Market Commentary — 2nd Quarter 2011

After a strong earnings season, the bullish tone of the equity markets that we witnessed in the first quarter continued into April as the S&P 500 advanced by nearly 3%. But in what has seemingly become an early summer tradition, the markets were once again spooked in May and June by the renewed fear of a sovereign debt crisis in Greece as well as questions regarding the strength of the economic recovery here in the United States.

As Greek citizens protested austerity measures in the streets of Athens, European officials scrambled to find a solution to the Greek crisis and to ease fears of contagion into Portugal, Spain and – more recently – Italy. Investors, sensing a repeat of the second quarter of 2010 in which the S&P 500 declined by more than 11%, exited equity markets in favor of the safe haven of U.S. Treasuries. As the quarter came to an end, the Greek government agreed to austerity measures in exchange for a European bailout that will likely keep Greek debt concerns simmering in the background of the financial landscape until it once again moves to front page news next summer. Nevertheless, equity markets welcomed the news, and the S&P 500 rallied by just over 4.1% over the final four days of the quarter to squeak out a quarterly gain of 0.1%. The Dow Jones did marginally better and was up 1.42%, while the Nasdaq slipped by a meager 0.3%. For the year, the Dow, S&P 500 and the Nasdaq are up 8.6%, 6.0%, and 5.0%, respectively.

Despite some headwinds, we believe that the economy continues along the path of a slow but steady recovery, and the investing environment for equity markets remains relatively positive. Slow growth combined with high profit margins and historically low interest rates bodes well for equity valuations going forward. Severe weather in the South, supply disruptions resulting from the tsunami in Japan, and other seasonal factors conspired to dramatically slow economic growth in the second quarter. We believe most of these issues have worked their way through the system, and we expect growth to improve to more moderate levels as we move into the fall. The recent decline in oil prices - partially a result of slowing economic activity and partially due to the Obama administration’s decision to release 30 million barrels of oil from the Strategic Petroleum Reserve (SPR) - is expected to relieve some inflationary pressure and to help improve discretionary spending. Unfortunately, the unemployment rate, traditionally a lagging indicator, is likely to remain elevated for the foreseeable future, although we hope to see the first quarter trend of moderately improving job growth reassert itself in the second half of the year.

While most of the attention and headlines were focused on events taking place in Europe, signals that the economic recovery on this side of the Atlantic had stalled also pressured equity valuations late in the quarter. After showing signs of improvement in the first quarter, employment trends stubbornly reversed course in the second quarter. The unemployment rate climbed during each month and peaked at 9.2% in June. After several weeks of improving data, weekly jobless claims also began to trend above the psychologically important 400,000 level. While some of this is due to supply disruptions caused by the Japanese tsunami as well as extreme weather and flooding in the South, the recent data is nonetheless troubling.

In addition, the housing market is showing signs of further weakness despite record low interest rates and relatively attractive affordability ratios. One factor dragging on home prices remains the banking industry’s reluctance to loosen lending standards, making it difficult for prospective buyers to purchase and finance new homes. Moreover, the Federal Government has done little to instill confidence and rein in our fiscal deficit. In our opinion, both parties can equally be blamed for failing to reach any compromise regarding the imminent breach of the $14.2 trillion debt ceiling. We have little doubt that both sides will eventually come to some agreement before the August 2nd deadline. Our concern, however, is that the near term “solution” will do little to address reducing the ongoing $1.5 to $2.0 trillion annual deficit, and much like the crisis in Greece, will only kick the can down the road. In our opinion, the economy would further improve if the President and Congress were to agree to a combination of tax law changes and spending cuts that significantly reduces the deficit over the medium term.

Despite some headwinds, we believe that the economy continues along the path of a slow but steady recovery, and the investing environment for equity markets remains relatively positive. Slow growth combined with high profit margins and historically low interest rates bodes well for equity valuations going forward. Severe weather in the South, supply disruptions resulting from the tsunami in Japan, and other seasonal factors conspired to dramatically slow economic growth in the second quarter. We believe most of these issues have worked their way through the system, and we expect growth to improve to more moderate levels as we move into the fall. The recent decline in oil prices - partially a result of slowing economic activity and partially due to the Obama administration’s decision to release 30 million barrels of oil from the Strategic Petroleum Reserve (SPR) - is expected to relieve some inflationary pressure and to help improve discretionary spending. Unfortunately, the unemployment rate, traditionally a lagging indicator, is likely to remain elevated for the foreseeable future, although we hope to see the first quarter trend of moderately improving job growth reassert itself in the second half of the year.

The investing environment for equity markets also remains relatively positive. Slow growth combined with high profit margins and historically low interest rates bodes well for equity valuations going forward. Given the current expectations in job growth, it is unlikely that the Federal Reserve will raise short-term rates in the foreseeable future. Low debt levels and solid cash positions on corporate balance sheets also continue to paint a backdrop that supports strong capital spending and merger activity. Lastly, the IPO calendar is beginning to gain momentum, a further sign of investor confidence.

The fixed income markets continue to perform admirably despite the headwinds in sovereign and municipal debt markets. Fixed income indices, as represented by Barclays (formerly Lehman), were up between 2% (short-term treasuries) and 5.4% (high yield) over the first 6 months of the year. The crisis in Greece helped to create a rally in U.S. Treasuries as investors flocked to the safety of the U.S. Treasury market. The 10 year treasury yield dipped below 3% for the first time since late last year, and yields on one month treasury bills were actually negative for a short time. While commodity prices such as corn, wheat, oil, and metals all point to inflationary pressures, the fixed income markets clearly suggest that deflation is the primary monetary risk facing our economy. From our perspective, we lean slightly towards the inflationary side of the argument, and given the seemingly unsustainable levels of government debt in the United States we find it surprising that yields remain at historically low levels. In either case, we currently prefer the risk/reward profile in the equity market relative to the fixed income market.

Going forward, worldwide GDP growth forecasts are dependent upon China’s continued future growth as it evolves from an emerging economy into a developed economy. Will Doheny went to China in April on a three week visit with Stanford University Travel. They had an excellent professor who lectured and accompanied them on excursions. They visited several regions and cities around the country, and Will thought he would list a few of his observations without drawing any conclusions.

The enormity of the country in terms of both land mass and population is incredible. China’s rulers number about 60 million, and they govern a nation with a population of 1.3 billion. More money is spent by the Chinese government on internal security than on national defense. Mandatory retirement for government employees is 55 for women and 60 for men. As you travel to China’s secondary cities, such as Xian, massive building is going on everywhere, and multiple new 50-story apartment and condo buildings stand empty that are all paid for by private investors. The impact of the “one child” policy is evident by the relative scarcity of younger working adults. For the obvious reasons, there are many more young males than females. Many people were driving cars and scooters and not as many riding bikes as in the past. This enormously large and growing country will have to do a lot to keep up with the demands of those that have moved out of poverty and have become big consumers.

Market Commentary 3rd Quarter 2011

Market Commentary 2nd Quarter 2011

Market Commentary 1st Quarter 2011

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