The second quarter can be best characterized by extreme volatility. Despite all of the volatility, our portfolios held up remarkably well, when compared to the market. Most of our portfolios were down in the 1% to 5% range compared to an almost 12% drop in the S&P 500 stock market index during the second quarter. We view this as proof that our strategy of focusing on risk first and return second is working well.
The market recovery that started back in March 2009 hit a serious pothole in the second quarter as sentiment declined to lackluster U.S. growth, the European debt crisis, the possible economic repercussions of the oil spill in the Gulf of Mexico, uncertainty about the costs of the new health care bill, new financial regulations and the potential increase in taxes as the Bush tax cuts expire at the end of 2010.
Contributing to the growing unease was the so called “flash crash” of May 6 when (although its causes have yet to be fully explained) an inadvertently large sell order by a major investment bank sent the Dow tumbling almost 1,000 points in a matter of minutes. Though the markets briefly bounced back, they remained jumpy and never really recovered.
More broadly, the big question weighing on investors was whether last year’s tentative recovery would continue to gain momentum in 2010. The answer appears tentative, relative and in the eyes of many economists and financial professionals dangerously dependent on continued government policy actions. As such, austerity measures passed by major trading partners such as the U.K. andGermany only served to further unsettle investors even as it became clear, at least in the U.S., that there were political and fiscal constraints on any further stimulus efforts.
The result was a broad drop in all stock indices with the S&P 500 slipping nearly 12%, the large-cap benchmark’s worst quarterly performance since the fourth quarter of 2008. On the small-cap side, the Russell 2000 Index fell nearly 10%. Foreign markets were hit especially hard as European credit problems reverberated globally. Consequently, the MSCI EAFE index of developed markets lost about 14%. Under these very difficult global circumstances, no investment style or cap size emerged with any clear advantage, although large-cap growth fared the worst. As might be expected, with anxious investors looking for safe harbors, the only equity category that was a clear winner was precious metals, principally gold. The U.S. dollar continued to appreciate against most major world currencies throughout the quarter, particularly the euro and the British pound, eroding the returns of U.S. investors in foreign securities.
Fixed Income Review
In the fixed-income arena, the flight to quality that characterized the quarter most directly benefited Treasury securities, with the most significant gains accruing to the longer maturities. As a result, Treasuries were the best performing asset class of the quarter. The yields on both the Treasury’s bellwether 10-year note and the 30-year bond slid to levels not seen in over a year. Corporate high-yield (junk) bonds were essentially flat, reflecting apprehension over prospective earnings growth, particularly among lower-quality issues. At the very shortest end of the yield curve occupied by money market instruments, returns remained negligible.
Despite ongoing concerns regarding default risk, the flight to quality also boosted municipal bonds, though less than Treasuries. The market was propelled by strong investor demand, relatively light supply and reinvestment of maturing principle and coupon payments. Against a background of declining tax revenues, we will continue to be vigilant about the condition of state and municipal balance sheets.
Cash Equivalent and Inflation Review
The market rally that lasted through the first quarter of this year was largely based on expectations that the economy would begin to firm up and, to some extent, the U.S. has experienced a real improvement in economic fundamentals. The corporate sector, cushioned by an estimated $1.8 trillion in cash reserves, put up some impressive manufacturing numbers as companies rebuilding their depleted inventories drove up factory orders. Corporate activity seems to be picking up globally as well, as the total value of mergers and acquisitions hit the $1 trillion mark in the first six months of 2010, a 9% jump over last year.
Major Market Indexes
|Index||2nd Quarter 2010||12-Mo. Return|
|Dow Jones Industrial Average||-9.36%||18.94%|
|S&P 500 Index||-11.43%||14.43%|
|MSCI EAFE GR (International equities)||-13.75%||6.38%|
|Russell 2000 Index(Small-Cap Stocks)||-9.92%||21.48%|
|Barclay’s Aggregate Bond Index||3.49%||9.50%|
|Barclay’s Municipal Bond Index||2.03%||9.61%|
|Taxable Money MarketFunds||0.01%||0.05%|
Yet, with first-quarter GDP growth being revised down to 2.7% and a Fed announcement in June that short-term interest rates would remain at about zero indefinitely, it has become increasingly apparent that the recovery is fragile at best. While companies seem to be holding the line, gains in productivity rather than increased hiring are driving business. Consequently, unemployment remains stubbornly high (officially at 9.5% but by many estimates more likely to exceed 16%) with disturbing implications for other critical areas of the economy, including the housing sector and consumer spending.
This on top of the new austerity measures that means, generally speaking, higher taxes in tandem with lower government spending being embraced here and abroad have renewed fears recession, the dreaded “double dip.” Certainly, there is cause for worry in Europe. Our view is that the most probable scenario will involve slow growth in developed markets with perhaps slightly better performance in emerging markets, largely driven by rising commodity prices and currency devaluations.
Moving forward into what has been dubbed the “new normal” meaning sluggish growth caused by increased regulation, heightened market volatility and ongoing corporate and government de-leveraging we believe our cautious; balanced value-driven investment style is and will continue to serve our clients well.
As always, we remain alert to developing opportunities, especially now that beaten down markets are offering exceptional values. Our portfolios have benefited from being overweight in small cap stocks, but we are now gradually trending more into mid- and large caps with a greater emphasis on foreign, particularly European, equities.
In the short and medium term, our strategy is to navigate around volatility while seeking out stable, high-quality investments with relatively low correlation to the broader market. We are primarily managing for risk first, and then looking for return. Our strategies are based on careful analysis and well developed research capabilities, which include selection and access to the best investment managers, with proven track records, during difficult times. We are making use of balanced funds (to provide income and capital appreciation) and asset allocation funds (to enhance diversification and generate steadier returns) that continue to represent essential components of our core holdings.
As a rule, we avoid making decisions based on short-term market developments. This helps us avoid making emotional decisions and helps us remain realistic about the most probable direction of the global economy longer term. We place emphasis on liquidity and defensive holdings. In a complex and rapidly changing market environment, flexibility to navigate realistically is the key to success.