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Quarterly Letter to Clients

January, 2006

Indices at quarter-end (December 31, 2005):

Dow Jones Industrials: 10,717.50 4Q'05 +1.41% YTD -0.61%

Standard & Poor's 500: 1,248.29 4Q'05 +1.59% YTD +3.00%

Quite a bit has happened this quarter and over the past year. Long-reigning Fed chief Alan Greenspan’s term is ending and Ben Bernanke has been anointed to replace him; oil hit highs for the year and then lows for the quarter; interest rates were boosted again; New Orleans got washed out; gold hit multi-year highs; Iraq held elections; and General Motors traded at 20-year lows.

But you wouldn’t know it was such an eventful period if you just looked at the markets, which managed only small single-digit moves for the second year in a row. In fact, to find another year in which the Dow Jones Industrials moved such a small percentage, you would have to go back 79 years, to 1926.

Thus, in terms of market movement, the temptation is to send you a blank page as my commentary on the quarter and year; it would be an apt reflection on how much has not happened in stocks and bonds. But considering all of the forces working against it (war, oil prices, interest rates, deficits, etc.) it is a minor miracle that the market remains where it is.

This may sound like a broken record (remember records?), but the Fed raised rates again, the thirteenth consecutive such move, to a Fed Funds target rate of 4.25%. I have long postulated that 4.5% would be the goal of our monetary watchdogs, and attaining that number now looks like a certainty. For the moment, at least, given the changing of the guard at the Fed, we cannot predict anything substantially higher, but I will note that as recently as 2000 the rate was above 6%. The January meeting will be Mr. Greenspan’s last, and it will take us a few years to know how his successor will act.

There were two big news items in the bond market. First, General Motors and Ford were pushed below investment-grade, and their bonds subsequently traded as if the two behemoths were on the edge of bankruptcy. And second, the yield curve inverted, meaning that shorter-term instruments now yield more than longer-term items. This is a somewhat rare, although certainly not unknown, condition, that is being talked up as a presage to a recession. Well, maybe yes, and maybe no. But one thing is easy to predict: the curve will not remain inverted. Either long rates will jump up or short rates will decline to attain a more natural balance. My money is on the former; I believe that long rates will rise to restore the normal relationship.

It is more difficult than ever to predict the coming year. You could make a case for either a bear market or a bull market. Certainly the last two years of non-directional movement offer us no clues. If there’s a trend there, it is sideways, in itself extremely unusual. I would guess that if we were to withdraw from Iraq the stock market would soar. But I would also guess that we are not likely to withdraw anytime soon. I expect interest rates to rise, putting a little pressure on stocks and bonds. But I feel that the economy is robust enough to weather any rate rise and to withstand the resulting overdue contraction in the housing market, which I (and everyone else) expect.

I feel that the prudent course is to remain invested in quality stocks that are likely to grow their earnings; in dividend payers; and in shorter bonds, including convertibles, for their yield. I will, as always, exercise care and prudence in selecting securities for your account.

I wish you a happy, healthy and prosperous New Year.

Jim Pappas