets. A correction is officially described as a loss of 10% in value of an index. For instance, if the S&P 500 Index hits 1250 and then over a period of time sells off to the level of 1125, we have had a 10% correction. We have gone over 830 trading days without a 10% correction in the S&P 500. This is the second longest streak since 1965 without a correction. The average length of time between corrections is 222 days. You can see from these numbers that we have enjoyed a rather benign market over the past three years. 10% corrections are actually very common. In the great bull market that we experienced from 1996 to 2000 we actually had at least one 10% correction each year. In the fabulous year of 1999 we actually had two 10% corrections in that one year and still went on to achieve over a 19% return.

We do not anticipate a 19% return for 2006. We do not anticipate a particularly bad year in 2006 either which leads us to the most important question of all, what are we doing in response? We are waiting and watching as events unfold. We are investors not speculators or market timers. Since May of 2006 when the markets first started to respond negatively to the inflation numbers, the Dow is down 5.1% and the NASDAQ is down 8.7%. Conversely, the markets peaked in March of 2000, two months later in May of 2000, the Dow was down 8.4% and the NASDAQ was down 33%. Events in 2006 do not mirror those which precipitated the rapid decline in 2000.

Patience is a virtue. To exhibit patience when everyone around you is in a panic is prudent. We own stocks of very good companies that make real products that are sold every day. We own these stocks at very reasonable prices. We own stocks to share in the profits and growth of proven, stable companies. Therefore, our plan is to continue to maintain our course of action and retain the holdings that we have.

September 11, 2001 reminded everyone how radically everything can change in an instant. We are constantly monitoring events and your accounts to be certain that your investments can provide the best possible return with the least amount of risk. We take our fiduciary responsibilities very seriously. If you have any questions at any time, please contact us immediately. If there have been any changes in your personal or financial circumstances, please contact us so that we may discuss them and make appropriate changes. We want to thank everyone who has recommended us to their family and friends in the past few months. The response has been overwhelming and we do appreciate the confidence that you have expressed in us. Rest assured that we are monitoring the events and will do our very best to provide the best service and returns to you that are possible.