2nd Quarter 2010 Commentary
Volatility was reintroduced into the stock markets during the second quarter as sovereign debt risk reared its head. Greece and Portugal credit default spreads spiked, encouraging the bears to warn of a double-dip recession. These events also begged the question of whether the recent market selloff is just a correction in an ongoing cyclical bull market, or the precursor of something more. We are in the camp that this is more like 2004, when we experienced a similar growth scare, and not like 2007-2008 when these events signaled a real downturn.
The last and only double-dip recession of the past 100 years was in the early 1980s as Paul Volcker crushed inflation by spiking short-term interest rates and inverting the yield curve. The yield curve now is at one of its steepest points in history. If that isn't enough, bears then point to the sovereign debt issues of southern Europe. Despite the fears of many, the spreads on credit default swap rates of Greece and Portugal have come off a lot, and recent bond offerings have been very successful. In our opinion, the behavior of the Eurodollar confirms that things aren't quite as bad as some would make it. Why is it acting so well if Europe is going into a double dip? Our contention is that a devaluing of the Euro enhances the economic picture of that continent far more so than a declining dollar does the U.S. The U.S. only derives 7.5% of its Gross Domestic Product (GDP) from exports, while Europe gets almost 25% of GDP via exports.
The housing market is another risk that is being bandied about, and it certainly could be a risk. Prices in California, the largest market in the country, are up 10% year-over-year and it should not have surprised anyone that the national market would soften once the housing tax credits expired at the end of April. The same phenomenon occurred once "cash for clunkers" expired last fall. Mortgage rates are at all time lows and we feel that once the jobs picture starts to turn, which will most likely coincide with an improved stock market, the housing market will start to move higher. Although most view the jobs picture as another negative, in fact private household employment has surged by 1.5 million as the American entrepreneurial spirit is at least alive and well.
Probably our biggest concern during the second quarter was the BP oil spill and what that could mean to oil prices, especially since the Obama administration placed a moratorium on offshore drilling. The good news is that, as we write this letter, BP has stated they are within days of capping the well and perhaps the worst case scenarios can be taken off the table. We’ll see.
Economic Signs of Hope
On the plus side, earnings have been phenomenal and inventories are very lean across a multitude of industries. A direct result of this is that most industries have kept additions to capacity well within check, including semiconductors, airlines and many more. According to data from the ISI Group, nominal GDP and nominal consumer spending are both already in expansionary territory.
Rail car loadings are up 18.8% year-over-year and 0.4% higher than in the same period in 2008. This was the sixth highest reading ever. Apartment rents are moving higher, credit card delinquencies are at an eight-year low and the commercial real estate collapse has failed to materialize. In fact, commercial prices have been moving up. Balance sheets are flush with cash and the average strategic takeover during the past year has paid an average 35% premium, as we saw this week when AON announced its acquisition of Hewitt Associates for $4.9 billion—a 41% premium.
The Fund lagged its Russell 1000 Growth Index benchmark for the quarter, but still retains its edge for the year-to-date through June 30, 2010. There were no real standouts relative to the benchmark during the period, though an overweight stake in Consumer Discretionary served as a drag on returns. We did cut exposure to the sector from 27% at the end of May to 16% by the end of June, and redeployed much of that capital back into Technology and some Industrial names. A lot of this happened right before and just after quarter-end. We also built up positions in the Energy area, primarily holdings levered towards natural gas, and some within Materials.
The two best performers during the period were Akamai Technologies and Sandisk, both big beneficiaries of the further proliferation of the Internet and smart phones. The two main detractors were US Steel and Marvell Technologies. Still, there was no overarching theme to the quarter. Macroeconomic factors ruled the day just as it did in late 2008 and early 2009.
All in all, when volatility spikes like it did during the middle of the quarter, we would have expected to lose more ground to the benchmark. We believe that this is the result of the portfolio's earnings surprise and revision characteristics that far exceed that of the index. In fact, we saw a significant acceleration since the first quarter. This is what we think ultimately drives stock prices.
To conclude, the wall of worry has been rebuilt and expectations have again been lowered. While the rest of the summer may still be choppy, we feel the rest of 2010 will most resemble 2004, economically, politically and from a market standpoint. We have weathered the storm and we feel that the market will challenge the highs of the year before the year runs out.
Charles F. Mercer, Jr. CFA
B. Anthony Weber
Michael E. Johnson, CFA
July 14, 2010
As of June 30, 2010, Akamai Technologies comprised 0.00% of the portfolio's assets, SanDisk – 1.95%, US Steel – 2.81%, and Marvell Technologies – 2.61%.
Note: Growth stocks are generally more sensitive to market moves and thus may be more volatile than other stocks.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
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