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Market Insight- Second Quarter 2008
For the most recent quarter and year-to-date the Standard & Poor’s 500, our benchmark index, declined substantially, reflecting the significant headwinds investors faced during the period. After signs that government officials were taking proactive steps to help the housing and financial companies, equity markets turned higher during July. Some of the difficulties concerning investors include strains in the financial industry, declining housing prices, a softening labor market and rising prices for food and energy. The combination of a slowing economy and inflationary threats have placed the Federal Reserve in the spotlight as to what actions might be taken to resolve these seemingly conflicting economic events. The good news is that the numerous economic and financial market headwinds appear to be easing modestly as we progress through the third quarter of 2008. The enclosed Market Commentary outlines our reasons for feeling optimistic about the financial markets and the U S economy over the balance of the year. Some of our clients have asked if we have seen the stock market bottom and are entering a better period for equities. While we caution that anything can happen during these eventful times, we certainly hope the environment for equity investors is improving and that investor confidence improves through the second half of 2008. Regardless of the market environment, our investment discipline blends growth, value and GARP stocks in structured portfolios designed to provide attractive, low-risk returns in all market environments.
Fixed income investors saw declines in prices across the U.S. Treasury yield curve as investors took gains after the sharp run-up during the first quarter. The benchmark ten-year Treasury note declined in value during the quarter as the yield rose to 3.97% from 3.41% at the end of March. Short-term interest rates, represented by the three-month U.S. Treasury bill, also moved higher and ended the quarter at 1.74%, up from the 1.32% level three months prior, and close to the 2.00% Federal Funds rate. Our outlook for the next few quarters is for
very modest U.S. economic growth, although we continue to believe the economy
will avoid slipping into a recession, as classically defined in economics.
Stimulus checks have helped retailers show better sales than had been expected
in both May and June and should continue to help the economy through the summer
months. We are now just over 10 months past the beginning of the Fed Funds rate
cuts and this should begin to help in the resumption of more normalized credit
markets. Economic data reported during the second
quarter showed the economy growing at a very slow pace. While we believe GDP
growth for the second quarter will remain positive, it will not be positive by
much. The Federal Reserve’s aggressive rate cutting has helped ameliorate the
impact of the credit crunch on the broader economy. We are encouraged the
Federal Reserve has stopped cutting rates. This leads us to believe they think
the economy does not need another boost from lower rates. GDP growth will remain
minimal through the remainder of 2008 but should pick up again in 2009 as the
full effect of lower interest rates cuts flows through the economy. We have not seen such a wide array of market forecasts from the financial media in quite some time. Some are predicting a deep recession and with it, a significant further market drop. We advise you to step back from the daily headlines and examine the broad economic landscape. When removing the housing and automotive sectors from the picture, the economy does not look as bad. We admit the two industries represent a fair portion of the economy, but these are the two industries generating most of the negative headlines. When you remove the overwhelming effect of financial companies, earnings have continued to grow over the past three quarters and may do so again in the second quarter. While Financial and Consumer Discretionary stocks have been suffering, the Materials, Energy and Industrial companies – which are a larger portion of the S&P 500 – have been performing very well. We firmly believe the current level of oil prices (approximately $140 per barrel) represents a speculative buying frenzy, rather than any fundamental cause. Globally, we see evidence that prices of $125+ per barrel are starting to depress demand for crude oil. The primary exception has been China thus far. We believe once the Olympics conclude in August, China will reduce its demand for fuel and this will be represented in the futures prices. Most inflationary concerns in the US are tied to commodity prices in general, and oil specifically. The developing world has become the primary area of commodity demand growth during the past five years. If growth in the developing world slows, commodity pressures will diminish. We see this beginning in the second half of 2008. This bodes well for global inflationary pressures, the US dollar, and equities in general. We mentioned in our first quarter letter to you that bear markets since 1926 have lasted an average of 10 months. The current downturn began in mid-October 2007 so we are nine months into this pullback. As of early July, both the Dow Jones Industrial Average and the S&P 500 had both declined by 20% from the October 2007 peaks, marking an official bear market. Semantics aside, we continue to see some positive signs in the economy, and would argue that there are more reasons to be optimistic than the media would have you believe. Housing foreclosures have begun to decline in many regions, inflation has remained under control, and retail sales have exceeded expectations. One area of growing concern remains the Financial Sector. What began as a sub-prime mortgage problem has spread quickly to encompass a wide range of debt instruments. Credit in general has become much tighter and the effect on the financial companies has been dramatic. It is not just the banks that have been hurt. Brokerages, Insurers, Asset Managers, and most other sub-industries in the financial arena have been negatively affected to some degree. Our strategy from the onset of the credit crisis had been to remain in the largest, most-liquid companies due to our conviction that they would be best prepared to weather the downturn and survive while other smaller players would not. While that conviction has not changed, we have done further analysis on the changing landscape of financial companies. Even though we are more than 18 months into this credit downturn, it continues to be extremely difficult to quantify how large some of these credit losses will be at many companies. Several products that helped these companies generate earnings and returns in the past are either no longer existent (sub-prime mortgages) or much less profitable (consumer credit). The bottom line is that investors need to understand it may be well into the next decade before these companies even begin to approach their historical levels of earnings and profitability. It was this analysis that caused us to sell some financial holdings and move to an underweight position in the financial sector. While the stocks sold generated meaningful losses, we believe it was the prudent move to help protect capital during these highly uncertain times. Although the financial sector looks very cheap and oversold at current levels we could still have another move lower as the current season exposed another wave of write-offs. On the other side of the performance spectrum, Energy companies have performed remarkably well during the past four years and many of these stocks were selling above our fair value targets. During the second quarter, we began to reduce our Energy holdings to lock in some profits, while still maintaining meaningful positions in the sector. The sales in these two sectors were not
reinvested in new equity holdings, which allowed us to build cash positions
generally in client accounts. This cash allowed us to both cushion the
performance decline in the portfolios, as well as to have available buying power
when we become more convinced the equity markets have bottomed. During the quarter, our equity portfolios approximated the return of the S&P 500. Our fixed-income portfolios continued to outperform their benchmarks due to our focus on safe investments in U.S. Treasuries and high quality municipal bonds. While some of our individual equity holdings may experience large swings in price (both up and down), our focus on risk control gives us the confidence that over a full market cycle, our portfolios will achieve attractive returns. In closing, we acknowledge the turbulent economic and financial news, but continue to counsel a long-term approach to investing. Volatility has increased during the past two years and may stay elevated for some time. As your investment advisor, we maintain a risk-averse strategy with a blend of different investment styles. This allows us to participate in positive market periods, while limiting downside in market pullbacks. We believe the past several months have shown how resilient our capital markets continue to be. This encourages us that brighter days for the US economy, the US dollar, and equity markets in general lie ahead of us. [top] |
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