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Fourth Quarter 2005

2005 was characterized by a relatively flat stock market, which is not surprising given that oil prices rose by more than 50%, interest rates were increased eight times by the Federal Reserve Bank to 4.25%, and Hurricane Katrina devastated the Gulf Coast region. Nonetheless, the U.S. economy has proved capable of withstanding the strain, and we observed vigorous earnings growth, low inflation and healthy corporate balance sheets. U.S. corporations, whose cash flow positions improved, undertook share buybacks and increased dividend payouts, while corporate profits were at record highs.

There are many positives favoring the market for 2006. Business investment and job growth are still increasing, inflation remains tame, personal income growth is reasonably high, while consumer spending remains robust. The U.S. is still a net beneficiary from strong growth in Asia, while the global economy is being helped by an overall rise in productivity. Since 1945, the average economic expansion has lasted for five and a half years; the current expansion is four years old. Large cap blue chip stocks have been relatively flat the last five years, while small cap stocks have outperformed in every year since 1999. We now believe that the tide will turn. Even if the economy were to moderate at some point in the second half of 2006, the high dividend yields and stability of earnings offered by blue chips will serve to cushion any downside. The minutes of the December 13th Federal Reserve meeting, released yesterday, indicate that their campaign to increase interest rates may soon come to a conclusion. If this is the case, the net effect will be positive and will likely result in stock multiples “catching up” to the higher corporate earnings of the last two years.

We do foresee, however, a moderate slowing of U.S. GDP growth in 2006, down from 3.8% last year and 4.2% in 2004. This is because the consumer is stretched with debt, the price of oil has a negative effect on purchasing power, and the “wealth effect” that home prices have created may now lessen as housing price growth slows. Residential construction, which contributed significantly to GDP growth in 2005, may slow in 2006. We believe nonetheless that any pullback in consumer spending will be partly compensated by higher business spending. We also still believe that commodity and energy prices will continue to rise in 2006, as long term demand growth outstrips supply growth. The run-up in gold prices seems to be predicting a confluence of lower confidence in the U.S dollar and the Euro currencies, higher inflation ahead, and greater demand for physical gold out of Asia. We think the dollar will resume its downward path in 2006, due to the excessive trade and budget deficits in the U.S., and that gold will continue to rise.

For the year 2005, the Dow declined a slight 0.61%, the S&P rose 3.0%, and the Nasdaq gained 1.37%.

Grant Rogers Elizabeth Allen

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