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Market Commentary — 1st Quarter 2010The equity markets registered robust returns during the first quarter, extending their nearly 13-month rally. The gains came despite a pullback lasting nearly two weeks beginning in late January in which the Dow Jones Industrial Average (the Dow) fell more than 7%. The market drop was driven primarily by concerns related to the deep fiscal crisis in Greece – a script that has played out in a number of countries of late – and that government’s ability to make good on its debt obligations as well as the broader implications of the crisis for the other European Union (EU) members and the long-term viability of the EU as a whole. Not surprisingly, as the outline of a bailout plan emerged and fears of a sovereign default receded, the equity markets bounced back sharply, resuming their steady upward march, gaining nearly 10% from the early February lows. The rationale for the sustained move upward in the markets is largely based on the same thematic underpinnings that provided support last year (i.e., continued improvement in the stability of the banking sector; international growth driven by China; steadily improving corporate earnings; signs of life in the US economy; and, an accommodative fiscal policy of near zero interest rates). The rationale for the sustained move upward in the markets is largely based on the same thematic underpinnings that provided support last year (i.e., continued improvement in the stability of the banking sector; international growth driven by China; steadily improving corporate earnings; signs of life in the US economy; and, an accommodative fiscal policy of near zero interest rates).As you know from our recent letters and the composition of the portfolios, we have had a fairly constructive stance on both the equity and debt markets over the past year. We thought and continue to believe that the stage was set and the markets were priced – both debt and equity – to a level that afforded us a favorable entry point on a risk/reward basis with an opportunity to participate in a significant rebound and in an eventual economic recovery. That having been said, with regard to most corporate credits we are beginning to temper our enthusiasm as mispriced opportunities are extremely limited and spreads in general have tightened to a level that offer limited value (e.g., current yields on investment grade paper maturing in five years are in the mid to low 3% range), making investments much less attractive in the current environment relative to a year ago. As such, other than investing in select preferred securities and looking for ways to profit from rising rates, we have not been that active in the fixed income markets. The equity markets, on the other hand, buttressed by myriad macro-economic factors continue to offer select opportunities to invest in quality companies at reasonable prices. And, although the markets have snapped back sharply and the current rally could be due for some sort of breather, the markedly improving health of the banking sector – which was on life support in late 2008 – coupled with the recent trends in the labor markets suggests the worst has truly passed and the long road to economic recovery has begun. While we are generally constructive on the markets and the economy, we’re not blind to the risks and the ongoing issues around the globe. One has to look no further than the recent happenings in Greece to be reminded of the underlying problems that abound. The fiscal issues in Greece – which received a $40 billion bailout as of the writing of this letter – are shared by many other countries in the EU (e.g., Portugal and Spain) as well as Japan and England. Obviously, the risk is some type of sovereign default similar to what was experienced during the Asian currency crisis in 1998. Similarly, another issue getting a lot of press of late is the unfunded pension liabilities of numerous states and municipalities. The current mismatch between revenues and contractually obligated outlays, coupled with increased life expectancies and the rising cost of health care, make the funding requirements for such plans mathematically unsustainable. Draconian changes – as opposed to the standard operating procedure of simply kicking the proverbial “can” down the road – must be made if such entities want to avoid ratings downgrades and the consequent increased debt financing costs or possible default. Any discussion of risks to the economic recovery would be incomplete without touching on the state of the housing market. Nearly four years removed from the top of the market, the statistics continue to be nothing short of dismal. Currently, approximately 11 million mortgages or over 20% of borrowers are underwater. Around eight million mortgages are delinquent or already in the foreclosure process. Moreover, foreclosures are expected to increase this year to 4.5 million homes from 2.8 million in 2009. Not surprisingly, the government has announced yet another set of programs, this time seeking principal forgiveness in an attempt to stem the tide of foreclosures. The government is concerned that borrowers who are current on their mortgages but deeply underwater will default, putting further pressure on the housing market. Clearly this is a significant problem with no easy solutions. We’re not sure principal forgiveness is the answer; however, the fact that it has been proposed and is being seriously considered highlights the magnitude of the problem. The much-anticipated March non-farms payroll report was released earlier this month. The report showed 162,000 jobs added. The report represents a continuation of the improvement in the labor markets that began in November. While the labor markets are hardly robust, things are incrementally better and moving in the right direction inasmuch as the issue has changed from one of jobs being lost to a lack of new job opportunities being created. Although it is widely thought that the aggregate economy came out of the recession in Q2 2009, we have yet to see any significant growth in the labor markets. Employment is unfortunately an increasingly lagging economic indicator in any recovery. The pattern of excruciatingly slow job creation experienced after the last two recessions in 1990 and 2001 is playing out similarly in the current environment as companies are taking increasingly longer to add new jobs, instead relying on overtime and temporary services. * * * * * * The President’s major health care legislative initiative was passed during the quarter mostly along party lines. While it will take some time to reach a verdict on changes in terms of quality and access, the cost at least to certain investors is clear…the hurdle rate required will be higher as the Bush tax cuts are allowed to expire and a special 3.8% tax is slated to be added to earners in the top two brackets in 2013. Whether these tax increases will put downward pressure on earnings multiples or cause companies to cut back on dividends in favor of share repurchases remains to be seen. In closing, it is worth noting that the Federal Reserve and Treasury have succeeded in shifting investor appetites from complete risk aversion to fully embracing risk by dropping rates to near zero and stabilizing the banking sector. While we have been nearly fully invested during the upward move over the past 13 months in the equity and debt markets, which allowed us in most cases to significantly outperform the markets for clients, we are exercising prudence, taking profits in names where valuation has become stretched and looking for solid ideas that have yet to fully participate. Market Commentary 3rd Quarter 2011Market Commentary 2nd Quarter 2011Market Commentary 1st Quarter 2011Market Commentary 4th Quarter 2010 |
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