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Second Quarter 2005

In the second quarter of this year, we have observed a mid-cycle growth pause in the U.S and abroad. However, while corporate profit growth is beginning to soften, GDP growth figures are being revised upward, demonstrating that the economy has been growing solidly with only modest inflation, despite high oil and commodity prices. The dollar began to strengthen especially against the Euro, as signs of economic slowing were particularly pronounced in Germany and Italy, while France rejected the European constitution. There were some signs of slowing in China thanks to government tightening of credit in that booming region, but in general, the economic outlook both there and in the U.S is still sanguine. U.S. business investment is still growing at a double digit pace, job creations have driven unemployment down to 5.1%, inflation still remains tame despite rising commodity costs, personal income growth is still strong, consumption remains elevated, and consumer confidence is relatively robust highlighted by strong housing start numbers and existing home sales. On the negative side, economic growth is slowing from its breakneck pace of last year, debt in the U.S. is burgeoning, localized housing market bubbles have emerged, wage and price inflation pressures may be building, oil prices may begin to act as a brake on the economy, and manufacturing and leading indicators are declining.

Alan Greenspan raised rates for the ninth time since last year at the last meeting of the Federal Reserve. Prior to that meeting he suggested that any recent signs of weakness “are likely to be transitory” and that it would be “a mistake to overreact to comparatively small number of disappointing indicators.” Fed officials are like to repeat the rhetoric we have seen over the past year that they are likely to keep raising the rate at a “measured” pace going forward. Since 1945, the average economic expansion has lasted for around five years. The current expansion is 3.5 years old. Whether we are in the middle of the game, or in a later inning, the economic cycle is maturing, and when a cycle matures, large cap stocks that can provide solid earnings growth with or without a booming economy are where funds tend to flow. Large cap blue chip stocks have been in the doldrums for the last five years, while small cap and beaten down value stocks have outperformed. Even if the economy were to head into a downturn at some point, the high dividend yields and stability of earnings offered by blue chips will serve to cushion the downside.

For the first half of 2005, the Dow declined 4.7%, the S&P fell 1.7%, and the Nasdaq lost 2.2%.

Grant Rogers Elizabeth Allen

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