Market Commentary — 3rd Quarter 2011

When we last wrote in early July, the equity markets were celebrating with a quarter-end rally as Greece finally agreed to austerity measures in exchange for a European bailout. While we never believed this to be a final solution to the sovereign debt risk in Europe, we were at least hopeful that it would temporarily remove the headline risk associated with European debt concerns.

The absence of headlines was short-lived, however, as Greece failed to receive a bailout and renewed concerns surrounding the much larger economy of Italy began to garner attention. Suddenly, the viability of the European banking system came into question as did the political will of European leadership to implement a viable solution. It now appears as if a Greek default of some kind is inevitable. The only questions that remain are what form the default will take, and to what extent the contagion will spread to other countries and to the banking system in general.

As you may have surmised by the tone of this letter, our outlook is increasingly cautious. We expect the economy to grow but at a slow pace. As such, earnings estimates are likely to be ratcheted down in the coming months, and we are keeping a close eye on events taking place in Europe and other international markets. Despite our caution, we continue to believe that an allocation to equities is prudent as news or even rumors of effective policy solutions has the potential to send equity markets markedly higher. In addition, corporate balance sheets generally remain strong, and merger and acquisition activity has been relatively robust. We continue to focus on high-quality companies trading at attractive valuations that offer sustainable dividend income. Until we see stabilization both here and in Europe, earnings growth is likely to be subdued, and as a result, we prefer to invest in companies that generate income for shareholders as we await the eventual recovery.

Equity markets around the world responded to the lack of any closure in Europe by going into free-fall in late July and early August. In fact, from July 25 through August 8, the S&P declined by almost 17%. The second half of the quarter was marked by almost unprecedented volatility as uncertainty surrounding a European solution intensified and flashbacks of the 2008 financial crisis danced in investors’ heads. Despite the extreme volatility, equity markets did not meaningfully move up or down during the remainder of the third quarter, and the S&P 500 ended the September quarter down 13.8%. The Dow Jones declined by 11.5%, while the small-cap Russell 2000 index shed 21.8%. For the first nine months of 2011, the S&P 500 and the Dow Jones were down by 6.5% and 3.7%, respectively, while the Russell 2000 declined by a much worse 14%.

Equity and commodity markets also suffered from news that China’s economic growth was possibly slowing significantly more than expected. In response to fears of a housing bubble bursting in China, government authorities have steadily been implementing policies such as higher minimum down payment requirements and tighter monetary controls in an effort to reduce speculation in the housing market. The negative effect of these actions has been an apparent slowdown in economic growth, and reports coming out of China late in the quarter indicated that manufacturing activity actually contracted in July and August. As the world’s largest importer of raw materials, the news sent commodities such as oil and copper into a tailspin. As we have stated in the past, projections for continued worldwide GDP growth are largely dependent on robust growth in China. While we believe that growth in China will slow in percentage terms, it is likely to continue to post annual GDP in the mid to high single digit range, but there is unquantifiable “tail” risk due to the lack of transparency and rumors of significant leverage.

In addition to the international headwinds, domestic issues that we have been commenting on over the past several quarters continue to act as a drag on growth. These include a perpetually weak housing market, a near double-digit unemployment rate, and ballooning government deficits at the federal, state and local government level. While many of these symptoms are not getting worse, we do not expect much improvement in the foreseeable future, and as such, we see little hope for robust economic growth going forward. Many of the pundits that were earlier forecasting a return to 3% growth in the second half of 2011 are now arguing that we are on the verge of a “double-dip” recession.

From our perspective, a debate over a slow-growing economy or one that dips into recession is really a matter of semantics. In either case, profit margins, which are at cyclical highs, revenues, and thus earnings, are likely to decline more than expected. As a result, equity valuations will also likely decline, and in many ways, we believe that the recent market correction is an adjustment to this new reality. We would not be surprised to see a further reduction in earnings expectations as companies release third quarter earnings later this month and into November.

Longer term, we are increasingly worried by the lack of leadership in Washington. Both parties have little to offer in terms of policy other than uncertainty. There was no greater display of this than during the debt ceiling debate and the ensuing federal debt downgrade by Standard & Poor’s, in which one of the stated reasons for the downgrade was a lack of confidence in government officials to offer a meaningful plan to reduce the exploding federal deficit. In addition, many small and mid-size businesses are sitting on their hands with regards to hiring new employees as future tax rates, regulations, and government spending plans remain unresolved. Although the Tea Party movement and the recent Take Over Wall Street demonstrations are starting from diametrically opposed political points of view, both are manifestations of the dissatisfaction Americans feel towards the current status quo and the lack of effective policy response to the current economic crisis.

While not in a position of leadership, the Federal Reserve continues to shoot monetary darts at the ailing economy. In addition to the commitment to keep short-term interest rates at zero until at least the middle of 2013, the Federal Reserve initiated a further stimulus with what is being called “Operation Twist.” The program involves buying $400 million in longer-term treasuries and, at the same time, selling the same amount of short-term treasuries. The idea is to further reduce long-term interest rates with the aim of encouraging borrowing and more robust business activity. In theory, this seems sound, but interest rates were already at multi-decade lows prior to this move. Moreover, most would agree that the weakness in loan demand is not a function of high interest rates, but rather a result of a consumer that is deleveraging and banks that continue to maintain very strict lending guidelines. On the negative side, reduced interest rates hurt retirees and others who depend on interest income for their livelihood. It will also likely lead to a flatter yield curve, which we believe will pressure profit margins in the banking system, which has yet to fully recover from the 2008 financial crisis. Ironically, the Federal Reserve’s move may actually hinder lending as banks reduce risk taking due to reduced profit margins.

We continue to believe that the current interest rate environment offers little in the way of attractive opportunities. As the yield curve flattens and economic uncertainty increases, however, we are beginning to see spreads between corporate debt and treasuries widen to more attractive levels. At this point, we remain mainly on the sidelines in terms of putting capital to work in the fixed income market, but we are likely to see more attractive alternatives in the future.

Market Commentary 3rd Quarter 2011

Market Commentary 2nd Quarter 2011

Market Commentary 1st Quarter 2011

Market Commentary 4th Quarter 2010