2011 3rd Quarter Commentary


Instability, uncertainty, and overall headline risk drove stock prices for the last three months. While many of the concerns we have written about earlier this year persist, the drama in Europe supersedes everything right now. On the whispers of agreements or dissensions between the deal makers/politicians in France and Germany, equity markets have moved hundreds of points upward or downward. Sentiment is quite negative these days and sentiment is driving the fluctuations we’ve witnessed this quarter. At the end of the day we still believe the fundamentals of the U.S. and world economy should drive stock and bond valuations. In the following pages, we will discuss the themes that are developing in the capital markets and their impact on investors.


While macroeconomic concerns continue to pervade the media, we observe that employment in the private sector is rising (while government employment is falling), home sales are stabilizing, auto sales have improved (albeit adjusted for a short-term interruption in supply due to the tsunami in Japan), retail sales are rising, exports are rising, individual balance sheets are strengthening, and most importantly we believe the U.S. Real GDP is expanding. Despite these positive factors, there has been continued weakness in various “sentiment” indicators and although the economy is not shrinking, it is not as robust as we need to materially reduce unemployment. Consumer and business confidence is quite low, unemployment remains stubbornly high and the housing market continues to slowly grind its way through the worst real estate market in decades.

We believe the economy continues to only muddle along because of the continued hangover of excessive debt, uncertainty related to world and political events and a swath of new regulations on large portions of our economy (namely Energy and Finance). Political risk is front and center at the moment. Stories about the National Labor Relations Board suing Boeing for opening a Dreamliner plant in South Carolina can be chilling to new business investment and erodes business confidence. The flow of capital has been constrained by new capital requirements and trading rules that are being implemented by financial institutions. Future healthcare expenses for corporations continue to be a moving target as the Court system currently holds the fate of the healthcare bill. All the while, changes to the tax policy are recommended weekly in an effort to spur our economy. In short, this has created a sense of “wait and see” until agreements are finalized.

Last year at this time we noted that an improvement in GDP would need to come from the export and private investment components of the GDP formula[1] (while consumption keeps pace) since the government could not continue to fill the gap. We’ve seen the consumer hang in quite nicely and we’ve seen exports doing their part (more on both below), but business investment has lagged for reasons we’ve noted above – hence a year later we are not in recession, but growth remains tepid. With large amounts of business capital on the sidelines, we see the “I” component of GDP (business investment) as the bullet yet to be fired.

Through all the uncertainty we’ve experienced, the consumer continues to spend money and keep the wheels of the economy turning. Same-store retail sales, as reported by the International Council of Shopping Centers, have continued to increase at a 3%-5% level for the last year. One helpful ‘stimulus’ during the past quarter was the price of gasoline which fell approximately 13% over the past three months.

Besides consumer and government spending, exports have been the biggest driver of GDP growth. According to Morningstar, through the first eight quarters of the current recovery, exports have been responsible for 50% of the growth in GDP. A weak dollar, a revival of the manufacturing sector and strong capital goods sales in emerging markets have all contributed to this growth. Exports now account for almost 14% of GDP, one of the highest levels on record. We need exports to continue their growth and if some or all of the trade agreements waiting to be finalized by Washington are implemented, then export growth should get an added boost.

As we write this letter, European officials are crafting a plan aimed at shoring up the stability of European banks. The plan would involve money from the European Financial Stability Facility (EFSF) which was created in 2010 in response to the sovereign debt crisis in Europe. The EFSF would then fund a special purpose investment “vehicle” that would be created by the European Investment Bank, a bank owned by the member states of the European Union. The hope is that this would alleviate the pressure on distressed countries and on the European banks that hold a majority of the distressed sovereign debt. To put it more simply, European banks that carry a lot of distressed sovereign debt (Greek, Irish and, Portuguese debt, etc.) would be able to sell the debt to the special purpose vehicle. In some ways, this resembles the original plan for our own Troubled Asset Relief Program (TARP). As originally conceived, the TARP’s goal was to purchase “toxic securities” from banks. In this case, the securities would be sovereign debt rather than mortgage bonds.

We thought a brief summary of the Greece situation would be helpful. The majority (75%) of Greece’s €350 sovereign debt is held outside of Greece; mainly by Portugal, Ireland, Italy, and Spain and the banks within. Assuredly, these countries are experiencing economic woes in their own right (Italy’s national debt is 120% of GDP to Greece’s 180%). Germany and France, relative bright spots in the EU, are themselves heavily exposed to Spain and Italy. Furthermore, the financial institutions that hold the Greek debt are much more important economically speaking than banks are in the U.S. For instance, in Europe, banks supply about 70% of consumer and corporate funding whereas the figure in the U.S. is closer to 40%. So the basic argument is that if the Greek situation is not handled satisfactorily, it could cause Spanish & Italian bank failures which would in turn be stressful to the financial systems of France and Germany, two globally important economies. Among other repercussions in our globalized world, such fallout would directly affect U.S. money market funds. Of the ten largest U.S. money market funds, approximately 40% of their assets are invested in European bank short term debt. (As an aside, Fidelity’s money market funds have no direct exposure to banks in Greece, Ireland, Portugal or Spain.)

At the end of the day European officials will keep their noses to the grindstone until they are successful, primarily because the risks of inaction are too great. Ultimately, we trust that the Europeans will be able to solve their difficult problems using methods that will not be self-destructive. Consequently, we do not believe a world economic depression is in the offing, even though news about such a scenario is quite popular right now.


Stock prices declined during the third quarter as measured by the S&P 500. This quarter’s descent has included some of the most volatile trading days since 2008. This quarter’s decline brings most indices into negative returns for the year to date.

We see a disconnect between current equity valuations and what we observe in the end demand for product across a wide cross-section of the U.S. economy. We understand why this disconnect exists because markets trade on tomorrow’s data, not yesterday’s. Thus the fears of a European meltdown and a subsequent worldwide credit crash are driving markets lower as investors re-price shares based on a perceived negative future. The question on the minds of many investors is whether this is a ‘growth scare’ or are we headed into another recession?

Sentiment about the economic future has very real consequences on the stock market. It is estimated that just the companies that make up the S&P 500 have almost a trillion dollars currently in cash on their collective balance sheets (estimates for all of corporate America approach the two trillion dollar level). In aggregate, cash now accounts for 7.1% of all corporate assets; this is the highest level since 1963. Clearly, managers are hesitant to spend down their emergency reserves when economic prospects on the whole seem so uncertain. Already we have witnessed some companies purchasing their own stock (ConocoPhillips, Microsoft, Harris, etc.). With depressed equity prices, this is one way to return value to shareholders. For this trend to continue or for substantial investment in business growth to occur, sentiment will need to shift dramatically.

History has recorded only two double dip recessions in the modern era, one in 1937 and the other in 1982. Each occurred after Government action to raise interest rates, raise taxes, or some combination of both. If our leaders in Washington had caused a U.S. default in July or had raised taxes as part of the debt ceiling agreement, we believe the potential for a recession was quite real. Even now, credit is constrained because of new regulations on banks and the natural reaction by lenders to overcompensate for loose lending practices prior to 2008. In spite of this, the economy has continued to expand. If we enter a recession, it will be the first time the U.S. has ever done so with both increasing rail traffic and increased auto sales. Just this week, rail traffic hit a three year high which is clearly not recessionary. Thus, fears of a significant recession are overblown in our view. As we’ve heard one commentator mention, it is very difficult to fall from what is still the ground floor of an economic expansion.

All of the economically sensitive sectors of the S&P 500 fell during the quarter, with Materials, Financials and Industrials leading to the downside. The historical safe havens of Consumer Staples, Health Care and Utilities managed to post gains.


The factors that drove down appeal for riskier assets had the opposite effect on the bond market as we just witnessed one of the best quarters in recent memory. It seemed the more interest rate risk the better, as the long end of the U.S. Treasury market returned an eye popping 29% during the quarter. This left the yield on the 30-year Treasury a paltry 2.92%. The 10-year Treasury has had a stellar run as well, leaving its yield at 1.92%. This was a result of the economic uncertainties we outlined above, but it was also driven by the latest monetary policy initiative from the Federal Reserve, dubbed “Operation Twist.” The Fed has accumulated over two trillion in U.S. Treasury bonds and Agency securities over the past few years, mainly through the “QE” and “QE2” programs, where bonds were purchased in the open market in order to increase liquidity and hopefully stimulate the economy. The Fed is now in essence selling shorter maturity bonds out of their portfolio and reinvesting proceeds into longer maturity bonds in an effort to more directly target consumer rates. Another goal is to make yields unattractive and therefore encourage risk taking in the economy as a whole, which in a capitalist system is essential. We expect that the Fed’s goal of lowering long term rates will be achieved, at least until the program expires mid 2012, and it may even have a modest stimulative effect on the economy. We do not view a sub 2% 10-year yield or a sub 3% 30-year yield as attractive at this point and are avoiding the Treasury sector.

Credit spreads, on the other hand, have widened relative to Treasuries as investors are demanding more compensation to hold corporate bonds in light of the perceived economic headwinds. We believe corporate bonds are inexpensive in general relative to Treasuries although the nominal yield is still low. For taxable bond accounts we are being patient as value is hard to find at current levels.

Municipal bonds continued their ascent as fears of massive defaults appear to have evaporated. According to Bloomberg, State tax collections jumped 10% in the three months ended June 30 from a year earlier which is the fastest quarterly growth since 2006. Municipal bond portfolios were positive for the quarter and we expect to end the year with attractive profits. We are still able to find value in this sector as it tends to be a little less efficient and specialized in nature. We are investing in yields near 3% to a short to intermediate call date that increases to 4% on a longer final maturity. These rates equate to 4.5% to 6% on a taxable equivalent basis, far outpacing the net to client yield available in the Treasury market.


Last quarter we espoused the hope that many of the uncertainties outlined would be resolved by our next quarterly letter. No such luck! Instead we suffered through a difficult quarter with falling stock prices plagued by widespread pessimism. However, we continue to believe this too shall pass. It bears repeating that our economy is extremely adaptive, as millions of individuals make decisions to better their lives, and we believe our current set of problems is not insurmountable. We have overcome greater difficulties in our history.

We continue to hold the view that the worst case scenarios the markets have imagined will not materialize and that as we maintain our investment strategy of investing in undervalued businesses we will see higher market values in the coming 12-18 months. We do not underestimate the irrational moves that equity markets can make in the short run, but we view stock prices as too low given our views of the economy. Conversely, prices for safe haven fixed income securities appear too high which is another way of saying the yields are too low. The risk appetite of investors will likely turn back into the favor of stocks as we overcome the challenges we have discussed. We are prepared for this eventuality.

[1] GDP = Consumer Spending + Investment made by industry + Excess of Exports over Imports + Government Spending