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.
As far as the portfolio performance for the second quarter, the Fund lagged the Russell 2000 Growth Index by a little more than a percentage point. Surprisingly, small-cap stocks outperformed large-caps, which again indicates to us that this is a correction amid an ongoing bull market. Weakness came from exposure to Technology, Industrials, and Financials. Technology was the biggest detractor in the portfolio as semiconductor stocks were beat up on concerns that the recent up-cycle is over. If it is over, it will be the shortest semiconductor cycle ever. We don't buy it given that the average PC in this country is 5-years old. Bucking the trend was the stellar Rubicon Technology, the sapphire substrate LED maker and top-10 holding, as it completed a successful secondary offering enabling it to double its capacity in a supply constrained market.
The portfolio's Financials exposure suffered from the uncertainty of the proposed FinReg legislation moving through Congress. The Fund owns a small handful of hotel REITs that are classified by FactSet as being within the Financial sector. This is one of the few ways that we can gain exposure into the hotel group as there are not many small-cap names in that industry. This group was down 15.7%. Industrials were only down 1.9% on an absolute basis, but the sector lagged on a relative basis despite the takeover in Dollar Thrifty Rental Car for a nice premium and a strong performance by US Air.
Holdings within Consumer Discretionary outperformed the index despite posting an overall loss for the quarter. We did cut back the portfolio's exposure to the sector somewhat as we felt that China's move to revalue the Yuan higher would result in higher cost structures for some apparel and retail names. Chipotle Mexican Grill was the Fund's best name within the sector as the company reported another superb quarter.
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 focus on 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.
B. Anthony Weber
Charles F. Mercer, Jr. CFA
Michael E. Johnson, CFA
July 14, 2010
As of June 30, 2010, Rubicon Technology comprised 2.25%, Dollar Thrifty Rental Car – 0.00%, US Air – 0.00%, and Chipotle Mexican Grill – 1.15%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.