2011 4th Quarter Commentary


2011 was a wildly volatile and emotionally taxing year for investors worldwide. After an attractive first quarter, the Japanese tsunami devastated a portion of our manufacturing supply chain which damaged production, sales and ultimately, GDP. Following that natural disaster, we experienced a man-made one when politicians seemed intent on creating a financial crisis over America’s very large debt. Their indecisiveness contributed to a decision by the ratings agencies to lower our nation’s pristine triple-A credit rating. Then, as we began to overcome the effects of the tsunami and the hangover from the budget debacle, Europe’s debt problems reappeared on the world stage and its leaders seemed so ineffectual that they made our politicians look stately by comparison. Yet for all the noise, intrigue and fear, the U.S. stock market ended virtually flat for the year. International equities fared far worse, losing 12% on average and much worse for some individual countries.


After smoothing out bumpy GDP results, we think the economy will have grown about 2% for 2011. Not much to write home about, but much better than the alternative. While the 4th quarter numbers have yet to be released, we believe we experienced some of the strongest growth of the year during this quarter; possibly as much as 2.5% to 3.0%. We noted last quarter that we did not believe we were in for a “double dip” recession and so far that belief has been vindicated.

Economic fundamentals continue to strengthen and it is easy to see ways in which the economy could surprise us to the upside during 2012. With that said, uncertainty surrounding Europe’s debt crisis persists and the fear of economic catastrophe emanating from Europe hangs over our heads like the sword of Damocles. Setting those fears aside we see that here at home employment is improving, leading to a strengthened consumer that is in the best financial shape in years. Businesses continue to be conservative by keeping very lean inventories and limiting new hires. If the economy continues to accelerate business may be caught unprepared for the increase in demand. On that note, with over $2 trillion on the collective balance sheet of corporate America, we are confident that businesses would be able to move quickly to satisfy any unexpected demand.

Given that consumer spending makes up 70% of our GDP, it bears mentioning that the financial situation of the household sector has improved markedly from two years ago. According to the Federal Reserve Bank of New York, delinquencies on consumer loans have fallen 30% in the last two years while U.S. consumers have reduced debt by more than $1 trillion in the 10 quarters ended in March. When measuring household obligations (mortgage, car, lease, and credit card payments) as a percentage of disposable income, the ratio got up to 19% at the peak in 2008. Today household debt obligations are down to about 16% of disposable income, on its way to 15%, a multi-decade low. Lower debt payments as a percentage of income means families have extra money that can be saved, spent elsewhere or used to further reduce debt. In our view, if the American consumer can continue to spend right through all of the bad news of 2011 (including the U.S. deficit and downgrade) we think it bodes well that they will keep spending despite worrisome headlines from Europe or Washington.

As for Europe, we should remember that U.S. exports to Europe represent about 3% of our GDP, much of which is for necessities. Therefore, a large amount of that spending will persist even if Europe experiences a deep recession. Our primary concern regarding Europe is not government austerity and recessions. Our primary interest (which we think is shared by Wall Street) surrounds the European financial system and the fear of systemic failure and the contagion which would ensue. Leverage is a powerful force; our country experienced this lesson first hand in the 2008 crisis. While we are concerned with the amount of leverage in the European banking system and the cross lending dependency that it breeds, we believe that systemic failure has been averted. While Europe will most likely continue to struggle, we believe the financial framework will not collapse.

Potential sources for an economic surprise to the upside include a strengthening housing market, increased U.S. oil/gas production and a strong rebound in auto manufacturing. The housing market seems to be stabilizing after years of decline. Recent reports on housing starts, housing permits and builder sentiment have all been improving. Thankfully, banks are moving foreclosed homes out of inventory while new housing starts have stayed low enough to allow the excess inventory to be absorbed. As this process continues, inventories should return to normal levels. Home ownership affordability is at a record high due to increasing rental rates in most markets and record low interest rates.

Amazingly, U.S. oil production is now growing again after years of decline, led by new shale discoveries in Montana, North Dakota, Ohio and increased production in Texas facilitated by new drilling technologies. During the 1990s, the United States imported over two-thirds of its oil. As of this year, less than half of U.S. oil consumption is imported and we are now a net exporter of refined petroleum products. We have the potential to significantly reduce our need for foreign imports over the coming years through both new production and the increasing use of cheap and clean natural gas. We have long been proponents of domestic natural gas which has the added benefit of generating thousands of well paying jobs in the energy industry. The stockpile of cheap natural gas in the U.S. is having a very positive economic impact on those industries that use it as a key input such as manufacturing, chemicals and fertilizer.

As for automobiles, it is clear that production is on the mend as consumers have ceased putting off the purchase of a new automobile indefinitely. After the bankruptcy and reorganization of automobile companies we are witnessing signs of a manufacturing renaissance where the U.S. is becoming more competitive on a global basis. As confirmation of this fact, Honda (a Japanese company) recently claimed that they plan on producing substantially more cars in their U.S. plants for global export.


Surprisingly little has changed since we wrote our last quarterly letter with uncertainty around Europe's future continuing to depress stock prices. The risks associated with the fiscal and financial difficulties in Europe remained the focus of attention and contributed to the pronounced volatility in a wide range of capital markets. American companies have seen their stock prices whipsawed without regard to improvements in their underlying business fundamentals. Many strong earnings reports over the last three months have been met with muted responses from the market. The stock and bond markets continue to take their sentimental cues from European headlines. Eventually this focus will shift, but for now it is the investment environment in which we operate.

To summarize, many of the themes and trends we were seeing at the end of the third quarter still hold true today: the market's laser-like focus on Europe, continued undervaluation in economically sensitive sectors (such as Industrials, Basic Materials, Energy, and Financial Services), and reasonably strong reports coming from U.S. corporations. The silver lining is that the U.S. is beginning to look more and more like the strongest of all the developed economies.


The bond market outpaced the stock market by a wide margin for the whole of 2011. Similar to the third quarter, the European sovereign debt concerns created an insatiable appetite for long dated U.S. Treasuries. The U.S. Aggregate Index experienced a total return of nearly 8% for the year. The majority of this performance was driven by the 10 and 30-year segments of the U.S. Treasury Market. It appears that international investors are parking dollars in our bond market to escape the headline risks in the Euro Zone. The Federal Reserve is also a buyer of long dated Treasuries in the ongoing “Operation Twist” that we highlighted in previous letters.

Callable agencies, mortgage backed securities and corporate bonds lagged. Notably, corporate bonds of Financial Service companies were negative for the year. We are seeing many short dated credits in this sector yielding north of 5%, which we view as attractive. Many of the Financial Service companies are in much improved financial position which makes their bonds especially attractive at these yields.

We expect interest rates to fluctuate as the uncertainties surrounding the economy persist. Overall, we still do not find value in buying 10-year bonds yielding sub 2% nor 30-year bonds under 3%. If the employment numbers improve along with modest growth in the economy, which we expect to see, then the longer end of the yield curve could move substantially higher (meaning current prices would fall), notwithstanding another round of “easing” from the Fed. In this environment we are currently investing in longer dated “step-up callable agency” securities that have above market short term coupons. We are offsetting this duration risk with corporate bonds maturing in five years or less. The yield on this “credit barbell” approach allows us to generate yields well in excess of benchmark rates. This strategy also hedges the potential increases in long term rates as the coupons on the callable agencies “step up” to higher rates over time.

Municipal bonds turned in stellar returns even with the stumble out of the gate at the beginning of the year. The concern that there would be hundreds of billions of municipal defaults did not materialize; in fact we did not even broach the $5 billion mark. While it was frustrating to see markets react to this sort of outlandish forecast, it was a net benefit to our clients as we were provided an opportunity to buy high quality municipal bonds at cheap prices. Now that the fear has subsided and prices have rallied, it is getting harder to find attractive yields at current levels. However, on a taxable equivalent basis municipals are still cheap to their taxable counterparts. We are finding value in longer dated municipal bonds that have a short to intermediate call structure where yields are in excess of 200% of the Treasury equivalent. We expect municipal solvency concerns to abate as budget shortages are closed on a nationwide basis. While we do expect limited defaults of local municipalities, this should be limited in scope and focused primarily in states such as Michigan, California and Illinois, to name a few of the more fiscally constrained. Overall, the credit profile in municipal bonds remains strong on a nationwide basis.


For 2012, the markets will likely show similar patterns that we witnessed in 2011; mainly volatility and uncertainty driven by debt discussions on a global basis. In the U.S., the Presidential election will likely add to these concerns with each side of the aisle proposing very different policies to put our country on the right track. We are hopeful that the political impasse experienced last year will not be repeated, but we are also not naïve enough to expect much progress given how divided our government has become during these uncertain times.

As we discussed last quarter, we continue to hold the view that the dire European scenarios the markets have imagined will not fully come to fruition. We believe 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 experience in the short run, but we view stock prices as currently too low given our perspective on 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 in favor of stocks as we overcome the challenges we have discussed. By way of example, in October of last year the market thought we had gotten through the worst of the European situation and stocks rose substantially – the S&P 500 alone rose almost 11%. We look forward to a similar situation as uncertainties subside.