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R  E  P  O  R  T

May 2006

Inflation and the Stock Market

The financial markets were clearly unnerved on May 17^th when the April core Consumer Price Index (CPI) exceeded expectations with its second consecutive monthly increase of 0.3%. Analysts had forecasted increases of only 0.2% in each of those months, and this news served to fan the fires of inflation in the minds of investors. Furthermore, the University of Michigan’s 12-month inflation expectations jumped to 4% in May from 3% in March. Not surprisingly, expectations that the Fed would raise rates yet again in June, the 17^th consecutive rate hike, sent the stock market into a tailspin.

The S&P 500 Index posted its worst monthly performance since July 2004, with only 27% of the companies within the S&P 500 delivering positive performance in the month of May. Eight of ten sectors posted negative performance and breadth – the exceptions being Consumer Staples and Utilities. For the month, the S&P 500 Index was down about 40 points or almost 3%. Likewise, the Dow Jones Industrial Average declined 198.8 points in May for a loss of 1.5%. By comparison, the tech-laden NASDAQ Index sustained the greatest damage, falling 6.1% for the month.

Despite the recent news, the specter of inflation does not appear to pose a long-term threat to the economy or financial markets. In anticipation of a relatively strong U.S. economy, the Federal Reserve has followed a “measured” program of 16 consecutive ¼ point rate hikes over the past two and a half years designed to dampen the potential threat of inflation. There is also a “lag” effect that takes place following any type of Fed action indicating that it is too early yet to assess whether inflation is truly a threat. At RiverPoint, we believe that the rise in core inflation is temporary given that the recent increases in oil and food prices have not, as yet, seemed to have a material impact on core inflation.

More importantly to stock investors, especially given the recent decline in the market, valuations look attractive now – especially for the largest, highest quality companies. In fact, the rotation from small cap to large cap companies and a shift from high beta (higher risk) stocks to lower beta stocks (higher quality) that took place in the market in mid-May seems to be signaling a trend reversal. Even the 2006 consensus forecast for the S&P 500 companies’ year-over-year earnings growth inched up to 13.3% from 13% in the month of May. These companies, having taken advantage of the low financing rates of the last few years, have paid down enormous amounts of debt and are now flush with cash, giving them the flexibility to increase dividends, acquire new businesses or buy back their own shares.

The Tax Increase Prevention and Reconciliation Act of 2005

After months of negotiations and discussions, the final bill containing $70 billion in net tax cuts and $20 billion in revenue raisers was signed into law at a White House ceremony on May 17^th. Some of the features of this bill will prove interesting to investors and clients alike. Of particular interest are those issues dealing with AMT relief, extension of the dividend and capital gains rate cuts and the important changes to Roth IRA’s.

Tax Cuts/Extensions:

• AMT exemption amounts: Although Congress has not repealed or reformed the AMT, it did provide limited relief. According to a report by the AICPA, without this 2006 retroactive relief, an additional 15 million taxpayers would be subject to the AMT. Now taxpayers will be able to take advantage of higher alternative minimum tax exemption amounts.
• Personal credits: Personal credits include the dependent care credit, elderly and disabled care credit, credit for interest on certain home mortgages as well as the Hope and Lifetime learning credit. The ability for taxpayers to use these nonrefundable personal credits to offset AMT liability is now extended through 2006 and $20 billion in revenue raisers.
• Dividend and Capital Gains Rate Cut Extended: Extending this tax break through December 31, 2010 represents a significant tax cut for many investors. This is the cheapest tax investors will ever pay. In 2011, capital gains will effectively be taxed at 20% instead of 15%, a rate of 33.3% higher at the lower end. Investors in the highest bracket will pay over 160% more tax on dividends with the reset to the former rate of 39.6%.

Revenue Raisers:

• Roth IRA Conversions: Elimination of the $100,000 adjusted gross income (AGI) ceiling for converting a Traditional IRA to a Roth IRA: High-income taxpayers with a large amount in a Traditional IRA were shut out from converting to a Roth IRA. With the elimination of the $100,000 AGI ceiling for 2010, anyone can convert to a Roth IRA. Taxpayers who convert in 2010 will have the option to recognize the conversion income in 2010 or average it over the next two years. This is very advantageous to individuals who can pay the taxes outside of the converted account.

Trivia

In 1999 which two companies became the first non-NYSE stocks to be added to the Dow Jones Industrial Average?

More interesting trivia…

The NYSE ticker symbols I and M are currently unused.  Reportedly they are being held in reserve in case Intel and Microsoft decide to join the NYSE.

Microsoft went public on March 14, 1986. 1,000 shares purchased that day would be worth approximately $7,600,000 today.

In 1974 Intel’s microprocessor 8080 became the brains of the first personal computer--the Altair, allegedly named for a destination of the Starship Enterprise from the Star Trek television show. Computer hobbyists could purchase a kit for the Altair for $395. Within months, it sold tens of thousands, creating the first PC back orders in history.

In 1973 Gates entered Harvard University as a freshman, where he lived down the hall from Steve Ballmer, now Microsoft's president and chief executive officer. While at Harvard, Gates developed a version of the programming language BASIC for one of the first microcomputers - the MITS Altair. Gates would drop out of Harvard in his junior year to pursue a career in software.

Answer: Microsoft and Intel

Market Summary	5/31/06	YTD Price Change
Dow Jones Industrial Average	11,168	+4.2%
Nasdaq Composite	2,179	-1.2%
Standard & Poor’s 500 Index	1,270	+1.7%

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