Third Quarter Update

Election Year Markets

The last quarterly report was entitled, “Caution Inflection Points Ahead.” Those points are upon us now as the preliminary hand over of Iraq is complete, the Federal Reserve Interest Rate Policy meeting has come and gone with a 25 basis point increase and numerous economic reports have begun to show a slow rise in inflation driven primarily by higher energy prices. The stock market during the 2nd quarter traded mostly lower while discounting these most recent economic concerns. The increase in the Federal Funds rate of 25 basis points on June 30th importantly signaled that future increases will be measured but sustained. Historically stocks have shown that they can continue advancing, even in the face of rising interest rates. The real concern with inflation increases is the threat that the Fed may raise rates faster than expected and cause concern among investors. However, our opinion is that the biggest concern for the financial market is the economy and its ability to sustain the current levels of growth. This is of major concern to both the Bush Administration and the Democratic nominee John Kerry.
“It’s the economy stupid,” said Bill Clinton in his 1992 election campaign in summarizing the key issue during his election and this is again one of the concerns of the current election. Indeed, the state of the economy is considered by many as the most important factor in determining whether an incumbent president will be successfully reelected. While the economy seems to be improving and is showing signs of job creation, more importantly the political debate will be on the quality and sustainability of these jobs. It is our opinion that Bush is in for the fight of his life and barring any major event (i.e. a timely capture of Osama Bin Laden) this election will hinge on economic and job growth. It seems obvious that the upcoming election is far from certain.
And what if Kerry were to win? While we believe investors might act negatively at first to the increased uncertainty of a new administration, the stock market has actually fared best in the past during periods of political gridlock. That fact is well demonstrated in the Merrill Lynch chart listed on the following page. Since the mid-1950s, stocks have shown a compound annual growth rate (CAGR) of some 3 percent, on average, when a single party controlled both Congress and the presidency. But stocks appreciated at a much greater rate of 9.7 percent during periods of divided power. Perhaps the prospect of nothing being accomplished outweighs the uncertain outcome of a definite agenda. In other words, investors might actually react better to an environment in which our politicians are effectively precluded from doing any harm.

Political Gridlock Is Good for Financial Markets
	White House	House	Senate	S&P 500 CAGR

2001-Present	Republican	Republican	Republican	-4.30%
1995-2000	Democrat	Republican	Republican	19.2%
1993-1994	Democrat	Democrat	Democrat	2.70%
1987-1992	Republican	Democrat	Democrat	10.30%
1982-1987	Republican	Democrat	Republican	13.90%
1981-1984	Republican	Democrat	Republican	5.40%
1977-1980	Democrat	Democrat	Democrat	6.00%
1968-1976	Republican	Democrat	Democrat	1.20%
1961-1967	Democrat	Democrat	Democrat	7.50%
1955-1960	Republican	Democrat	Democrat	8.30%
		Average	One Party	3.00%
			Gridlock	9.70%

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    Source: Merrill Lynch

So what will we do?

We’ll go with the flow. The end of this bull market phase may be coming into distant view. But short-term corrections aside, we think that stocks are likely to continue moving higher for a while longer. Stay invested.
Second, be price sensitive. This is not going to be a 1990’s type of one-directional market. Good companies may not translate into good stocks if they become too expensive.
Third, reduce beta (volatility) as the market moves higher into this summer we may leave some upside potential on the table. And possibly hold cash reserves in floater bonds (mentioned in 2nd quarter update) to temporarily conserve cash.

Fourth, pay attention to sectors. Some groups are early cycle, while others move later. Also, be aware that although the former bull market leaders often lead the first advance off the bear market bottom, they also usually become bogged down as time moves on.

Fifth, and unique to the current environment, be very leery of owning long-term bonds. The only reason interest rates would not rise over the coming year, would be if the economic recovery breaks down. And we consider that highly unlikely.

And finally, remain in a positive mindset. The great bear market is over. While the stock market environment we perceive may not be as attractive as it was during the 1990’s, we believe that the next few years will provide quite favorable returns to diligent and committed investors.

SWCM Composite Portfolio (Equity and Fixed Income)

We remain optimistic with the current equity market conditions and consequently the current holdings in the SWCM composite. Recent additions to the SWCM Composite include AUO (AU Optoelectronics). AUO is one of the largest manufacturers of LCD flat panel displays in the world and has a current ROE of over 30 percent. Flat panel displays are projected to grow over 100 percent this year and into the foreseeable future while AUO sells at only 6 times earnings. I believe the next few quarters AUO will continue to have positive earnings outlooks. On the fixed income front we remain cautious and continue to own floater bonds with a correlation to higher interest rates and increases in inflationary concerns. Contrary to last quarters outlook we believe we will see higher interest rates at the end of the month and see increases in rates over the next 6 months and into 2005, putting increased pressure on Fixed Income Securities. While interest rates rose in anticipation of the Fed raising rates the Fixed Income market had its largest sell off since 1980. Overall, the SWCM composite has underperformed the S&P 500 index by 3.5 percent during the first 6 months of the year. We expect a strong second half of the year and SWCM to outperform.

Our approach for the quarter

Market conditions will continue to be quite volatile as we enter the final stages of the presidential election and interest rates begin to trend higher. As mentioned in the previous quarterly outlook we are in the midst of a confluence of market changes that once behind us should allow the recovering economy to be reflected in increasing equity valuations.

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. Stocks remain the most attractive broad investment category currently available to the average investor. Bottom line, we continue 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).