Market Commentary — 1st Quarter 2011

During the first quarter of 2011, equity markets continued their climb up the proverbial “wall of worry” as the S&P 500 advanced by 5.4%. Likewise, the Dow Jones and the NASDAQ improved by 6.4% and 4.8%, respectively, through the first three months of 2011. Concerns around the world stemming from natural disasters in Asia and civil unrest in the Middle East are overshadowed by tangible improvement in the economy here in the United States.

Fueled by near-zero interest rates and ample liquidity, many of the factors driving the equity markets since early 2010 continued into the first quarter of 2011. Earnings growth, as a result of an improving economy as well as gains in employee productivity, is expected to grow by the low- to- mid teens percentage range in 2011. Merger activity also remains strong, as several large mergers in the healthcare, industrial, and financial sectors were announced or completed during the first quarter. We expect this to continue as companies look for profitable ways to deploy the large amounts of cash available to them on their balance sheets as well as through low-cost borrowing. We also expect capital spending to display strong growth in 2011, particularly in areas of technology and physical infrastructure. However, housing, which is a strong component of overall job growth, remains in the doldrums. Recent data indicates that we are likely heading into a second dip down in the housing market. Overall, the data bodes well for reasonable economic growth in 2011, coincident with improving employment trends and a positive outlook for the stock market.

In fact, the employment picture is improving at a pace that exceeds most forecasts from only a few months ago. For example, in our last letter we echoed the consensus view that the unemployment rate would not likely fall below 9% in 2011, but since late last year the unemployment rate has fallen from 9.8% to 8.8% currently. There are many encouraging signs that this trend will continue. Initial jobless claims are now routinely reported to be below the 400,000 mark, a sign that companies are slowly beginning to hire new employees. In addition, we have now seen six consecutive months of positive non-farm payroll growth, and the number of jobs being added each month is also growing. In March, the economy added 216,000 jobs, up from the 194,000 added in February. After losing over 2 million jobs between 2008 and early 2010, the current pace of job growth, while encouraging, is still well below that of past recoveries. It is likely that the unemployment rate will remain elevated for the next several quarters.

Fueled by near-zero interest rates and ample liquidity, many of the factors driving the equity markets since early 2010 continued into the first quarter of 2011. Earnings growth, as a result of an improving economy as well as gains in employee productivity, is expected to grow by the low- to- mid teens percentage range in 2011. Merger activity also remains strong, as several large mergers in the healthcare, industrial, and financial sectors were announced or completed during the first quarter. We expect this to continue as companies look for profitable ways to deploy the large amounts of cash available to them on their balance sheets as well as through low-cost borrowing. We also expect capital spending to display strong growth in 2011, particularly in areas of technology and physical infrastructure. However, housing, which is a strong component of overall job growth, remains in the doldrums. Recent data indicates that we are likely heading into a second dip down in the housing market. Overall, the data bodes well for reasonable economic growth in 2011, coincident with improving employment trends and a positive outlook for the stock market.

While we are generally encouraged by the overall direction of our economy, events taking place on the international front will likely hamper overall growth in 2011. Early in the quarter, rising food and fuel prices set off civil unrest, and ultimately a government overthrow in Tunisia. As news of the overthrow spread via social networks such as Facebook and Twitter, a grassroots movement demanding government change caught fire in several countries in North Africa and the Middle East. Mubarak’s government in Egypt fell, and Libya is in the early stages of a civil war. Governments in Syria, Yemen, Iran, and others are also facing varying levels of rebellion from their citizenry, and it remains unclear how the political landscape of this region will ultimately reform. What is clear, however, is that as long as the Middle East suffers from instability, the risk premium on the price of oil will continue to rise. This bites into consumer consumption and places further inflationary pressure on economies around the world.

In the Pacific, natural disasters upended the global supply chain. Economies have become so efficient and global that a disruption in Asia can slow down or halt production in plants and factories throughout the world. While our main concern lies with the victims of these disasters, the economic impact cannot be ignored. Severe flooding in Australia brought the country’s mining industry to a standstill, with many open-pit mines transformed into lakes from relentless rain. Almost simultaneously, Japan suffered the wrath of an enormous earthquake in the Pacific and the tsunami it triggered. A wide stretch of Northern Japan was obliterated, and a nuclear meltdown at a plant north of Tokyo ensued. The plant is not only leaking large amounts of radiation, but the instability at those plants is wreaking havoc on the country’s electric grid. Rolling blackouts are occurring throughout the country, curtailing production in plants supplying many industries, including the automotive and the technology sectors. The vast majority of these disruptions are transitory, and we expect both Japan and Australia to recover fully from these disasters. Nevertheless, these disruptions will likely have a hindering effect on global GDP in the first and second quarters of 2011.

Most fixed income markets were flat during the first quarter of the year. The one exception was the high-yield or “junk” bond market, which was up 3.8% during the quarter. This growth was instigated by investors moving into this segment of the fixed income market in search of higher yields and bolstered by confidence in an economic recovery. Rates in government and investment-grade corporate bonds were essentially flat during the quarter, and remain well below historical norms. As a result, we believe that there is limited upside in fixed income, and accordingly, reasonable risk/return opportunities are the exception, not the norm.

Despite very low rates on fixed income instruments, early signs of inflation are emerging in several areas. This is likely to push interest rates higher over time. Commodity prices in food, metals, and energy are at or near all-time highs. As of printing this letter, oil is trading above $108 per barrel and gasoline prices are near or above $4 per gallon. Until recently, these price increases were being absorbed by producers and not passed on to the consumer, but we are beginning to see a change in this trend. Hershey’s recently increased prices of its products by 9% across the board, and Wal-Mart’s head of North American sales warned that prices at Wal-Mart would be increasing substantially in the near future. Currently, the Federal Reserve appears reticent to raise rates for fear that it will stymie the current recovery.

As we look into the remainder of 2011, we remain positive on the outlook for the economy and the stock market. We see less opportunity in the fixed income market as we anticipate rates increasing over the next several months. There are many risks domestically and internationally, but we believe that economic growth will prevail. Equity valuations, in our opinion, are approaching fair value, though we continue to discover opportunities that offer compelling risk/reward profiles. The stock market, however, has strengthened in seven of the past eight quarters, so it would not surprise us to see a minor correction in the near future. On the other hand, we are in the third year of the presidential cycle, which historically, is positive for the stock market, as both parties tend to introduce legislation that will improve the economy in an effort to gain control of the White House in the next election.

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