US Equity Income & Capital Appreciation Strategies
Stock Market: Rebound Reversal

Rising energy prices and the credit market’s ongoing problems sent stocks lurching downward in the second quarter. The S&P 500 index lost -2.7% to close at 1280, bringing this broad index of large-cap corporations down -11.9% for the first half of a tough year. Rallies in April/May that accompanied good corporate earnings reversed in June. Normally a month of pleasant weather and outdoor weddings, June 2008 (down 8.4%) bore the unpleasant distinction of being the stock market’s worst-performing June since 1930 (down 16.5%).

The market’s hope that the government’s $168 billion stimulus-rebate program would revive the economy influenced the quarter. Retail, financials, capital goods, material and technology sectors all participated in the April/May uptrend. But momentum changed in June as concern about growing weakness came to dominate economic news. The U.S. economy now faces strong negative headwinds, as record prices for oil and other commodities are pushing inflation higher, and difficulties in the housing sector and availability of credit is suppressing economic growth toward recessionary levels.

Consensus estimates of reduced second quarter corporate earnings put the stock market under increasing pressure. This consensus -the fourth quarterly contraction in a row - reflects that S&P 500 earnings per share will decline 9% over the next 12 months. Since financials comprise the largest market sector, their dismal performance - down 53% - has had an oversized impact on overall market performance. The best-performing sector is energy, up approximately +22%. Next quarter estimates are for +13.9%, but this number has been falling and will continue to decline. Lower estimates are the result of companies’ limited ability to improve margins by passing on higher commodity costs through increased prices.

We clearly remain very cautious on the stock market. The key to success, we believe, is to continue to invest carefully in sectors/industries that offer good relative returns in the continuing market turbulence that awaits us. We adhere to our belief that well-structured, highly diversified portfolios are our best means of positioning to reap the benefit from the inevitable turnaround.

Market Outlook: Hope for the End of 2008
A recent Merrill Lynch/Haver Analytics study compared the S&P 500 to government indicators of the economy. The study caught our attention because it intelligently guess-estimates a timetable for market recovery.

The government’s terminology for data-indicators—leading (before the economy turns), coincident (when the economy turns), lagging (following the economy’s turn)—are great business cycle barometers and have been very useful in determining our position in the economic cycle. The study’s intriguing aspect is its finding that the coincident-to-lagging indicator ratio has been a better indicator for projecting the economy’s direction than the leading indicator alone.

Based on May numbers (see chart), the leading economic indicator was up 0.1%, but the coincident-to-lagging indicator was down 0.1, to 95 – the lowest level since November 1982. According to the study, recession begins once this metric is 96.3 – precisely where it was in January 2008. At 95, the study suggests that the economy is about 20% of the way through a correction; which means that, typically, another 8 months (range 4 to 11 months) remain before the downturn ends. Historically the stock market generally bottoms four months before a recession ends. Thus, the average decline in the S&P 500 in that four-month time frame from the 95 level (on the coincident-to-lagging indicator) to the lows in the market, has been in the 12% range (-2% to -19%). The study concludes that the market could indeed turn around in the fourth quarter.

Portfolios: A Defensive Posture
We managed our way to market-beating performance in the second quarter in a very difficult environment, and have positioned ourselves prudently for the year. The second quarter’s outperformance may be credited to:

• US large-cap defensive securities performing well
• prescient underweighting/overweighting of sectors
• cash reserves from selected sales adding defensiveness to the portfolio

We continue to believe the key to superior rates of return during the current U.S. market correction will be proper sector/industry weightings and stock selection. As you know, we’ve been overweighted in energy and slightly underweighted in capital goods (until our recent sale of some defense stocks). We think the economy’s structural changes will allow energy/commodities and certain companies in the industrials sector to have superior returns compared to previous down markets. Specifically for the energy sector, we believe, long term, that demand outweighs supply; despite this, we would not be surprised by a short-term pullback in energy stocks. Thus we remain overweighted in energy even though we reduced our exposure by taking profits.

We have substantially underweighted financials in prior quarters. This quarter we began to add some names on the processing side of the banking industry. We also added one banking name that boasts credit quality and a balance sheet stronger than others in the industry.

In capital goods – where we intend to increase our weighting – we sold defense companies in the belief that a new administration will put defense budgets under scrutiny. That’s why we are focusing on capital goods exporters that stand to benefit from the weak dollar.

In technology, we purchased for the US Equity Income portfolios a large-cap stock with a great five-year track record. One of the world’s largest IT firms, the company is a player in enterprise storage and servers, services, software and laptops/PCs, imaging and printing and financial services. For US Capital Appreciation portfolios we purchased a small-cap stock in the semiconductor industry. Its principal activity is to design, develop, manufacture and market proprietary, high-voltage, analog integrated circuits used in converting alternating current (AC) power to direct current (DC) power. We are currently slightly underweighted in this sector.

We continue to be underweighted in consumer staples. We should point out that for the past two months this sector has underperformed due to the recent bounce in the dollar. We are currently looking to add to this sector as we find undervalued companies.