3rd Quarter 2010 Commentary
The third quarter saw a continuation of the "de-risking" trade right up until September, as the threat of a double-dip recession started to gain momentum in July, and especially in August. That all changed, however, with Ben Bernanke's speech in Jackson Hole, Wyoming stating that the Federal Reserve was prepared to do whatever it took, including implementing Quantitative Easing II (QE2), at the next Federal Open Market Committee (FOMC) meeting in November. Equity markets turned in their best September since 1939 as the Fund's Russell 1000 Growth Index benchmark gained 10.6%. The Fund itself bested the index in September. Unfortunately, August was miserable, and the Fund lagged the benchmark by nearly three percentage points overall during the quarter.
From a sector perspective, Technology, Financials, and Energy proved to be significant drags on the Fund relative to the benchmark. The portfolio's Technology exposure gained only 6% compared to 12% for the index. Financials, consisting mainly of regional banks, severely lagged the less focused index exposure. Positions in natural gas stocks suffered, as not even the heat of this summer could put a dent in supply. Holdings within the Consumer Discretionary and Industrials sectors were the lone standouts for the Fund, far outpacing the benchmark as well as other areas of the index.
We find it very difficult for the Fund to delineate itself when correlations within the market spike like they did during the third quarter. Correlations not only spiked, they went above the levels seen in November 2008 after the Lehman Brothers crisis. The only time that correlations have been higher in the past 50 years was during the Crash of 1987. This basically means that 80% of all stocks moved in the same direction—in this case down. After peaking at 81% on August 24, 2010, correlations have collapsed to 64% as we write this letter. The portfolio has been geared towards the more cyclically oriented part of the economy since the spring of last year, namely in Consumer Discretionary, Technology, Industrials and some Financials holdings. Although this positioning has provided a significant boost for the 12 months ending June 30, these areas were the first to suffer in the most recent downturn—though they are also the ones still showing the greatest earnings revisions to the upside.
In summary, the third quarter saw a big downdraft that was followed by an outstanding September ignited by the Federal Reserve hinting at a newer and bigger round of quantitative easing. We remain confident that earnings are going to come through again as expectations have been reset lower. As the mid-term elections loom and with stocks at generational low valuations, we feel very good about the rest of this year and 2011. We have stated that this market is very analogous to what we saw in 2004 and it is playing out very closely to that scenario. We are staying with the Fund's early cyclical exposure as that is where the greatest earnings revisions to the upside are occurring.
Charles F. Mercer, Jr. CFA
B. Anthony Weber
Michael E. Johnson, CFA
October 12, 2010
Note: Growth stocks are generally more sensitive to market moves and thus may be more volatile than other stocks.
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