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QUARTERLY COMMENTARY FOURTH QUARTER 2004

THE YEAR OF BIG NON-EVENTS

Though the Presidential election stole many of theheadlines in 2004, in many ways the events that didnot happen were even more significant. Long-terminterest rates, widely expected to increase in 2004(and 2003 AND 2002), remained stable despite theFed increasing short-term rates five times. Fears ofterrorism loomed over the Summer Olympics inGreece and the Democratic and Republican NationalConventions, but eachwere held withoutevent. Deflation didnot materialize.Consumer spendingdid not decline. Oil,after barreling throughthe $40 and $50 pricelevels, peaked in themid $50s and has sincesettled down around $43.00/barrel. The presidentialelection did not end with an uncertain victor or acontested vote, as it did four years ago, but insteadwith a President that received the majority of thepopular vote for the first time in 16 years.

The stock market responded positively to thedevelopment, or lack thereof, of each of these events.Heading into 2004, we anticipated the market wouldhave below average returns in the high single digits.With a stellar 4th Quarter the broader indices, like theS&P 500 and the Nasdaq, did not disappoint, but thenarrower Dow Jones Industrials lagged due todisappointing returns from Merck & Co (-29.4%) andGeneral Motors (-25.2%). See the table on this page.

To our surprise, the bond market did not punishinvestors on the longer end of the yield curve. TheLehman Brothers Aggregate Index was up despite thefed funds rate rising from 1.00% to 2.25% over thecourse of 2005. Interest rate stability on the longerend of the yield curve allowed for mortgage rates toremain attractive and the housing market, asmeasured by new home starts, remained strong.

BUSH AGENDA, TAKE II

As we toast 2004, we turn a watchful eye toWashington D.C. and President Bushs second termagenda. Emboldened by the increased Republicanrepresentation in congress we expect him to firstaddress the growing concern surrounding SocialSecurity. President Bush campaigned on the notion ofa Personal Savings Account (PSA), which wouldseparate a guaranteed portion of a taxpayers Social

Security benefit froman optional PSA that

could be invested atthe direction of thebeneficiary. It remainsto be determined howthe PSAs will beadministered, whatinvestment options are

available and what the effect participation will haveon the guaranteed benefit, but each of the issues willbe heatedly discussed by congress. The short-termeffects on the market would appear to be positive, asa greater number of dollars will be allocated toward

market investments.

The administration has promised an overhaul to theoutdated tax code. Will the estate tax code berevised or repealed together? The key will be howwell congress can focus on modifications that makethe code simpler while promoting economic growth.

Any revision to the tax code, the nations primarysource of income, will need to consider the increasingdeficit. Addressing the deficit will require thegovernment to exercise fiscal restraint. Marginalreduction in government spending will have to beoffset by increased spending activity on the part ofconsumers and businesses to maintain GDP growth.We forecast 2005 GDP to be a solid 4.0%, less thanthe 6.9% growth of 2004 as higher interest ratesimpact retail spending and the housing market.

RISING INTEREST RATES

Interest rates will rise as a result of increasedinflationary pressures. There are two significant

Index Performance Q4 04 YTD

Dow Jones Industrials +7.56 +5.20S&P 500 +9.21 +10.74EAFE (international stocks) +15.34 +20.35Russell 2000 (small stocks) +14.14 +18.29Lehman Intermediate -0.98 +1.53Lehman Municipal +0.46 +3.65

7/31/2019 4th Quarter 2004 Commentary

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reasons why we feel that 2005 will be the yearinterest rates rise. The first reason is the dollar.

After ending 2002 at near parity relative to the Euro($1 / 1), the dollar has declined to its current level of$1.32/. The decline of the dollar has two major

repercussions. Foreign goods become moreexpensive in dollar terms causing inflation for U.S.manufacturers and consumers and dollardenominated assets, specifically U.S. Treasurysecurities, become less attractive to foreign investors.To get foreigners to continue to hold the dollars theyreceive from our burgeoning trade deficit, U.S.interest rates must rise.

The second reason is the relative level of Fed Fundsto inflation. Despite five consecutive rate hikes, thecurrent Fed Funds rate at 2.25% is still significantlybelow the current inflation level (CPI) of 3.5%. (Seethe chart above). This results in a negative real costof funds. Historically, the Fed Funds level runs atpositive real rate of return, averaging 1.0%-2.0%.This suggests the Fed will continue to tighten untilFed Funds is greater than the inflation rate.

Over the last two years we have been diligentlypositioning portfolios in anticipation of a risinginterest rate environment and believe that rising long-term rates will vindicate these actions in 2005.

INCREASED CORPORATE SPENDING

As the economy recovered over the last two years,corporations have focused on streamlining businessesand increasing cash reserves. Now, as theirbusinesses have stabilized executives must decide

what to do with these increased cash reserves.Microsoft made the decision to return cash to theirshareholders, implementing a special one-timedividend of $3.00/share in December. Oracle madethe decision to purchase a competitor completing ahostile bid to acquire Peoplesoft for over $10 billion

in cash. We see both these actions as indications that2005 will see improved levels of spending from thecorporate sector.

With capital spending driving the economy both theIndustrial and Material sectors will lead the market.Paychex (PAYX) and Automatic Data Processing(ADP) will benefit from both increased corporate

spending and rising interest rates.Merger and acquisition activitywill increase fees to GoldmanSachs (GS) and Morgan Stanley(MWD). Interest rate sensitiveretail oriented banks will suffer.

The Healthcare sector hasrecently made headlines, firstwith the healthcare reformplatforms of Presidentialcandidates and more recently withthe findings of the heart riskassociated with Cox-II inhibitorsVioxx and Celebrex. The negativepublicity has created a valuesector from one that hashistorically been associated with

growth. We feel that these concerns will continue toplague the sector in 2004 leading to just marketreturns for the Healthcare sector.

Fed Funds Target Rate and Inflation

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1999 2000 2001 2002 2003 2004

CPI YOY % Change

Fed Funds Target Rate

Negative real

cost of funds

The energy sector will come under pressure as oilcontinues to fall off its recent high and consumerdiscretionary stocks will take a breath after two yearsof great returns.

International stocks underperformed their U.S. peerson an absolute basis, but continued pressure on thedollar allows them to outperform after adjusting forexchange rates.

We expect 2005 to reap the benefits of the catalystsput in place during the last two years of economicrecovery. Though corporate earnings will be stellar,the current valuation level will keep market returnsmore moderate. Whether or not inflation can be keptat bay will determine if the economy will enter a newgrowth phase.