Market Commentary — 2nd Quarter 2010

The volatility that was commonplace during the financial crisis of 2008 returned to the markets in the second quarter of this year, sparked in large part by the ongoing sovereign debt concerns in Greece as well as questions regarding the strength of the economic recovery here in the U.S.

The sovereign debt issue involving Greece, which has been simmering since late last year, reached a boil during the quarter, causing many to flee the equity markets in favor of gold and Treasuries. Investors once again became fearful that the issues in Greece and, to a lesser degree Spain, could spill over and become a full blown debt contagion as several European countries are in similar dire predicaments. The downward pressure exerted on the markets was further exacerbated by an economic report, which showed slowing growth in China.

Against this backdrop of global macroeconomic pressures there was also the tragic deepwater oil drilling disaster in the Gulf of Mexico, the “flash crash” in the U.S. equity markets, as well as a series of underwhelming economic reports. Not surprisingly, given this confluence of headwinds, the equity and debt markets sold off during the last two months of the quarter.

Our read of the proverbial tea leaves is that many unanswered questions remain. While we do not believe that the recent downward pressure in the markets is the beginning of a return to the tumult of 2008, there are no doubt some legitimate concerns about what is going on in Europe. In fact, as of this writing, regulators were in the process of conducting stress tests on European banks to determine the impact to such institutions’ balance sheets from Greek and Spanish debt under various scenarios. Domestically, recent data indicate a still very sluggish labor market, calling into question the underlying strength of our economy. Equally concerning is the significant budget shortfalls at the state and municipal levels throughout the country, which are likely to result in continued layoffs and furloughs, negatively impacting the labor markets, consumer spending, and housing.

Notwithstanding these issues and concerns, a pullback or consolidation of some sort at this stage in the economic recovery is not completely unexpected. The rally in the equity markets, which began in March 2009, had gone on almost uninterrupted for nearly 14 months, and returned over 83% in the S&P 500 through April 26, 2010. The pullback or correction in the markets has to be viewed in that context. That having been said, there is no way to sugarcoat it, the quarter in general was a tough one – losing 12% on the S&P 500 – and the final two weeks were particularly difficult as the Dow Jones Industrial Average fell seven of the last eight trading days and closed out the quarter at a low for the year.

Although nearly 16 months removed from the depths of the financial crisis, with the worst likely behind us, the animal spirits remain high. Fears primarily based on events in Europe have made investors once again much more risk averse, opting for preservation of capital over opportunities for growth, as evidenced by the general shift out of equities and into more defensive investments. In such an environment, where there is a flight to safety en masse, correlations on most equity sectors increase dramatically, and the benefits of sector diversification become severely muted and yields on high quality fixed income investments drop to absurdly low levels. Case in point, it is difficult in our opinion to make an argument that the two-year Treasury, which hit a record low of 0.58%, and the 10-year, below 3%, are good investments. Without question, a significant portion of the demand for U.S. Treasuries is likely driven by the sovereign debt issues in Europe as well as concerns about the long-term viability of the Euro, although a percentage – albeit a small one – is driven by investors with deep doubts about the sustainability of the recovery here in the U.S. and fears of deflation.

Our read of the proverbial tea leaves is that many unanswered questions remain. While we do not believe that the recent downward pressure in the markets is the beginning of a return to the tumult of 2008, there are no doubt some legitimate concerns about what is going on in Europe. In fact, as of this writing, regulators were in the process of conducting stress tests on European banks to determine the impact to such institutions’ balance sheets from Greek and Spanish debt under various scenarios. Domestically, recent data indicate a still very sluggish labor market, calling into question the underlying strength of our economy. Equally concerning is the significant budget shortfalls at the state and municipal levels throughout the country, which are likely to result in continued layoffs and furloughs, negatively impacting the labor markets, consumer spending, and housing.

With the recent pullback in the markets, valuations are beginning to get attractive, but not quite compelling enough for most investors to take on more risk. It is difficult to invest with a lot of conviction, given the uncertainty, although many companies are getting near price points where the math on a risk/reward basis begins to make a lot of sense. For example, many world-class companies with fortress-type balance sheets that pay dividends north of 3% are trading at reasonable earnings multiples. In our opinion, it is not too much of a leap of faith to envision that such companies are going to be trading at higher prices down the road in a less fragile economy, all the while paying fairly handsome dividends.

As you might have surmised, our current mood is cautious. Longer term, we are generally constructive on the markets. The sovereign debt issues in Europe are real and much depends on continued demand from China. Our outlook for the domestic economy is for a slow recovery with speed bumps along the way. The recovery in housing is still tenuous at best and the labor markets will be slow to heal. We continue to believe that rates will gradually move higher. Treasuries are richly priced and offer limited value, other than peace of mind. Against this backdrop, where appropriate we have purchased and continue to hold the preferred securities of large banks, which offer significant spreads relative to U.S. Treasuries. We view the recent pullback as a healthy opportunity to selectively add high quality, industry-leading names to client portfolios at reasonable prices.

Market Commentary 2nd Quarter 2010

Market Commentary 1st Quarter 2010

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Market Commentary 3rd Quarter 2009