Second Quarter Update

Don't panic.We've seen this before

 Market concerns are abundant, inflation, interest rates and the deficit are only a few of the recent obstacles that the market has had to face.   Do these concerns mandate a more conservative investment approach?  I think not.   Inflation is a mixed bag at present and historically extremely low. On the one hand, there is little question that inflationary pressures are beginning to build. Yet inflation has been very slow to show up in the official data.  In order to remain competitive in this environment, companies must continually strive to be among the lowest-cost producers. And that objective entails constantly seeking to enhance productivity and, all too often, relocating manufacturing facilities to lower-cost locations.  We expect only a modest rise in inflation this year, but enough to encourage the Federal Reserve Board to continue on the path of raising short-term interest rates toward a more neutral stance. And for the Federal Funds Target Rate, we think that neutral is more than a full percentage point higher than the current level.

Insofar as longer-term interest rates are concerned, bond market yields are still very low. Over the last fifty years or so, the median yield on the ten-year U.S. Treasury note was 6.6%. Currently, that note yields 4.60%. Yet the remaining post-bubble deflationary pressures are dissipating, and higher interest rates seem a very likely by-product of our huge budget and current-account deficits. In our opinion, it is not a question of whether interest rates will rise. Rather, it is a question of when.

With rising interest rates will come lower bond prices, with that said there will be a time to lengthen fixed-income maturities, but that time is not upon us.For now, our fixed income posture remains short term, defensive and invested in floating rate bonds.

The Stock Market

As we write this report equity markets are hitting new lows for the year and reaching well below last years highs.  Not a good sign for the short term.  With this said it seems to us we are in the beginning stages of the first cyclical downturn of the beginning of a bull cycle.  No doubt this downturn seems scary as we experience the change, but it is important to remember that the secular bear market is behind us. The decline investors experienced during the first three years of the millennium was devastating. But historically, such an event happens only two or three times a century. The next decline should have a limited downside and therefore be looked upon as providing an opportunity to invest at more favorable prices.

Our plan is to approach the next downturn as an opportunity. Depending on the timing, it is entirely possible that the stock market will end 2005 higher than it begins, yielding reasonable returns overall. Also, it is interesting to note that since 1935, every year ending in the number five has been an up year for the market. But we know that is just coincidence.

We look forward to the years ahead. They are unlikely to produce the outsized gains of the 1980s and 1990s, and they will almost certainly require more patience and skill than before. But when all is said and done, stock market returns should stack up quite well, both relative to the rate of inflation and, we think, as compared to most of the alternatives.

Conclusion

The global economy is evolving. The U.S. and Europe are mature and growing more
slowly than in the past. Our manufacturing base continues to erode.  This evolution is a natural process, although it is certainly disruptive for those whose livelihoods are affected. Yet for investors, this is a world filled with opportunities. The global economy is increasingly open, and a growing world requires all kinds of goods and services - banking, insurance, raw materials, food, clean water, distribution, transportation, health care, and entertainment to name but a few. Entrepreneurs and innovative companies find unique niches to provide goods and services that they can manufacture and provide better, cheaper, and more efficiently than before, no matter where they are headquartered. There are globally-based companies which benefit from these trends, as well as U.S. companies which are doing business globally. In fact, it might surprise investors to learn just how many U.S. companies derive the majority of their profits from overseas.

A changing world provides both challenge and opportunity. As investors, we have a choice of where and when to invest - in what companies, in what sectors, and in what parts of the world. The glass we see is global, and it is certainly more than half full. Our expectations are high.

SWCM Composite Portfolio (Equity and Fixed Income)

As discussed in the last portion of this update, we remain very comfortable with the long term outlook for equity markets and consequently the current holdings in the SWCM composite.   With better than anticipated earnings and revenue expectations, we are confident we will see strong returns from our holdings in both the long and short-term.  On the fixed-income front, we have begun to purchase high quality, various maturities, floating rate bonds and have increased our asset allocation on bonds to near 10%.  These are bonds where the interest rate will fluctuate due to changes in inflationary pressures and interest rate changes.  Bottom line, floaters will increase in yield with increases in inflation and with higher interest rates. Contrary to last quarters outlook we believe we will see higher interest rates by the end of the year into the first quarter of 2006, putting increased pressure on bonds and increasing signs of commodity led inflation. 

Our approach for the quarter

Market conditions have changed since the last update as inflation and interest rates have begun to show more signs of life and are disrupting the equity markets.  As stated earlier, we believe there is a strong possibility for a continued increase in stock prices throughout this quarter and most of 2005, though a change in interest rates and market macro dynamics may begin to take hold and set up a different set of market conditions for the end of 2005 and into 2006. 

Closing Statement:

We remain optimistic about the long-term opportunities in the equity markets and continue to feel comfortable regarding the current stock market environment where stocks remain the most attractive broad investment category currently available to the average investor.  Bottom line, we remain constructive on stocks, continuing in our belief that the current risk/reward environment is positive for equity investors. 

While our strategy remains solid we continue to focus on companies with strong earnings and growing revenues as we select new names for the SWCM composite.  Our strategic outlook has us positioned for a longer, more powerful bull market. 

As always, SWCM values each client and continues to focus on your investment objectives.  If you have any questions or concerns please do not hesitate to call.

* All performance measures are based on a model composite portfolio managed with a growth perspective. All numbers are not audited and are not in compliance with AIMR. Ask for more detail regarding the model growth portfolio.

Disclosure: Examples of specific securities and/or sectors are given for illustrative purposes only and should not be used or construed as recommendation for any security and or sector. Past performance does not guarantee future results. Total returns are historical and include security values and reinvestment of dividends. Cumulative total returns are reported as of the period indicated. The results provided have not been audited and are based on a composite of client's accounts. . For information pertaining to the registration status of SWCM, please contact SWCM or refer to the Investment Adviser Disclosure we site (www.advsierinfo.sec.gov).