Economic & Market Commentary, Third Quarter 2005

Frederic M. Smoak, MBA, CFA

Euclid Investment Advisory

Two Steps Forward - Two Steps Back

Investing is often an exercise in balancing reality and optimism. So far this year has been nothing but an exercise in frustration to investors thinking either the markets would crash or surge. And the future looks little better as we head into the fourth quarter. I haven't given up hope for a reasonable year, but NO ONE can say for sure. When there is no day-to-day certainty, how can an investor cope? I recommend each participant look at his/her own time horizon and comfort level, then decide on the asset allocation that best fits that profile. Ignore the noise and remember that long-term goals require long-term strategies and execution. For now, the economy remains strong - above 3% real growth. Offsetting that is a surge in the price of energy that continues to hold down consumer spending. This is a mixed blessing since it keeps the Federal Reserve restrained in raising rates by acting as a drag on discretionary income. I am not expecting energy price to decline to the low levels of the past few years, but if they stay at these levels, economic growth will suffer in the future.

Equities:

Growth, the golden sector of the past few quarters, took it right on the chin last quarter. Across the board investors fled both large and small growth companies. This is a natural response to slowing growth. Investors won't pay as much for a dollar of the future when that future is not as secure. As long as growth remains above 3%, I will remain optimistic that earnings, and therefore prices, can advance. But sector rotation and choppiness will continue to make this market nervous and skittish until it finds a direction. The natural resources and oil sectors have recently taken a breather. Higher commodity prices have not automatically meant higher stock prices. This is a good sign for the rest of market and the economy as a whole. We are not primarily or a raw materials or manufacturing based economy any more. Growth in these sectors isn't nearly as important to US well-being as it used to be.

Looking ahead, the economy continues to post good growth. Barring the unforeseen, there is no reason equities cannot have at least an average year. Since most of the uncertainties that are factored into the markets are for negative events, the possibility of an ‘upside surprise’, either through earnings or outside events, could lift prices higher.

Fixed Income

Bonds had a very good - and very unexpected quarter. The model portfolios are kept diversified because the future is ALWAYS uncertain. No one has all the answers, and exposure to all asset classes is important for risk control. Fed tightening continued during the quarter, but bonds still made gains. Corporate bonds did better than the government sector. This is to be expected since economic growth reduced the credit spread investors demand to hold securities without government guarantees. But the strength in all bond market sectors does indicate that in some quarters there are questions about the durability of the recovery.

NERT Model Portfolios

The NERT models are designed as diversified portfolios to represent the major market sectors and a variety of management styles. The models are rebalanced on a regular basis to maintain a consistent risk posture and asset allocation. Investors should ascertain that the risk inherent in the portfolio is appropriate for their needs.

NERT Funds:

American Century Ultra (TWCUX)continues to wander between large growth and large blend. While still biased towards growth, the core of the management philosophy is now reliable, predictable earnings. The fund still prefers growth when conditions are right. For most of the year that has been a winning strategy, but it hurt this quarter.

Recent returns:                        3rd Qtr -4.4% -        1 year 10.0%       3 years - 3.2%

Russell 1000 Growth                             -5.2%                      7.5%                        1.6%

Artisan International (ARTIX) is an international fund for investors desiring the exposure and diversification of non-US companies. The fund's under-weighting of developing countries has hurt returns recently, but also made the fund more stable and less volatile. The lesser developed countries continue to be higher risk.

Recent returns:                      3^rd Qtr -       -2.4%   1 year   18.0%    3 years -  5.5%

MSCI EAFE                                                -0.2%                  4.8%                     9.5%

Fidelity Blue Chip (FBGRX) remains a broadly diversified growth fund with over 80% of performance linked to growth companies. Staying in one of the more volatile areas of the market has meant a rough ride over the past several years. The fund has been successful recently in reducing the risk without moving away from its core objective of investing in the growth sector.

Recent returns:                      3rd QTR -  -4.5%   1 year -      7.5%  3 years    1.2%

Russell 1000 Growth                                 -5.2%                     7.5%                   1.6%

The MFS Value Fund (MEIAX) continues to be one of the purest value funds. NERT looks for funds that maintain discipline in good and bad markets. The value sector, after lagging for must of the year, turned in a relatively good performance for the third quarter. With over-weightings in the finance, energy, and consumer staple sectors, the fund is less sensitive to economic cycles and looks at dividend rates as well as price appreciation.

Recent returns:          3rd QTR -      1.2%   1 year -  19.2%  3 years -    6.9%

Russell 1000 Value                           1.5%                  20.5%                   7.6%

The Parnassus Fund (PARNX) continues to be one of the few funds in NERT without a defined style. While other managers are selected for their performance in a niche, Parnassus has earned their place by being able to move between sectors while retaining socially responsible charcteristics. The fund is volatile though, and rebalancing ensures both a harvesting of profits in good years, and appropriate exposure while waiting for those years to come again. This was a good quarter for this manager.

Recent returns:          3rd QTR-        1.2%   1 year -  2.6%  3 years -  -0.7%

S&P 500                                            -1.9%                  13.9%                 4.0%

The Vanguard S&P 500 Index Fund (VFINX) mimics the performance of the large-cap market and seeks to hold transaction cost and fees to a minimum. Over the years it has been one of the most consistent funds in the mutual fund universe and is recommended as a core holding for NERT participants..

Recent returns:          3rd QTR  -       -1.9%     1year -   13.7%  3 years - 3.9%      S&P 500                                              -1.9%                    13.9%                 4.0%

The Vanguard Wellington Fund (VWELX) is balanced fund owning both domestic equities and bonds. Presently the equities are invested with a large-cap, value tilt. The bond segment continues to invest with a bias towards corporates. In spite of the volatility over this year, the fund's positioning has remained relatively static.

Recent returns:            3rd QTR -        1.7%  1 year -  14.2%  3 years -  7.8%

S&P 500                                               -1.9%                 13.9%                   4.0%

Lehman Aggregate                               3.2%                   3.7%                   5.9%

The Strong Corporate Bond Fund (STCBX invests in investment grade, non-government bonds. During the recent quarter, the fund remained exposed to lower credit, longer maturity bonds. Corporate bonds did VERY well last quarter as a growing economy reduced credit spreads and general fears for the recovery encouraged holding bond positions.

Recent returns:                    3rd QTR -   4.2%    1 year      5.2%  3 years     5.3% Lehman Aggregate                                  3.2%                     3.7%                   5.9%

The Strong Government Securities Fund (STVSX) predominantly invests in securities issues by the US government or its agencies. The fund's 'barbell' posture allows it to have some assets in the higher yielding, longer end of the market while maintaining large cash balances to offset their risk. The fund suffered from the Fed continuing to raise rates, but investors were far more willing to hold bonds this quarter than last.

Recent returns:                3rd QTR - 2.9%      1 year       2.6%  3 years     5.4% Lehman Aggregate                             3.2%                       3.7%                   5.9%

Principal U S Property Trust    I continue to recommend all participants look carefully at this fund as way to diversify, reduce risk and improve portfolio performance. Real estate is an integral part of many institutional accounts today, and we at NERT wanted our participants to have the same opportunities as large pension funds.                                                                                                                             

Recent returns:         3rd QTR - 2.8       1 years -        10.4%       3 years - 6.9%