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QUARTERLY COMMENTARY THIRD QUARTER 2005

HURRICANES AND THE ECONOMIC EFFECT

During the third quarter hurricanes stole theheadlines. As Katrina strengthened and ravaged theLouisiana coast, many prognosticators warned thesignificant damage, particularly to oil-refiningcapacity, would lead to an economic slowdown.

The ConsumerSentiment Index, takenjust after the hurricanewhen looting wasrampant and the deathtoll was expected tosurpass 10,000,recorded the largestdrop since 1990. Thepost-Katrina economic outlook now appears muchless grim than initially feared. Recent data releasescontinue to point to a sound economy in the run-up tothe storm. Before Katrina hit, GDP had risen,unemployment had fallen to 4.9%, retail spendingwas strong, and state tax revenues for the 2nd Quarterhad increased by 13%.

Interestingly, despite the economic uncertainty, the

Dow Jones rose 215 points to 10,678 in the twoweeks following Katrina. Economists generally areestimating that Katrina will lower 4th Quarter GDP by0.4% to 0.5%. Katrina represents a supply shock,raising the risks of both higher inflation and lowereconomic growth. The well-reported short-termeffect is reduced oil and natural gas production. Theconstraint on production will lead to higher oil andgas prices. Those higher prices will negativelyimpact consumers discretionary spending as moredollars are consumed by transportation and heatingcosts. While higher energy costs therefore hinder

growth in the short term, longer-term companies havehistorically found a way to pass higher costs on toconsumers. This will lead to further inflation. Withtheir latest rate hike, the Fed has clearly indicatedtheir concern about rising inflation, despite theeconomic dampening from the two hurricanes.

OUTLOOK

The odds of a recession in 2006-2007 are rising. Twohistorical indicators of recession apply today.Merrill Lynch points out one. When gasoline pricesrise by more than 50% over a two-year span arecession has always followed. (See chart followingpage). Over the most recent two years gasoline has

risen nearly 100%.

Another indicator isthe debt market. Whenthe rate of return onshort-term bonds is

higher than long-termbonds (called aninverted yield curve),

it implies that the demand for money is expected todecline in the future. Bond market participants,especially mortgage lenders, use the interest rateswap markets to hedge their interest rate risk. Thismarket for swaps is presently indicating that the yieldcurve will invert. The last time the curve invertedwas in August of 2000, one year prior to thebeginning of the most recent economic recession.

FIXED INCOME

Bond yields rose during the quarter across the entirematurity spectrum. The 10-year Treasury wasyielding a rate of 3.96% on June 30th and closed thelatest quarter at a yield of 4.33%. Current bondprices suggest at least one more increase in the FedFunds rate to 4.00% by year-end.

Spread products, particularly corporate bonds, highyield bonds and asset-backed securities, are notattractive. We continue to maintain a low durationposition with high credit quality issuers and believewe will be rewarded as rates rise.

HARD ASSETS

Gold, a safe haven in an inflationary environment,has moved to a 17-year high at more than $460 anounce, and was up more than 7% in the 3rd quarter.

Index Performance Q3 05 YTD

Dow Jones Industrials 3.44 -0.34

Standard & Poors 500 3.60 2.76

EAFE (international stocks) 10.46 9.60

Russell 2000 (small stocks) 4.71 3.43

Lehman Intermediate -0.52 1.06Lehman Municipal -0.13 2.76

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Golds price is typically driven by excess liquidity inthe short term and its recent movement is seen as aprecursor to inflation. Lawrence Kudlow, a well-known market strategist, maintains that gold leadsinflation by ten months. If true, then the Fedsconcerns about rising inflation are well founded.

EQUITIESOur stock selection continues moving down thecapitalization scale as exemplified by Symbion(SMBI), Avery Dennison (AVY), Stericycle (SRCL)and Fiserv (FISV). We are finding better values inmid-sized companies and do not foresee the negativeheadline risk thatlarger companieslike AIG orMorgan Stanleyhave experienced.In the Healthcare

sector, Biotechhas been verypositive. Amgenalone was up$20.00/share inJuly.Pharmaceuticalcompaniescontinue to beunder pressure aspricing power continues to move from themanufacturers to the managed care providers and

pharmacy benefit managers (PBMs). Hospitals areseeing profit pressures as highly profitableambulatory surgery is moving to specialized for-profit facilities. The technology sector had a greatJuly but mid quarter updates and earnings releasescaused many stocks to give up their gains.

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INTERNATIONAL

In July the London terrorist bombings rocked themarkets. Market participants, skittish about the threatof a coordinated terrorist attack, initially caused themarket to decline but in subsequent days the marketsrecovered.

Recent elections will have significant effects in keygeographies. In Germany, we witnessed electionstalemate. The stagnant German economy still awaitsan outcome and leadership that will start itsconsiderable economic engine. Perhaps moresignificant is Kozumis election win in Japan. Thewin provides him with a necessary vote of confidenceto enact dramatic reforms to reduce the size and

impact of the Japanese government. There is a goodchance that the Japanese Postal Service, the largestholder of Japanese household savings will be takenpublic in the future.

The highly publicized revaluation of Chinas

currency, the Yuan/Renminbi, brought about amodest 2% adjustment relative to the U.S. Dollar anda switch to pegging the Yuan against a basket ofother currencies rather than just to the Dollar. TheU.S. Dollar rose marginally against the Euro and fellmarginally against the Yen, Pound and CanadianDollar. In July we increased our investments in the

foreign equity marketswith the purchase ofthe Matthews PacificTiger Fund.

HEDGE FUNDS

As we predicted in our

LOOKING AHEAD

As hurricane season ends, the market turns its

last commentary, theproblems in selecthedge funds arecoming to light. TheBayou Capital saga isa sad tale of fraud anddeceit. The degree ofleverage in the overallmarket has risen due

to the activity of hedge funds. The CounterpartyRisk Management Group II (the revival of a group

formed in 1999 following the implosion of LongTerm Capital Management) reports that 40% to 80%of all market trading is done by hedge funds. Thelevel of derivative exposure outstanding isstaggering: JPM had $41 trillion of total exposure($60 billion net of offsetting positions) at end of the1st Quarter from facilitating hedge funds activities.

attention to 3rd Quarter earnings announcements. Wefeel it is too early to begin discounting an economicrecession and anticipate that corporations will largely

meet or beat earnings expectations and oil prices willmoderate as supply is normalized. Our focus will beon the consumer discretionary sector, expected to bethe most affected by the run up in oil prices. Fallingrevenues and compressed margins in this sector willbe a harbinger of declining consumer strength and asignal of recessionary storm clouds on the nearhorizon.