QUARTERLY COMMENTARY SECOND QUARTER 2005

A BULL VERSUS BEAR TUG-O-WAR

The stock market Bulls and Bears each had reason to feel vindicated during the second quarter. The stock market experienced increased volatility as bullish optimism and bearish pessimism about the health of the economy took turns driving market returns. Predictably, this uncertainty produced mixed results. Economic sectors such as healthcare and technology, which have long been in a funk, produced positive relative performance. Energy stocks, utilities, homebuilders, and real estate investment Index Performance trusts (REITS) continued to improve Dow Jones Industrials upon their 1st quarter Standard & Poors 500 gains. Material EAFE (international stocks) companies, consumer Russell 2000 (small stocks) durables and industrial Lehman Intermediate stocks all lagged, in Lehman Municipal contrast to the last several quarters. For the first time in almost five years, growthoriented stocks outperformed their value-oriented peers. In the 2nd Quarter, the Russell 1000 Growth Index was up 2.8% while the Value Index was up 1.7%. This change in market leadership is one that we feel will continue. In 2000, the average P/E of the growth index was 51x, compared to 21x for the value index. Today, the same P/E measure for growth is 21x while that of value is at 17x. Though we do not expect to see growth-oriented stocks trade at 50x earnings again, we are compelled to believe, based on multiple quarters of earnings improvement, today the best value resides in growth stocks. Leading the charge in growth stocks in the 2nd Quarter were large cap technology names; Intel (INTC +12.5%), Texas Instruments (TXN +10.23%), Fiserv (FISV +7.92%), Cisco (CSCO +6.82%) and Oracle (ORCL +5.77%). IBM ( IBM -18.59%), and financial stocks Goldman Sachs (GS 7.02%) and Morgan Stanley (-7.88%) were all laggards. Relative to the S&P 500, we have had an underweight in the materials sector. The sector as a whole has been a disappointment thus far, but we have used this weakness to add duPont (E.I.)

deNemours (DD). Furthermore, as the dollar continues its rally, we are poised to increase our exposure to international stocks. The bond market continued last years trend with rising short-term rates and falling longer-term rates with lots of ups and downs in-between. The unwinding of currency bets by hedge funds and other speculators impacted bond yields. Many investors had significant positions intended to Q2 05 YTD capitalize on the U.S. -1.62 -3.64 dollar continuing to 1.36 -0.81 fall. Early in the -0.72 -0.79 quarter the dollar 4.35 -1.23 bottomed, especially 2.48 1.59 against the Euro. As a 2.93 2.89 consequence, many foreign currency and bond positions were sold, with the proceeds coming back in the form of U.S. dollars seeking highly liquid U.S. Treasury bonds. As a result of this capital flight to liquidity, yields on longer issuances have decreased.
ECONOMIC STABILITY

The economy has produced quarterly GDP growth of at least 3% for eight consecutive quarters. Employment growth continues, as indicated by the unemployment rate dropping from a high of 6.3% in June 2003 to its current level of 5.1%. Moreover, throughout the first half of 2005, wage growth has outpaced growth in consumption spending for the first time in years. Contrary to the message being sent by the performance of both the stock and bond markets, the economy continues to improve. Signs of inflation continued to be muted. Both the Consumer Price Index (CPI) and Producer Price Index (PPI) declined during the quarter and the PCE was virtually unchanged at 1.6%. Though the last two data releases were better than expectations, strength in the U.S. economy and weakness in Europe and Japan plus the continued lopsided trade with China resulted in our trade deficits increasing to all time highs.

Due to domestic economic strength coupled with political uncertainty, as evidenced in Europe with both the French and Dutch voting down a Euro-wide constitution, the U.S. Dollar reversed its trend by rallying 13% against the Euro, 6% against the British Pound and 6% against the Yen. THE FEDS CONUNDRUM On June 30th the Federal Reserve increased the funds rate for the 9th consecutive time to 3.25%. Chairman Greenspan and the FOMC continue to act upon their belief that we are in a period of solid growth and their moves to increase short-term rates evidence their focus on not letting inflation generate any head of steam. In spite of the nine consecutive percent increases the 10-year Treasury yield has declined from 4.59% to 3.91%, furthering Mr. Greenspans conundrum, meaning that he is puzzled by the fact that long-term rates have fallen. A decline in long-term rates usually serves as an indicator that economic growth is slowing. This leaves us with the question: Whom do we believe, the Fed or the Bond Market? According to noted economist, Liz Ann Sonders, during the past 35 years, the Fed tightening, though well intended, has typically resulted in economic crisis. Perhaps a slowdown is around the corner? Our views coincide more with the outlook of the Fed, in that we continue to see solid, sustainable economic growth in the year ahead. & HEDGE FUND FROTH After declining at the end of the 1st Quarter, the price of oil rose from $45 per barrel to an all-time high of just above $60. Oil price strength continues due to demand outstripping refining capacity. OPECs announced production increases were ineffective in bringing oil down, since increasing world oil output does not result in more gasoline and other end products for consumer markets unless there is adequate refining capacity.
OIL, REAL ESTATE,

The U.S. housing market continued to be very strong and Chairman Greenspan has warned there are signs of froth in some local markets. Demand has been ignited by both low long-term interest rates and the popularity of short-term adjustable mortgages. There is concern that a mortgage trap could be developing. Approximately of all mortgages done this year in the U.S have been adjustable rate loans. The so-called option adjustable is attracting attention as it enables buyers to stretch their income to afford properties far beyond what they could otherwise afford. The trap would occur if rates rise to the point where these buyers payments adjust upward beyond affordability. Source: Bloomberg After posting strong relative performance numbers in the bear markets of 2000- 2003, demand for hedge fund investments has also rapidly increased with assets more than doubling from $400 billion to over $1 trillion. Historically, hedge funds have aimed to take advantage of small market inefficiencies with large leveraged positions. However, the significant increase in these assets has led to improved efficiency in these markets, leading to fewer opportunities. For example, the quality downgrades in the auto sector during the quarter negatively impacted many convertible bond arbitrage trades. Two notable firms opted to return investors capital and close down: Marin Capital, a convertible bond arbitrage hedge fund, and Bailey Coates, a London based hedge fund. NELSON ROBERTS NEWS We are delighted to announce that Steve Philpott has joined the firm, renewing an association that dates back 8 years. Steve brings to us additional capacity in a thoughtful, hardworking and trusted colleague. Please join us in welcoming and congratulating Steve. He will work closely with Brian Roberts in delivering an ever more robust and holistic approach to the management of our clients wealth.

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