QUARTERLY COMMENTARY SECOND QUARTER 2006

TURBULENT 2
ND

QUARTER

The second quarter of 2006 was not kind to investment markets. In the first quarter, investors The current account deficit continues to rise as we were optimistic and upbeat anticipating that the Fed import far more than we export. (Please see the chart was nearing the end of their rate hikes. In the second below.) This means that the U.S. is becoming similar quarter, fear of rising inflation drove the markets as to a profligate spender who risks maxing out all the Fed continued to raise rates. Large capitalization available credit only to find it daunting just to repay U.S. stocks were down -1.4%. This performance the interest required on all outstanding debt. would have been much worse had it not been for the Someday this deficit will have to decline or we will 2%+ market rally on June 29th . Small stocks declined see a run on the dollar as our foreign lenders, who 5.0% in the quarter. The fixed income markets were hold U.S. Treasury bonds and invest in U.S. assets, also off, falling -0.3% as bond prices declined by refuse to offer us more credit. more than the income they yielded. Large foreign stocks were up 1.0%, but emerging market shares fell The fixed income markets are by -5.2%. Housing U.S Current Account Balance & Its Components increasingly sensitive to markets in many parts Billion $ (Seasonally Adjusted) 40 comments about future Fed Balance on Services of the U.S., including action. The quarter began Bal. on Income Silicon Valley, have 0 with a flat yield curve, with moderated. Gold rose interest rates between 4.8% at -40 dramatically from $583 6-months to 4.9% for U.S. Net Unilateral Current Transfers per ounce to a high of Treasury bonds maturing in -80 $730 falling back to Balance on Current Account 30 years. In response to the $583 before closing the FOMC raising short-term -120 quarter at $615. The rates, yields on longer-term Balance on Goods volatile markets were -160 bonds have also risen. This not a reflection of the means that longer bonds have continued strength in -200 declined in price. Over the the economy as GDP last 12 months the 30-year growth was revised up -240 U.S. bond has seen its price to 5.6% for the first 1998 1999 2000 2001 2002 2003 2004 2005 2006 decline -16.9%, for a total quarter. return of 12.4%. In Source: US Dept. of Commerce contrast, our portfolios durations have continued to Ben Bernanke had a bumpy start to his first full be very short; as a result, we have out performed quarter as the Chairman of the Federal Reserve. In benchmarks and have positive returns from our fixed April, he showed his inexperience when he casually income investments. mentioned to a reporter at the White House EARNINGS REMAIN STRONG Correspondents Dinner that the markets had misunderstood his recent comments. The markets For the 16th quarter in a row, the earnings of the S&P fell the next trading day after his comments were 500 companies grew more than 10%. Investors widely broadcast. Mr. Bernanke is learning that continue to worry that double -digit earnings growth when speaking with reporters nothing is off the cannot continue, leading to the muted performance of record. At the May and June meetings the Federal large cap stocks over the last eighteen months. The Open Market Committee (FOMC) raised the Fed combination of earnings growth and moderate price Funds rate by percent for the 16th and 17th appreciation has resulted in the valuation of the S&P consecutive increase. The markets are not convinced 500 trading at 17 times earnings. This is very that Chairman Bernanke has the conviction to keep reasonable given it traded at 27 times in 2000 and 43 inflation under control, but reveled in the language times in 2002.

within the committees statement that further rate increases may not be necessary.

PORTFOLIO ACTIVITY

On the heels of our March 30th sale of Paychex (PAYX), we exited our position in Automatic Data Processing (ADP), completing our profitable investment in the payroll processing companies. During the quarter, we executed our renewable resources theme and purchased SunOpta (STKL), Hain Celestial (HAIN), and United Natural Foods (UNFI). With the Index Performance addition of these three Dow Jones Industrials companies we are now vertically invested in Standard & Poors 500 the natural foods EAFE (international stocks) businesses: raw Russell 2000 (small stocks) material manufacturing, Lehman Intermediate product processing, and Lehman Municipal packaging and distribution. These investments also contribute to two additional areas of focus. The first is to gain exposure to under-discovered industries with long term growth prospects, and second is to reduce the average size of our portfolio companies. PAYX and ADP combined for nearly $40 billion in market capitalization, while the combined market capitalization of STKL, HAIN, & UNFI is $2 billion. Attractive opportunities in the equity markets exist in todays environment. We are currently researching investments in alternative energy sources such as the oil sands in Canada, and fountain of youth stocks (those that will benefit from the aging of the baby boomers).
HEDGE FUND EXPOSURE

One of Paulsons primary focuses will be tackling a bulging trade deficit. He has already hinted at one way to address this issue: to convince the Chinese to allow the Yuan to rise and to further open up their markets to U.S. goods and services. Having traveled to China seventy times over the last 15 years, Paulson has the experience and understanding to deal with the Chinese government and to convince them that it is in the best interests of both Q2 06 YTD countries to close the 0.94 5.22 trade gap. If Paulson is -1.44 2.70 successful, we believe this will put pressure on 1.00 10.56 the dollar to weaken. -4.98 8.26 As a way to profit from 0.21 -0.17 a falling U.S. dollar, we 0.03 0.28 are looking at investing funds into un-hedged non-US sovereign debt. We anticipate adding a small percentage of foreign debt while maintaining a 12% target for foreign equities.
ESTATE TAX

The hedge fund industry and hedge fund investments have attracted an increasing amount of media attention and investment dollars. We consider our position in Goldman Sachs as a proxy for a hedge fund. The company is #1 in terms of the alternative assets under management at $21 billion. Even with the stocks 6% decline in the second quarter it is up 15% year to date, surpassing the average return of hedge funds themselves during that same time period. NEW TREASURY SECRETARY/ WEAK U.S . DOLLAR President Bush named Hank Paulson, the CEO of Goldman Sachs, to replace John Snow as Treasury Secretary. The U.S. Senate voted unanimously on June 28th to approve Mr. Paulson. We believe Paulsons appointment will be positive for the economy as he brings credibility and a deep understanding of the risk and return factors of the markets.

We have seen some recent progress in Congress towards permanently amending the estate tax. Proposals for a $5 million personal exemption and then a 15% tax on the next $25 million in assets, look promising and could mean significantly lower contingent estate tax liabilities for all but the ultra wealthy. Additionally, the 15% Federal capital gains tax would be extended and there is a proposal to eliminate the $100,000 Modified Adjusted Gross Income limit on Roth conversions. If passed this last item will be important for all of our clients with significant retirement accounts.
OUTLOOK

In the near term, if domestic interest rates continue to rise faster than those in Europe and Japan, the dollar will likely move higher. The effect will be further widening of the trade deficit and current account balance. Longer term, increasing deficits will exert downward pressure on the dollar in order to finance these deficits. A weaker U.S. dollar will benefit the U.S. economy, especially larger capitalization companies who sell goods and services overseas. At present, the stock market offers reasonable value. However, as the economy begins to slow, the markets concerns will make increased diversification paramount in buffering the type of volatility we experienced in the second quarter.

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