2011 2nd Quarter Commentary


The second quarter of 2011 had an all too familiar feel. After a strong start to the year, investors “sold in May and went away.” However, this time rather than an oil spill and the ensuing disaster, it was global supply chain issues caused by the Japanese tsunami, massive flooding in the US, a slowing growth rate in China and continued European debt concerns that caused investors to pull back. Added to that backdrop was heated debate and grandstanding by both political parties over the need to raise the debt ceiling. It should come as no wonder that consumer confidence was rattled. As Dan Pickering, one of our favorite analysts says, “in a world where the news cycle is 24/7 and people are swamped with information, anecdotes are king.” Anecdotes give a quick glimpse but often fail to adequately describe the complex machine that is our economy.

As always we will try to drill down to a few items that are pertinent to investors. We will try to avoid anecdotes and stick to the facts as we see them. Those points are outlined below.


Economic reports have been less than inspiring for the last few months. Industrial production, jobless figures and measures of consumer confidence have all weakened by various degrees since March, when the earthquake/tsunami disaster took place in Japan. As we examine the implications of this tragedy on our economy the most obvious area that experienced disruptions was the global supply chain. The most profound instance concerned both domestic and foreign car manufacturers. A great number of auto parts are sourced from Japan and as inventories dwindled, many domestic plants were forced to stop production altogether or at a minimum curtail output. The lack of new automobile supply then hurt sales for car dealers. Japan is the world’s third largest economy, so this scene was replayed across various industries all across the globe.

The flooding in the Midwest also played a major role in disrupting our economy this quarter. The Mississippi is the one of the largest water based distribution networks in the world. Beyond the devastating destruction the flooding and tornadoes caused themselves, the damage from closing this major economic artery was felt all over the country. Although the ability to measure its impact at this time is difficult, it is known that 6.8 million acres of farmland, billions of dollars in livestock and farm equipment, and tens of thousands of homes and commercial buildings were lost. It is estimated that the Joplin Missouri tornado alone will cost insurers close to $8 billion. Economics aside, it will always be impossible to measure the grief and suffering these disasters have caused our fellow Americans and our hearts go out to them.

Turning to Europe, Greece once again pushed out the Middle East from the headlines with rioting, austerity packages and bailouts. The one important message for investors is the exposure that European banks have to Greek debt and derivative instruments based on those obligations. Ultimately, we believe that the EU will not turn its back on the banks of England, Germany and France. So while there is pain ahead for the EU, we remain confident that they will avoid disaster.

The ongoing political debate regarding the debt ceiling in the U.S is still prominently in the background. Currently the capital markets have expounded a collective “yawn” as Treasury bond prices are not indicative of an eminent default. A short term deal appears to be the likely scenario which only means this uncertainty will reappear before long. The $14.294 trillion limit is estimated to be reached on August 2nd of this year. If history is on our side (since 1962 the limit has been raised 74 times, according to the Congressional Research Service), we expect the ceiling to be raised once again.

When considering these uncertain headwinds it’s easy to see why businesses and consumers aren’t feeling as confident as they were three months ago. Worry is only amplified by the ending of the QE II program (Quantitative Easing) and many question whether the economy is ready to stand on its own. While we believe it can, all is not “pumpkins and mice.” We do see inflation moderating from the first quarter, as evidenced by falling gasoline, oil, and other commodity prices. Relief at the gas pump, although minor, will free up a portion of consumers’ budgets for other goods and services which drive economic growth.


Stock prices declined during the second quarter as measured by the S&P 500, but if you include dividends the index finished slightly positive. The quarter was not shaping up very well until a strong rally during the final week which erased much of the decline. The descent has been moderate, especially when compared to the slump during the second quarter of 2010 when we saw a correction of over 10%. This year’s decline still leaves most indices in the black for the year.

A look back at where the returns came from shows that Financials and Energy were the worst performing sectors by a wide margin. Financials have European contagion fears, new regulation from Washington with Basel III and SIFI (Strategically Important Financial Institutions, as defined by the Dodd-Frank financial reform bill) as well as the general response to the fear that housing will continue to cost the banks money in lawsuits, foreclosures and write downs. On the other hand the Energy sector, which was on a tremendous run, corrected as oil prices declined on concerns that the economy is slowing. The strengthening dollar relative to the Euro is an additional reason that oil has fallen (the price of oil, which is usually traded in dollars, will decline with an appreciating dollar with all else held equal).

Oil prices were already falling due to concerns of diminished demand from a slowing economy when the EIA orchestrated the release of 60 million barrels of oil over a thirty day period. All 28 members agreed to the release with the United States releasing roughly half of the total. The action came as a surprise to the market and resulted in short term downward pressure. The move demonstrates that the EIA wants oil prices lower and that they are willing and able to make moves to adjust prices. However, the release should have little long term effect on oil markets since the 2 million barrels a day are only a small portion of the roughly 90 million barrels a day that the world consumes.

The other side of the ledger shows that investors sought a safer play in equities pushing Health Care, Utilities and Consumer Staples into positive territory. These sectors are generally considered safe havens. With traditionally higher dividend yields, they tend to benefit more during times of uncertainty.

Ultimately we seek to position your portfolios for what is coming, not for what has already occurred. Of course this is a delicate process because no one knows for certain what tomorrow brings. We do know that Corporate America looks quite healthy as demonstrated in the sharp rise in earnings over the last two years. We also foresee an increased pace of merger and acquisition activity that signals businesses are still looking for ways to grow and become more competitive.


The renewed uncertainties that we have outlined were generally positive for the investment grade fixed income markets. The yield on the benchmark 10-year U.S. Treasury bond fell from 3.47% at the start the quarter to 3.16%, and briefly fell below 3% intra quarter (uncertainty drives investors to safe Government bonds and causes them to accept lower yields). GDP growth projections being revised down coupled with lower inflation expectations due to the correction in commodity prices drove the bid for safe haven assets. The Federal Reserve ended the Quantitative Easing process on June 29th, and somewhat counter-intuitively bonds rallied into this. With the largest buyer of Treasuries substantially reducing purchases, conventional wisdom is that yields should rise over the coming quarters. This may or may not materialize in the short term due to the sovereign debt issues in Europe. Regardless, we do not view a taxable 10- year bond near 3% as attractive for long term investors. We continue to prefer step-up coupon callable Agency bonds in the 5-7 year effective maturity range. This structure allows for a higher current income in the short term due to the optionality while providing some protection for rising yields over the longer term.

The municipal market continues to mend from the sell-off that started at the end of 2010. While some prognosticators have loudly proclaimed impending catastrophe for municipal bonds in 2011, so far the results have been exactly the opposite. In fact, according to Bloomberg, the tax-exempt bond market had the best second quarter since 1992 driven by limited supply and renewed interest from investors. State governments appear to be getting their fiscal houses in order, and most have passed balanced budgets for 2011 which is bullish for municipal bonds. The yield on 10-year AAA rated municipals dropped from 3.32% at the beginning of the quarter to 2.67% at end of the quarter, or 85% of the taxable Treasury equivalent. The string of monthly outflows from municipal bond mutual funds appears to have ended, with investors adding over $400 million during the last week of the quarter. We expect this trend to continue and are generally more optimistic about municipal yields versus the taxable market. Supply will likely continue to be anemic as municipalities are generally adverse to stretch their balance sheets any further. We favor longer dated maturity structures with an intermediate call date in which we can find yields higher than general market rates. While it is getting more difficult to find value, we are able to buy tax free yields in the 3.5% to 4% range, which translates into over 6% taxable equivalent yield for investors in the top tax bracket which we view as attractive.


We are hopeful that many of the uncertainties outlined above will be resolved by our next quarterly letter. While we do expect volatility to remain ingrained in capital markets for quite some time, we also expect many of the pressing issues to subside and disappear from the headlines. We are confident that our Federal Government will solve the debt ceiling issue and avoid a U.S. default, and in doing so we expect the values of riskier asset classes to improve. Europe, specifically Greece, is making strides and should be less of a concern to market participants in the intermediate term. With election season heating up, it is inevitable that many of the troubling economic circumstances will be politicized and will contribute to the ups and downs of the market. Our economy is extremely adaptive and we believe our current set of problems is not insurmountable. Most importantly, we are maintaining our process for discovering and investing in undervalued securities and creating a mix of assets that adheres to each client’s investment policy statement.