Client Letter

The S&P 500 gained 3.4% in the 3rd quarter and is up 2.3% for the year. We thought the S&P 500 would be doing better by now. YTD all gains in the S&P 500 have been driven by the energy sector and to a lesser extent commodities producers. Earnings continue to shine, with estimates ranging from +16% for Q3 to +14% for Q4 2005. Earnings for Q2 were booked at 12% versus 8% forecast at the start of the quarter. If earnings going forward appreciate at a 9% rate while the ten year yield rises to 5%, the

stock market remains undervalued by 30% according to the Fed Model.

Investors won't step up to buy stocks until

We were in a similar situation through last October - investors wouldn't buy stocks until they got clarity on the Presidential elections, at which point stocks rallied sharply into the year end. Unfortunately, as far as energy, the Federal Reserve and

Iraq

are concerned, we don't have an "election day" - we just have to see whether our start-of-year forecast of 8% in the S&P 500 is still achievable.

Since January, we’ve thought oil should be heading back towards $50/barrel and since January, we’ve been wrong. Hurricane Katrina drove oil to a record intraday price of $70.40, settled back to $62 post Katrina, rallied back to $68 in anticipation of Hurricane Rita, settled yesterday at $66.24. Katrina and Rita were the 8^th and 3^rd strongest hurricanes on record, but damage to offshore facilities was limited. Onshore refineries (representing 26% of

capacity) were damaged slightly but are still only 50% back on line either due to electrical outages or to displacement of personnel. The latest weekly fuel inventories report shows crude stocks down slightly, but still above average for this time of the year. Gasoline inventories are on the increase as the driving season comes to the end and as consumers adjust behavior in light of high prices at the pump. The focus of analysts will switch to heating fuel stocks which currently are adequate despite the reduction in refining capacity.

Although current supplies are fine, traders are worried more about future supplies. The socialist government in Venezuela, the US’s closest supplier, is threatening to divert its production to

China

despite a host of delivery problems. Middle-Eastern suppliers are producing at maximum draw rates with the exception of

Iraq

which still must invest heavily in infrastructure to increase past the current 1.5 million barrels/day. Development of Russian fields continues, but there is a lack of pipeline capacity to get that oil to the rest of the world.

Demand in the rest of the world, particularly in

China

, may abate as high prices reduce the rate of economic expansion. The

, consumer of 25% of the world’s oil and 40% of the world’s gasoline, may have to get serious about energy alternatives.

Federal Reserve Policy

In the immediate aftermath of Katrina, economic forecasts projected 3^rd quarter GDP being reduced by up to 1%, falling from the 3.3% rate recorded in Q2. It appears, however, that having the country’s 13^th largest city wiped out will have only modest impact on the rest of the economy, and GDP will remain in the 3.5-4% range. Thus, the Fed continued its policy of raising rates 0.25% at a time for the 11^th straight meeting. The Fed is concerned about inflation picking up on the back of higher energy prices and as the economy moves towards full capacity.

The Fed would also like to take some of the pressure out of the housing bubble by increasing the costs of borrowing (which is tied to the 10 year Treasury bond yield.) Although the Fed only controls the overnight rate directly, generally speaking, higher short term rates will push yields higher across the entire yield curve. In the current cycle, the yield curve is actually flattening as the 10 year rate has held in the 4-4.25% range for months (versus our expectation of plus 5% yields by now.) The explanation is that the Chinese government is aggressively investing dollars earned from export activity back into the US Treasury bond market to keep the Yuan from appreciating against the dollar, which would make Chinese exports less competitive.

For over a year, we’ve warned our clients that the housing market was looking over-bought. We’re starting to see confirmation of that analysis with recent new home sales down sharply, with inventories of houses creeping up, and with prices leveling somewhat after the substantial increases of the last 4 years.

Violence ebbs and flows in

Iraq

, with Iraqi civilians suffering the most from sectarian fighting between Sunnis, Shiites and Jihadis. Deaths among occupation (primary US and British) forces have tailed off in recent weeks. Key goal of occupation forces is to provide security through the constitutional referendum (October 15^th) and parliamentary elections (December 2005.) If those goals can be achieved, Iraqi forces will start taking up the task of defending the country from foreign fighters while the Sunni fighters are co-opted into the political process. There is some evidence (the transition from military to civilian targets, the use of female suicide bombers) that Al-Qaeda in

Iraq

is exhausting its resources, although, if we use the Israeli-Palestinian situation as a proxy, hostilities will go on for years.

The Bush administration staggers from crisis to crisis, most recently Hurricane Katrina. Although much of the fatalities (latest estimate: 900) were attributable to New Orleans geography (“a soup bowl surrounded by soup”) and local governmental incompetence, incompetence in FEMA shed doubt on the national government’s preparedness for a large scale terrorist attack or the outbreak of an infectious disease. These concerns were not assuaged by the smooth evacuation of Galveston and Houston two weeks later during Hurricane Rita. Discussion of Social Security reform was tabled. Judge John Roberts was confirmed for Chief Justice with relatively little acrimony, but now a second Supreme Court judge must be nominated and confirmed.

402 days remain until the 2006 elections (all Representatives, 1/3 of Senators.) We don’t expect any shifts between minority and majority party in the House and Senate. 1130 days remain until the 2008 presidential election. From a number of polls, Senator McCain and former New York City Mayor Giuliani are the current front runners on the Republican side; Senator Clinton is well ahead of runner ups Senators Edwards and Kerry for the Democratic nomination.

We took profits on energy positions this quarter, used the proceeds to add to positions in the technology, financial services and consumer discretionary sectors (selling high and buying low.) We are tracking with concern the state of the housing market, and also looking for dangerous excesses among hedge funds. However, the stock market remains at a compelling discount to fair value. The equity components of our clients’ portfolios are fully invested.

HCMI Client Letter - October 5th, 2005