With nine months of history under our belts for 2005, investment trends which have had a significant impact on our clients’ equity results have come into clear focus. Chief among these are the following:

1. Commodity-type investments continue to experience sharp price increases. Oil is, of course, the most obvious example as growing demand from emerging markets—most notably China and India—continue to absorb what in the past had been categorized as excess supply. Add to this the impact of supply disruptions from hurricanes and terrorists attacks on sources of production and the stage is set, in our opinion, for oil prices to remain relatively high for the foreseeable future.
   
   Other commodities are also experiencing surging prices as evidenced by broad-based commodity indices. Industrial commodities and materials such as copper, lead, cement, diamonds and nickel are all experiencing rapid price increases attributable to strong global demand, particularly from emerging nations. We believe this trend is secular.
   
   

2. Perhaps we are at the early stages of a growing global desire to convert worthless paper currencies (which continue to be printed in quantities that defy our comprehension) into "hard assets". One of the most sensitive barometers to the debasement of currencies is gold, and during the past quarter gold rose to a 17-year high in dollars, Euros and Yen. This is unprecedented. The markets are telling us that global discontent with fiat currencies is on the rise! Gold’s rise to a new high has caused gold and precious metals mining stocks to increase by 30-40% this year.
   
   

3. Overseas stock markets in general, and emerging markets in particular, have dramatically outperformed our domestic stock markets this year. The third quarter witnessed an acceleration of this trend.
   
   

4. Inflationary trends appear to be re-emerging—both at home and abroad as evidenced by various indices of inflation. In the U.S., the rate of increase in the federal debt is stunning. In the past twelve months (through September) an additional $563 billion has been added to the national debt, equal to an increase of $1.54 billion of debt each and every day. So far, the rest of the world continues to acquire our treasury securities issued to fund this rapid growth of government debt. Global demand for our treasury securities has kept pace with increasing supply preventing, thus far, longer-term interest rates from rising in sympathy with increases in short-term rates.
   
   Eventually, interest rates rise during periods of increasing inflation concern. For the first nine months of this year, however, this growing expectation still hasn’t affected the price of long-term treasury bonds. Long-term interest rates are virtually unchanged as of September 30 compared to interest rate levels on December 31, 2020. Bond returns for the year to date remain low. Should longer-term interest rates begin to rise in the fourth quarter, bond total returns will likely become negative for the year.
   
   

5. Finally, the broad domestic stock market continues to sputter as it has done all year despite strong corporate earnings growth. The U.S. stock market may also generate a loss for the year if incipient inflation fears result in rising long-term interest rates during the fourth quarter.
   
   

Client portfolios have enjoyed strong price appreciation for the nine-month period as investments in energy, precious metals, and foreign stocks substantially outperformed our domestic markets.

During the fourth quarter we will review client taxable account for tax loss possibilities and give clients a preliminary report on losses (if any) that we have realized. Please recall that it is our policy to take losses when available in taxable accounts near year end to offset other taxable gains, or to "stockpile" the capital losses for use in subsequent years against future capital gains. Realized losses have an economic value by virtue of our tax laws.

Our diversification efforts in the "other" category have been quite successful this year to date. Client portfolios have investments in real estate, gold, a commodities fund, and a hedge fund. The price action of each of these assets is relatively uncorrelated to the price action of our domestic stock market. In other words, these other assets follow their own pricing patterns independent of the price movements of the stock market. This is a good thing as client portfolios’ overall volatility will be lower by virtue of their inclusion. In plain English, our continuing diversification of client portfolios helps reduce the overall level of portfolio risk. This statement is illustrated by the enclosed charts presenting a sequence of hypothetical portfolios that are increasingly diversified. The objective of diversification, being reduced risk without a commensurate reduction of portfolio return, is clearly demonstrated.

One further observation regarding hedge fund investments is appropriate here. Hedge funds typically earn larger returns when the volatility of investment markets increase. We have now come through a period of very low stock and bond market volatility matched by low hedge fund returns in 2004 and 2005 to date. This may be coincidental but we think not. Markets are becoming more volatile now and, if old relationships hold true, hedge fund of funds returns should begin to improve.