Quarterly Commentary
Second Quarter, 2008
Despite some stabilization in the equity markets following across the board losses of the first quarter, pessimism surrounding the future of the economy and the financial markets abound. Consumers felt the bulk of the pain as they saw their home prices continue the decline, gas prices reach unprecedented levels, and wages remain flat. As would be expected, consumer confidence reached a low point last seen over 28 years ago, May of 1980; and for the first time ever in the Department of Commerce’s Conference Board survey, more workers believed pay would go down rather than up over the next six months. The Federal Reserve dropped the Fund’s rate to 2% and reaffirmed their commitment to keep inflation in check. Finally, the Treasury got over 70% of their economic stimulus checks in consumer’s hands. Little did they know that most went toward the next purchase at the pump; a far cry from stimulating an economic rebound.
Given the environment, the performance of the markets was admirable. It would appear that investors are focusing on the long term potential and prospects rather than short term ills. That being said, the outlook for the summer and into the fall Presidential election will be characterized by market extremes as even minor events will trigger volatile movement. Our view is that second quarter results provided an insight into investors’ beliefs that the likelihood of a market rebound is growing as we move toward year end.
Economic Commentary
Final results for first quarter GDP did show an advance of +1% and estimates for the second quarter still show growth in some cases at more than 2%, although it is still uncertain as to whether an economic downturn is in place or a rebound is beginning. Consumers, which still constitute 70% of our economic engine, have been slammed by item after item.
Housing depreciation and declining retirement accounts have cut consumer net worth. Almost negligible new job creation, six straight months of job losses from layoffs, factory shutdowns, or people exiting the work force and nominal wage growth paint a bleak picture of the working environment. Energy and food prices, both up sharply, now consume almost 21% of the consumer’s household budget. Although spending ended the quarter higher, 60% of the increase came from spending on food, gas, utilities, and transportation. Until stabilization occurs in energy prices and real wage growth occurs, it cannot be assumed that the consumer can lead any real type of recovery.
The recovery can still occur. Two ingredients are necessary. First, the Federal Reserve must find the right balance between lowering rates, supporting the dollar, and fighting inflation. So that our interest rates do not drop to a level below other nations, we would expect to be at the bottom of this cycle’s rate decline. This should lend some support to the dollar. If the Fed closely monitors the change in commodity prices, where the bulk of our current inflation is found, before instituting a rate increase, the balance should be in place. Second, the global economy for our businesses is alive and well. Recent trends show export orders up, import orders down do indicate global growth, can be in the impetus to pull us out of any slowdown.
We recognize that economic conditions have become more precarious since the first quarter, but unlike other consumer led slowdowns, business has not reacted negatively. Globalization has kept us producing and should continue to do so. The “muddling through” concept remains in our view the most likely scenario for the balance of the year.
Market Commentary
Although stock market returns appeared to stabilize over the quarter, most of the improvement occurred as an early quarter rebound from March lows. By mid-quarter spiking oil prices, rising from $101 per barrel to $131 by the Memorial Day holiday, continued the Financials sector credit deterioration, and overall earnings concerns reversed the market direction and erased much of the gain. In fact, as we moved into the third quarter, volatility has been dramatic as conditions continue to erode.
Still, we remain cautiously optimistic especially in the case of large capitalization S&P companies. These companies have the ability to better weather high and volatile energy prices. In part, this is achieved because they retain significant pricing power versus broad inflation measures and so far have not faced significant wage inflation. These companies are also global in orientation with a significant portion of earnings driven by foreign economies. Risk does remain in certain sectors of this market most notably Financials and Consumer Discretionary but Energy, Industrials, and Information Technology have recently performed well and should continue to do so. In the case of valuation, the market is paying little for large stocks that have growth potential with a mean P/E of 16. If Financials and Energy are not considered, the remaining stocks carry an extremely attractive P/E.
It is highly likely that equities will not move significantly higher until expectations and early signs of a recovery emerge. Earning announcements will be closely monitored as one critical indicator that we are moving in that direction. Until we have clear evidence that a recovery has begun, we believe a cautious approach to the equity market is warranted. As we wait for evidence of a recovery, large cap globally oriented companies should perform well and lead the market. Our sector weightings are expected to remain neutral, but specific stocks in especially beaten down industries should add value.
