Market Outlook/Strategy - Fourth Quarter 2006

Pugh Capital's six month economic outlook is for growth to moderate and inflation to gradually decline. The housing sector had been incredibly strong, but is now rapidly weakening. This downshift will be sufficient to slow the economy to below trend growth. Inflation indicators have recently stabilized. As the economy slows and capacity increases inflation will eventually decline. The Fed moved monetary policy to neutral in August. We expect policy to remain neutral for the remainder of the year, followed by easing in 2007.

Our outlook for an economic slowdown was validated during the third quarter. GDP growth has averaged 3.3% over the past two years. First quarter growth of 5.6% was followed by weaker second quarter GDP of 2.6%. We expect the second half growth to come in around 2.25%. The housing sector has consistently added 1.0% - 1.5% to growth over the past couple of years, but is now weak enough to detract from growth. While business spending and exports should remain strong, they will not be sufficient to offset the slide in housing.

Pugh Capital has been calling for a slowdown in the housing sector since early this year. While the housing market outlook was mixed in the second quarter, the third quarter view was decidedly more negative. Housing starts have fallen 26% since January. Existing home sales, which account for 85% of all sales, are down 12% from a year ago. Existing home prices have now declined for two consecutive months after years of extraordinary gains. Home builders have begun slashing their earnings estimates. Overall, the housing sector has weakened to the point of dragging down economic growth. The question still to be answered is whether there will be a soft or hard landing for housing. If the housing sector experiences an orderly decline, then the economy will avoid a recession. On the other hand, if the housing correction is more severe it could push the U.S. into a period of negative growth.

Interest rates declined by approximately 50 basis points during the third quarter. Weaker economic conditions should be supportive of lower interest rates. However, the current level of interest rates needs to be confirmed by weaker economic growth and ongoing favorable inflation numbers. We are maintaining the portfolio duration at above benchmark levels and continue to favor high quality sectors such as commercial mortgage securities, asset backs and agency securities. We like the yield pick up relative to Treasuries, the bullet-like structures and the "AAA" credit quality.

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