2011 1st Quarter Commentary

“He that can have patience can have what he will.”
Benjamin Franklin


The first quarter of 2011 closed with an upward trend in stock prices. A rally that began in December continued through March with the final day of trading in the quarter testing the highs set on February 5th. This type of behavior shows the extreme resilience of investors; that despite the prevalence of intense “noise,” the fundamentals that drive investing currently rule the Street.

The following paragraphs detail our observations on the overall economy and financial markets.


Three months ago, it would have seemed crazy to predict almost $4 gasoline, government coup d’états in the Middle East, and one of the largest earthquakes in history resulting in a nuclear scare. Considering these events, who would predict that consumer spending would rise in this sort of environment? A year ago at the front end of the European debt crisis, consumer spending slowed dramatically and the market fell right along with it. So why has this time been different?

One of the reasons for the difference in outcomes may be that the US economy is growing stronger every month and consumers simply feel more confident than they did a year ago. In light of the economic reports we analyze, we think real GDP between 2.5% and 3.5% is possible this year. As usual, continued consumer spending will be paramount to achieving this level of growth. Evidence of the continuing strength of the economy can be seen in the recent retail sales numbers. Retail sales reported this February were at an all time high and exceeded the previous high set in November 2007.

The employment numbers have been a positive surprise this quarter as unemployment claims have consistently fallen below the 400,000 mark. Additionally, the overall unemployment rate has fallen materially from almost 10% last year to 8.9% last month. Many pundits see the high unemployment rate as a negative for the economy and rightfully so. However, as employment begins to increase (as it has over the last year) it can create a virtuous cycle for businesses. As the economy continues to grow, having ten million people who are out of work but are willing and able to do so has created a ready pool of labor. This potentially allows business to add to payrolls without increasing pressures on wages.

We have all felt the impact of increasing food and energy prices over the last year. While wage inflation has not become a reality, due to the unemployment situation, there has certainly been inflation across the spectrum of consumables that use commodities. Cotton prices have increased at an above average rate over the last nine months and are on trend to continue higher this year.  This potentially raises clothing costs significantly. While unhindered inflation is certainly a threat, limited inflation is one sign of a strengthening economy.

The banking sector is undeniably the cornerstone of our economy. While the industry continues to struggle under the weight of bad loans spawned by the housing debacle, we see light at the end of the tunnel. This month the Federal Reserve completed another round of stress tests. After those tests the Fed permitted many banks to raise dividends for the first time since they were cut due to the crisis (Fed regulators would not permit banks who received TARP funds to pay out dividends to shareholders). This is a vote of confidence from the Fed that our banking system is financially sound.  It also shows the that regulators are more closely monitoring bank activity and funding levels in an attempt to prevent banks from becoming overly leveraged.


The markets continued their upward trend in the first quarter of 2011 locking in the best first quarter return since 1998. Multi-year highs in oil prices due to Middle East unrest, the Japanese tsunami, and continued European debt issues would normally put a damper on the bull market trend. While any one of these risks may come back to haunt investors, most have discounted the effects and are looking forward.  We give some credit to the Federal Reserve’s Quantitative Easing program (QE) for encouraging investors to look for better return potential in stocks to the detriment of the bond market.  With the prospect of the Fed holding down rates for an extended time to spur growth, it appears investors are reallocating funds from safe, low yielding assets into “risk” assets such as stocks and commodities.  We view this shift as healthy and will further assist economic growth.   The Fed’s QE program is scheduled to end in June. We believe the earnings power and fundamental valuations will allow the market to withstand this transition as the economy begins to stand on its own two feet again.

Additionally, Corporate America deserves credit for improving balance sheets and for positioning themselves to profit by the consumer’s strengthened position. Earning reports during the quarter were strong and dividends are increasing. As confidence grows, companies are using idle cash (which is earning next to nothing) to buy back stock and make acquisitions. These trends are very positive for equity prices.

The huge spike in oil prices drove the Energy sector to be the quarter’s best performer, up almost 17%. The Industrial sector was a distant second at +9%. It is interesting to note that these two sectors are the only two that outperformed the overall S&P 500 this quarter which returned 6%. The other 8 industry sectors underperformed. Consumer staples was the laggard in the group, as margin pressure is rising due to companies’ inability to pass through all of the higher input costs (commodities) to consumers.

We continue to see value in every economic sector of the market as well as in every market cap range. One significant change we’ve witnessed is on the Energy front as communities re-assess the use of nuclear power versus other forms of energy (like natural gas, coal and oil). We have long believed that natural gas has been under utilized in our national energy policy.  Recently there has been favorable momentum building towards this abundant, domestic source for fuel. We have positioned your portfolios accordingly.

We noted in our last letter that we expected a pickup in merger and acquisition activity and so far that has proved true. We continue to believe that with a record amount of retained earnings on balance sheets, US companies will look for ways to reinvest capital in operations or return it to shareholders. As shareholders, we like both options.


The taxable bond market, as represented by the Barclays’ U.S. Aggregate Index, returned 0.42% for the first quarter. Longer dated maturities lagged shorter maturities as inflation expectations have increased over the past few quarters. Inflation erodes the value of a fixed coupon and as such longer bonds will normally underperform as expectations for inflation rise.

Lower rated bonds outperformed higher rated bonds. For instance, the Baa rated sector (low investment grade) returned 1.43%, a full percentage point over the index itself. Spreads, or the additional compensation one requires to hold a riskier bond, have contracted due to the strengthening of the economy and the resulting improvement in companies’ balance sheets. While this is good for corporate America, spreads have tightened to the point where we have to look a little harder to find value. We do like certain corporate credits, but many bonds appear to be rich relative to safer alternatives. As always, we want to be paid an ample premium to take risk.

Overall the yield curve remains very steep, as evidenced by the 2-year U.S. Treasury yield of 0.83% compared to the 10-year yield of 3.5%. With this in mind we find the 5-7 year part of the taxable curve the most attractive in light of the recent concerns over inflation. We will not become overly concerned about the spectre of higher prices until we see wage pressure begin to build. While the prospects for hiring are improving, wage pressures continue to be muted.

The municipal market started the year with a resounding thud, as the fear mongering over “imminent massive defaults” drove retail investors from the tax free market. As of the date of this letter we have witnessed 20 consecutive weeks of withdrawals from municipal bond mutual funds. We are pleased the market has been able to weather these redemptions and it appears that withdrawals are abating. To date, the municipal market in which we invest has eked out a positive return, essentially in line with the taxable market. When one compares the debt levels of state governments relative to the U.S. Government (and other sovereign issuers), states’ debt levels are much better managed and less daunting (again, in the select states/credits in which we invest).

Issuance of new bonds in the municipal sector has dropped precipitously as governors across the nation are tightening their fiscal belts. We do not expect a large “wave of defaults” in the investment grade market and view the taxable equivalent yields as very attractive. The tax free curve is even steeper than the Treasury curve. As such, we are seeing value in intermediate to long dated credits.


From an investing standpoint, little has changed from our last letter. Economic cycles shift slowly and certainly do not reset on a quarterly basis regardless of what the financial section of your newspaper claims. This is why a sound investment discipline is critical to investment success. It is also why following short term trends can be very dangerous to your long term financial health. Amidst the uncertainty, we have seen enough economic momentum to support our conviction that investing in the right mix of stocks and bonds will yield ample fruit in the months and years to come.