2010 3rd Quarter Commentary

“The mind is its own place, and in itself, can make a heaven of hell, a hell of heaven.” John Milton

A recent story we read captures the idea of how many people think in linear ways that can lead us to underestimate the future – be careful how you think:

“In 1898, the first international urban-planning conference convened in New York. It was abandoned after three days because none of the delegates could see any solution to the growing crisis caused by urban horses and their output. In the Times of London, one reporter estimated that in 50 years, every street in London would be buried under nine feet of manure.”

The delegates underestimated how markets adapt, economies adapt, people adapt and, eventually, problems are resolved. In contrast, we (humanity) are often unable to see how problems will be resolved in the future. Tuning in the financial news before work most mornings, you can likely hear an analyst predicting hyperinflation. Tune in the next day and you may hear another analyst predicting depression and deflation. We don’t believe everything we hear (or read) and understand that most of these analyses are fundamentally flawed. Of these two analysts, we believe one – or both –will be proven wrong and that neither of these scenarios is most likely to occur. Instead we try to take a less apocalyptic, and more measured approach to the dismal science of economics.

Over the last 5 months investor sentiment has been volatile. Negativity and fear of a double dip recession, as measured by many metrics, reached a high in late June corresponding with a decline in stock prices (“risk assets”) and a corresponding rise in bond prices (“safe assets”). This negativity has abated somewhat since then and stocks have risen as a result. The market is sending mixed signals when stocks and bonds rise at the same time, while gold is at decade high levels. Strange times indeed!


The economy continues to grow – after 6 consecutive quarters of negative or flat GDP from 3/08 to 6/09 we managed to string together 4 quarters of positive GDP growth. In a service based economy, where more than 70% of GDP is personal consumption, with unemployment at 10%, it is encouraging to see growth. The American consumer has retrenched and “de-levered” but still manages to find a way to spend. An improvement in GDP will need to come from the export and private investment components of the GDP formula since the government cannot continue to fill the gap. Exports have improved and with some clarity out of Washington on new legislation we believe that private investment will improve with time. If this plays out as planned, the government will be able to step back from its attempts to stimulate, but we hope they don’t try it too early.

The NBER (National Bureau of Economic Research) says the recession ended in June of 2009 (by definition), but with jobless claims only stabilizing and unemployment very stubbornly staying above 9%, this is truly a jobless recovery. Much of this can be tied to structural employment issues, where the workforce is trained to handle jobs that are no longer available. Education and job training can address the needed changes but many are unwilling to take less pay and/or learn a new skill. We hope the growing demand for skilled labor will provide the needed incentives for unemployed or underemployed workers to retrain and get good paying jobs.

Uncertainty has abounded the last two years as we’ve experienced a significant political shift with many new approaches to the economy and health care being implemented. Uncertainty leads to hesitation in business, both in hiring and future investment. While the hesitation has been more pronounced this summer, as time passes the uncertainty will subside and business will again take center stage. We believe business hiring is picking up and we are hopeful it will continue do so at a rising rate over the coming quarters.

Europe is still fragile – although we have seen some easing of concerns, day to day headlines from the European Union continue to affect how our markets are trading. Recent bond issues by European PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) calm the fears of further EU bailouts, and each of those nations has a deficit-reduction plan in place.

On a longer term basis we acknowledge numerous economic headwinds, many of which we have detailed in previous commentaries. We continue to believe in this recovery, though it is certainly a mixed bag based on current numbers. Over the coming quarters and years we believe our economic ship will right itself and we will move forward with renewed GDP growth and an eventual decline in joblessness. For now “muddling through” seems the clearest description of our recovery.


From the recent lows of June 24th to the end of the quarter all component sectors of the S&P 500 were positive. Telecom, Materials, Consumer Discretionary and Industrials had the highest return and Financials, Healthcare and Consumer Staples brought up the rear. This is the typical sector performance one would see in a market that is pricing in a recovery in economic conditions with the one exception - the financials are the worst performing category. Financials usually lead as we come out of a recession. We believe that uncertainty surrounding both domestic and international regulations on banks, plus the continued purging of troubled assets on their balance sheet most likely account for this anomaly.

In today’s environment we believe the accumulation of a diversified portfolio of attractively valued equities where their dividend yield exceeds their bond yield will prove to be very successful over the medium to long-term. We also believe that active management of that portfolio is necessitated by the strong price movements (both up and down) we have recently seen.

Our equity approach has always focused on companies, fundamentals, and bottom-up stock selection with an eye to the larger economic landscape. Our approach is to invest in a good company at an attractive price and hold until we believe the full value is realized. When prices are fluctuating as much as they have for the last two years, we adapt and take advantage (as much as we can) of those price movements. With stocks declining significantly in the 2nd quarter of this year and then rising significantly in the 3rd quarter, our portfolio activity has increased accordingly. If we are able to sell a security after a short-term move upward in price that nets us 75% of our target price, we will take it. We are active managers and we believe this environment requires it.


Bond prices continue to be supported by the combination of the ongoing “flight to safety” transactions, such as the reallocation away from stocks into bonds (as witnessed by mutual fund flow data), and the widely held belief that the U.S. Federal Reserve will embark on another round of quantitative easing. Long U.S. Treasury bonds led the way with a robust 20% return for the year to date period versus 7.9% for the bond market as a whole.

We have taken the stance that buying 30 year bonds at sub 4% yields is not a good risk/reward trade off as history has shown that this trend of ever lower yields can reverse very quickly. The duration of a 30 year Treasury is roughly 18, which in layman’s terms means that if the yield curve was to move from the current 3.68% at quarter end to 4.68% (or a one percentage point increase) the price of that bond should drop by 18%. This would represent over four years of income, and we are not willing to take this risk. We are buying callable agency bonds and select intermediate corporate bonds that offer competitive yields as investors are able to capture over 80% of the yield curve with substantially less interest rate risk. Many of the callable agency bonds being offered have step up coupon features, which simply means that the initial coupon increases on a pre-specified schedule.

The bond market is signaling the onset of a deflationary environment, and should this perception change rates will correct accordingly. As we noted at the beginning of this commentary, we do not see severe deflation or inflation being a legitimate risk in the short run, but we will not turn a blind eye to what the Federal Reserve is doing with its monetization policies and the impact it will have on prices of goods and how that will affect the prices of bonds. The bond market is substantially larger than the stock market so we give a lot of weight to what trillions of dollars of investment capital is saying about inflation.

Municipal bonds have also performed well ahead of expectations this year. Several municipal credits are deteriorating in credit quality, but most of the deterioration is concentrated in the areas most impacted by the housing collapse (CA, FL, NV, etc.). With the appropriate credit research we are able to find attractive yields with minimal credit risk and view the municipal market as mispriced relative to the U.S. Treasury market. We can still find yields that are well over 100% of the taxable equivalent, which for those in even a modest tax bracket makes a great deal of sense. The issuance of Build America Bonds continues to be prevalent, and as such it is becoming increasingly more difficult to find tax exempt bonds that meet our investment criteria. Couple the supply curtailment with the risk that tax rates could rise in the short-term and the yield on the tax exempt bonds could be even more attractive.


While the economic picture is not particularly rosy right now, there is no question we are in much better position than we were even a year ago. Private job growth has begun and income growth has begun as well. We believe the Fed is committed to supporting asset prices and actively working to avoid deflation which means we see upside in equities. Bonds have run and run hard this year. As an asset class, many of them seem unattractive. The job of finding new bonds to purchase is much harder than it was a year ago.

We work hard to think about our investments strategically with an eye toward the long-term. In economies like this, where so much attention is paid to short-term measurements, we believe we have an advantage by thinking in terms of years, not days, weeks or months. We understand that markets adapt and change and we plan to change with them while still staying focused on the horizon.