Monday, October 30, 2006

2006 Quarter 3 Update

October 27, 2006

We hope you had a great summer and are enjoying the nice fall weather as we enter November. The first order of business in this third quarter update involves a simple housekeeping item. Phillips Ray has moved its offices and we are now located in the heart of the cultural district of Fort Worth. Our new address is as follows so please make note of it:

3108 West 6th Street

Suite 250

Fort Worth, TX 76107

In short, we offered the law firm that was adjacent to us in the downtown City Center Towers the option to expand into our space if ever they should need it. Well, they chose to take us up on that offer and we are excited about the change in venue. We share an office building with a number of good friends at our new location and we are looking forward to the even shorter daily commute!

And now on to the quarterly update. It’s certainly interesting to hear the financial media talking about how the markets are “on fire” again and we’re off and running like the go-go days of old. Since the close of the third quarter the Dow Jones Industrial Average has even eclipsed 12,000 for the first time in its history. You won’t, however, hear much about the fact that the Dow is made up of only the 30 largest stocks in the marketplace and is not terribly representative of the overall market as a result. In fact, the third quarter advance was a very narrow one driven primarily by the biggest stocks in the market. The truth of the matter is that the third quarter was not all that easy on the majority of money managers, however the media’s cheerleading and focus on indices that are capitalization weighted make many feel they have missed out on a big party when in reality there wasn’t much of one, at least not outside the few large names in the major indices.

The above being said, however, there are a number of things going right for this market and for the economy as a whole. As most of you have noticed, commodity prices fell considerably through the third quarter, namely oil and natural gas. This really helps to take the Federal Reserve and its desire to hike short term interest rates out of the picture as falling commodities have eased some of the pressure on inflation. It has also provided a nice tax cut for consumers as they have seen the price of gas and other necessities fall as a result. We have also witnessed a softening in the housing market, a good thing as long as it remains gradual and relatively shallow. Again, this helps keep the Fed on the sidelines and it allows for a slow and healthy correction in what appears to be an overvalued asset in some parts of the country.

But these healthier markets must see something more than simply a decrease in inflation and a housing market that is headed for a soft landing, right? Maybe, maybe not, but there is a lot more going on in the world that is effecting our financial markets than what we see everyday on the news. Corporate balance sheets are in perhaps the best shape they have ever been in. This is something that we have commented on many times in the past and are perhaps more confident about now than ever before. But there’s even more going on out there than this and one has to look outside of the box (read domestic economy) and see the forest “despite” the trees. Globalization of free trade and capital deployment along with more experienced central banks and economies around the world have helped to create global economic diversification, a reality which minimizes economic risks and maximizes economic growth. This is of significant economic importance and will continue to have a massive effect on both the domestic and global economies, hence our financial markets as well.

Just as interest rates, inflation, housing, energy prices and all the rest have a strong effect on the financial markets around the world, so do politics, and the fact that we’re currently in the thick of mid-term elections this quarter makes the markets especially vulnerable to its effect. While it doesn’t do us much good to look back at the past in order to discern why the markets behaved the way they did in any given period of time, it is quite possible that the correction in the second quarter of this year was a result of market participants pricing in the possibility that the Democrats might take control of the House this fall. That being said, the recent strength also suggests that market participants believe that the Republicans will likely maintain control of the Senate. Political beliefs aside, this would actually be a good thing for the markets as they tend to like legislative gridlock, something we would mostly likely have should the House and Senate be split between the two parties. One result of this gridlock could be the extension of the Bush tax law changes in some form as a result of a necessary compromise. Like it or not, this result would be good for the financial markets and therefore likely cheered with more rallying. Of course we have no way of knowing how the mid-term elections will end next month but there is increasing confidence that the above split might in fact occur and the markets are happy about it, plain and simple.

Of course there are always things that CAN go wrong in the world and there are things that DO go wrong. We rarely know the CAN before it happens but certainly know the DO once it has. Our job is to prepare for as many of the “can happen” scenarios that exist and correct when and if they “do” happen. Could the Fed raise rates unexpectedly in the near term because they see something that the rest of us don’t? Of course they could. And the housing market could turn into a collapse while the Democrats take both the House and Senate next month. Rather than be frozen by fear of what might happen, investors must weigh the odds and prepare accordingly. In our opinion the odds favor a relatively strong market going forward for many of the reasons stated above. However as most of our clients know by now we do not often take the short-term view and instead tend to focus on the long-term prospects for the companies and industries in which we invest. Bargains and opportunities can be found in any type of market, both bull and bear alike, and we continue to seek out these situations and invest for the future.

As always, we appreciate the confidence and trust you have shown in us by hiring our firm as your investment manager and we look forward to the remainder of 2006.

Paul R. Ray III Brian M. Phillips