4th Quarter 2011 – 3rd Quarter 2011 – 2nd Quarter 2011 – 1st Quarter 2011

QUARTERLY INVESTMENT REVIEW
October 2011

October 2011

At Least the Auto Services Company Is Still AAA

It wasn’t exactly a relaxing summer for investors.  What should have been a season of riding down a water slide into a refreshing pool felt instead like a season of bungee jumping over the Grand Canyon.  While Federal Reserve Chairman Ben Bernanke was doing his best to influence the direction of our economy by again lowering interest rates, his best efforts were no match for the locomotives of fear and chaos.  The cars of the “Fear Express” included: America’s credit rating taken down a notch by the Standard & Poor Corporation; lack of meaningful agreement by political parties on the Federal budget deficit and debt limit; concerns about the possible collapse of the European Union (EU); stubbornly high unemployment; and market volatility--evidenced by the Dow Jones Industrial Average which rose or fell by 400 points for four straight days for the first time in its 115-year history. 

Let’s take a look at the results for various indices for the quarter and how the end-of-quarter levels compare to an earlier market top in 2000.  All index values come from the Wall Street Journal.  Please note that performance of stock indices do not include dividends.

	3nd Quarter	2011 Year To-Date
Dow Jones Industrials (the Dow)	-12.1%	-5.7%
S&P 500 Stock Index (the S&P 500)	-14.3%	-10.0%
NASDAQ Composite	-12.9%	-9.0%
Russell 2000 (small companies)	-22.1%	-18.6%
Dow Jones World (non-US)	-20.2%	-18.6%
10-Year Treasury Bonds	+12.1%	+15.8%
Commodities:  AIG Index	-11.3%	-13.7%
U.S. Dollar Index (Morgan Stanley)	+10.4%	+2.8%

 

It’s unanimous.  It was a nasty quarter for stocks, with double-digit declines across the board.  Each month of the quarter was worse that the preceding, resulting in the worst quarterly decline in stocks since the first quarter of 2009.   On the other hand, bonds had a terrific quarter, the result of interest rates falling from the previous historic lows.  Unfortunately only those who were brave enough to hold longer-term bonds benefited from this.  The index of small companies (Russell 2000) and the non-US stock index were both down over 20%.  The U.S. dollar rocketed up by over 10% in the quarter, surprising to many since U.S. stocks were tanking and our credit rating was taken down a notch.  The explanation: whatever the S&P Corporation thinks, the good ol’ Greenback is still considered the safest currency around.  When the level of anxiety around the world rose to an acute level (when the existence of the EU began to be threatened), money flowed to the U.S. dollar as a safe harbor.  Even with our deficits and abysmal political landscape, it remains strange but true that we are a safe harbor.

Where We Are Now

At the end of the quarter, stocks presented an attractive valuation in comparison to earnings.  The P/E ratio of the Dow (stock prices divided by earnings—the lower the better) was at a level of 12.2, representing a better value than we’ve seen in a while.  This means that stocks either (1) represent a bargain, or (2) future earnings are not expected to be good.   Although the economy is growing (albeit very slowly), there is a chance that a recession could occur.  Unemployment continues to be stubbornly high.  Consumer confidence is at its lowest point in two years.  People are opting to pay down debt rather than spend.  The housing market continues to be weak.  Corporations are hoarding cash, concerned their funds may be needed should we slide back into recession. The beginning of October has brought some positive market movement, but it will take a number of good months to make up for the past quarter.  

Looking Ahead

In many respects we are at an interesting crossroads in our history.  It would not be surprising to see significant social unrest—the likes of which we have not seen since the Vietnam War.  This may have already begun with the Occupy Wall Street and Occupy Washington activities.  Why is this happening?  Many citizens feel the government has lost its compass, its members more adept at representing their political parties and themselves than their country and their constituents.   To say the least, it will be interesting to see how events unfold.  Ultimately we will be a better country as a result of the dialogue that needs to occur.

The extension of the debt limit in early August really just “kicked the can down the road”.  It set up future conflict without providing a real solution. During this upcoming quarter, the success or failure of the Joint Select Committee on Deficit Reduction will become evident.  With a deadline of November 23^rd for the committee to vote on a plan; and a deadline of December 23^rd for both houses to vote on the committee bill, the success or failure of each step of the process will play out in the markets.  Based on previous lines drawn in the partisan sand--and the strident defense of those lines by both sides--it is hard to see how party allegiances will be set aside in the interests of long-term solutions.  

There are important headwinds blowing: resolution of problems in Europe, progress in our own deficit-reduction efforts, and strategies for stimulating the economy will all play pivotal roles in shaping this quarter’s direction.  We expect economic growth to remain weak and interest rates to remain at historic lows.  Continued refinancing by homeowners will provide some assistance to household cash flows but it is hard to see improvement in the housing market until the economy picks up and unemployment improves.  Volatility is likely to continue, as buying by opportunists will probably be offset by fearful sellers.  While this climate presents a challenge to investors, the type of diversification we employ through asset allocation is a key strategy to reducing investment risk.

As always, we will continue to follow the markets closely and will take appropriate actions within client accounts to manage risk and return in accordance with each respective Investment Policy Statement.

 

Please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP, EA     

George S. Middleton CFA, CPA-PFS              

   

QUARTERLY INVESTMENT REVIEW
JULY 2011

July 2011

Beware Greeks Baring Rifts

Fits and Starts:  the notable advance in the first quarter extended through April, but May and June presented six long weeks of decline.  Stocks were brought down by stubbornly high unemployment and a dastardly dynamic duo:  (1) concerns that a compromise may not be reached on the approaching vote on the U.S. debt limit; and (2) Greece’s financial woes and their impact on the Euro community.  Near the end of June the market began a welcome recovery which has continued into July, though the pace is likely unsustainable. 

Following are the results for various indices for the past quarter:

 

	2nd Quarter	2011 Year To-Date
Dow Jones Industrials (the Dow)	0.8%	7.2%
S&P 500 Stock Index (the S&P 500)	-0.4%	5.0%
NASDAQ Composite	-0.3%	4.5%
Russell 2000 (small companies)	-1.9%	5.6%
Dow Jones World (non-US)	-0.5%	2.1%
10-Year Treasury Bonds	3.6%	3.2%
Commodities:  AIG Index	-6.7%	-2.6%
U.S. Dollar Index (Morgan Stanley)	-3.3%	-6.9%

All index values come from the Wall Street Journal.  Stock indices do not include dividend return.

After all the up and down action in stocks, they ended with little change for the quarter. Bonds put in a good showing—reflecting the doubts about the economic recovery—while high-flying commodity prices dropped like a rock and the U.S. dollar continued its long-term trend, dropping once again.  The decline in the dollar would have been worse had it not been for the Greek crisis, when the dollar found support as a safe harbor at the expense of the Euro.  Not listed in the chart above is real estate.  It is worth mentioning that the Dow Jones Equity All-REIT Index is up 9.9% year-to-date, outpacing stocks.  The dividend yield offered by many REITs (Real Estate Investment Trusts) has attracted investment capital.

Where We Are Now

The political maneuvering continues in preparation for the impending vote on the debt limit.  Without extending the debt limit, the country would run out of money and theoretically shut down--sort of like a “New World Greece”.  John Travolta eat your heart out…  There can only be one realistic outcome: compromise and agreement.  Hard lines drawn in the sand by either political party would be disastrous for both the country as a whole as well as for those drawing the line.  Let’s hope the outcome is the beginning of a pragmatic process of aligning spending and revenue collection (hope springs eternal).

The second quarter’s overall economic growth rate is estimated to have been +2.3%, about .5% lower than previous estimates. Consensus predictions for the rest of the year project growth that is modestly higher than the year’s first half--but still slow by normal recovery standards.

 If we were an isolated country, our growth rate would be even slower.  We are effectively “importing” growth through international trade with faster-growing emerging markets who are demanding our products and services at a rate faster than the demand from our own country.  Manufacturing activity here in the U.S. has improved.  One might ask “what other possible measures could the government take to help the economy?”  Recently the spigot for the national strategic oil reserves was tapped, resulting in increased supply and reduced prices for gas at the pump, helping “ease the squeeze” that gas prices has had on household consumer spending.  Good idea!  Stocks have recently experienced a significant advance--to the tune of +6.6% from June 24^th  to this writing (July 7^th)--reflecting investors buying into a previously over-sold market, as well as the expectation of the approval of the increased debt limit.

The issue of unemployment and the need for job creation has taken center stage--both economically and politically. Although marginally improved, unemployment remains stubbornly high.  Soon after the Federal Reserve estimated unemployment by year-end to improve slightly to the 7.8%-8.2% range, it was announced that the rate of unemployment increased in June to 9.2%.  The real estate market remains soft, with home sales volume increasing but average prices still declining, albeit at a slower rate.

Looking Ahead

Flooding in the Midwest and the Plains—in combination with severe drought in other places—is bound to curb agricultural production which in turn is likely to increase agricultural and ranch product prices.  Obviously this will have an inflationary effect.  The “Greece problem” will move to the back burner but may well return to the fore, representing a potentially devastating problem for the Euro community that could infect the U.S.  A question that remains: will the rescue package for Greece restore that country to self-sufficiency or simply postpone an eventual default, resulting in even greater losses and the weakening of the finances of the entire Euro zone, with ripple effects worldwide?

Impending corporate earnings reports are expected to be surprisingly good, reflecting demand from emerging countries and cost-cutting measures which, unfortunately, include layoffs.

It is likely that the economy will continue to improve at a slow pace.  The current momentum in stocks will likely slow due to the lack of economic support for a substantial move.  There may be an uptick in inflation due to increasing food prices, but the economy is still too weak to allow the Federal Reserve to increase interest rates.

As always, we will continue to follow the markets closely and will take appropriate actions within client accounts to manage risk and return in accordance with each client’s respective Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges  CFA, CFP, EA                                                    

George Middleton  CFA, CPA-PFS

Sometimes the financial writers and their editors have such a way with words.  The Financial Analysis and Commentary section of the June 16 issue of the Wall Street Journal deserves the credit for the byline on the top of the page.  The rift referred to in the heading refers to rifts between Greece and the other Euro members as well as the Greek government and its citizens who are protesting against austerity measures imposed by their government.

 

QUARTERLY INVESTMENT REVIEW
APRIL 2011

April 2011

Uncle Sam:  Brother Have You Got A Dime?

Or, Is Our Country “Too Big To Fail”?

The stock market had a terrific first quarter, reflecting the chorus of agreement that the economy is improving, even though at the pace of a Pacific Northwest slug going uphill.  Even the disaster in Japan and caution about increasing food and energy prices could not hold back the markets.  It fell on the shoulders of the Standard and Poor Corporation to be the messenger of reality.

With Congress and their constituents mired in a messy dialogue of opposing positions, the credit rating firm recently had the audacity to point out that the king has no clothes—actually, he is as naked as a jay bird.  In an unprecedented move, S&P lowered its long-term outlook for the federal government’s fiscal health from “stable” to “negative”, and warned of serious consequences if a deal to control the massive federal deficit is not reached.  While the ramifications of the S&P announcement were sinking in with investors, stocks quickly dropped nearly 2% as measured by the Dow Jones Industrial Average.  Ultimately the hubbub fell off the front pages and markets have recovered.  The underlying problem remains.

Following are the results for various indices for the past quarter.  In the far right column is a comparison to a previous market high achieved approximately 11 years ago. All index values come from the Wall Street Journal (“WSJ”).  Stock index returns do not include dividends.

	1st Qtr (Year To Date)	Since Earlier Market Peak (3/31/2000)
Dow Jones Industrials (the Dow)	+ 6.4%	+12.8%
S&P 500 Stock Index (S&P 500)	+ 5.4%	- 11.5%
NASDAQ Composite	+ 4.8%	- 39.2%
Russell 2000 (small companies)	+ 7.6%	+ 56.5%
Dow Jones World (non-US)	+ 2.6%	+ 19.3%
10-Year Treasury Bonds	- 0.3%	n/a
Commodities: AIG Index	+ 4.4%	n/a
The U.S. Dollar (JPM Index)	- 3.8%	n/a

Small companies set a blistering pace and large companies--represented by the Dow--were not far behind.  International stocks had a good quarter but lagged the performance of U.S. stocks.  The bond market remained stable, unruffled by inflation talk.  If it weren’t for the weak economy, inflationary influences would be a factor—but that was not the case this past quarter.  Commodity prices also increased—mostly reflecting increased food and energy prices. Gold and oil--commodities priced internationally in U.S. dollars--reflected the weakness of our currency, with gold recently topping $1500 per ounce and oil pushing past $110 per barrel.  Demand for oil is also increasing with improvements in economies around the world.

Where We Are Now

Recently 4^th-quarter GDP (Gross Domestic Product, a measure of overall economic growth), was revised upward to a healthy gain of +3.1%.  The overall economy has continued to grow on a slow-but-steady rate, with March consumer spending—which accounts for around 70% of economic activity—having increased 4% from the prior year, the highest rate of increase in 4 years.   There is concern that increased federal deficits and the declining dollar will continue to make imported goods and services all the more expensive.  Increased energy prices—notably at the gas pump—will likely put a dent in the rate of spending by consumers. On the other hand, auto sales in March were reportedly 17% higher than the previous month.

Sporadic fits of positive news splashed across the media have made it easier for hopeful investors to gloss over underlying problems that continue to hold back the recovery.  While changes in employment levels have been moving in the right direction, the progress has been as slow as predicted.  Stubborn unemployment has left the real estate sector weak, as the number of existing homes sold has increased a bit while the average sales price has continued to decline--an ongoing concern for everyone except buyers.  As quoted from the Wall Street Journal, sales of new homes in February were at the lowest rate since the government began keeping the data almost 50 years ago.  Sales of new homes were only half the number sold in 1963 even though our population has grown by 120 million people.  Widespread construction layoffs have added to unemployment.  On a national basis February home foreclosures fell sharply, but within our own geographic area the rate of foreclosures, number of sales, and average prices were all worse than those reported for the nation as a whole.  Need to buy a house?  Come here!

Even the bright spot of declining household debt is partially explained by debtors simply defaulting on their debt.  One household’s improvement is a lender’s loss. 

Looking Ahead

An important vote looms on raising the debt limit.  It appears the far corners of each party have been tamed by the need to quell fears of a government default.  There will obviously be positioning and jousting but the bill must pass.  One can only imagine the ridiculous amendments to be attached.  Estimates for 1^st quarter GDP growth range widely, from +2.3% to +3.8%

It is likely that the economy will continue to improve at a slow pace.  Stocks have shown resilience to recent challenges and will likely continue their slow climb. While there will be no fast track to lift the economy out of the quagmire, there appears to be continued progress ahead. Though demand--and prices--for natural resources will likely increase, overall inflation will probably remain low and interest rates will therefore be stable. At some point the Federal Reserve will hike rates but the economy is too weak to justify that now.

As always, we will continue to follow the markets closely and will take appropriate actions within client accounts to manage risk and return in accordance with each client’s respective Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges  CFA, CFP, EA                                                        

George Middleton  CFA, CPA-PFS

 

QUARTERLY INVESTMENT REVIEW
JANUARY 2011

January 2011

The Economy Climbs, Under Burdens of Joblessness and Weak Housing

Welcome to the New Year!  The year 2010 was another good year for investments and a banner year for Limoges Investment Management.  We would like to thank you once again for your business.  We appreciate the trust and confidence you have in us and we look forward to another year of providing top quality investment management services and sound financial advice. 

The economy stayed on its slow-growth profile during the past quarter, rewarding the patient investor.  While the third quarter brought a degree of confidence to the markets, Santa delivered a broad year-end stock rally, spreading most of the pixie dust on small company stocks.  Unfortunately bonds were left in the cold as anticipation for increased interest rates caused bond investors to desert their ship.  All stock indices experienced significant gains in the final quarter.  In fact, all indices were in positive territory for the year except for the U.S. dollar (which again got coal in its stocking instead of Euros). Though increased Federal debt, further deficit spending, and a stubbornly high rate of unemployment make for a less than solid foundation for success, stocks were apparently more impressed by strong holiday retail sales, the two-year extension of favorable income tax provisions, and economic indicators that provided modestly good omens for the future. 

Following are performance results for various indices for the quarter and for the year as well as a comparison of year-end levels to an earlier market peak.  All index values come from the Wall Street Journal (“WSJ”).  Stock index returns do not include dividends.

	4th Qtr	For year 2010	Since Earlier Market Peak (3/31/2000)
Dow Jones Industrials (the Dow)	+ 7.3%	+ 11.0%	+ 6.0%
S&P 500 Stock Index (S&P 500)	+ 10.2%	+ 12.8%	- 16.1%
NASDAQ Composite	+ 12.0%	+ 16.9%	- 42.0%
Russell 2000 (small companies)	+ 15.9%	+ 25.3%	+ 45.4%
Dow Jones World (non-US)	+ 7.3%	+ 10.1%	+ 16.2%
10-Year Treasury Bonds	- 5.5%	+ 8.3%	n/a
Commodities: AIG Index	+ 15.8%	+ 16.7%	n/a
The U.S. Dollar (JPM Index)	- 2.3%	- 3.8%	n/a

Another noteworthy development in the 4^th quarter was the surge of commodity prices.  As noted above, the AIG Commodity Index shot up almost 16% in the quarter.  Reasons for price increases included gold & silver reacting to the European and Korean problems, fears about future inflation, demand for oil, increased global demand--especially from emerging markets--for natural resources and food supplies, and food supply constraints.  Not included in the table above are REITs (Real Estate Investment Trusts), which gained +27% for the year, outpacing stocks.  This is less remarkable when one considers that REITs are recovering from low levels reached after setbacks in recent years.

Where We Are Now

“The Fed, Inc”: The Federal Reserve’s 2010 net income was $80.9B due to interest on mortgage bonds and Treasury debt acquired during the financial crisis.  $78.4B is to be transferred to the Treasury Department. As Chairman Bernanke stated (a message for Congress?), one can view the payments returned to Treasury as “interest that the Treasury didn’t have to pay the Chinese”, a reference to the top foreign holder of U.S. Treasury debt.

On the plus side, many indicators confirm that the overall economy has maintained its course of recovery and the rate of growth has exceeded economists’ modest expectations.  Including a solid holiday retail season (you just can’t keep the American consumer down for long), overall 4^th quarter economic growth is estimated to have been +3.3%.  Inflation remains low so far which has helped limit the government’s interest expense on Treasury debt.  (“Core” inflation for the year was only +0.8%, the smallest calendar-year rise since this measure began in 1958.) Banks have recently increased (though marginally) commercial, industrial, and consumer lending which should help growth.  Sectors reporting improvement include other areas of the financial sector, manufacturing, consumer sentiment and spending, and corporate profits.  Corporate cash stockpiles are the highest in 51 years as companies have conservatively declined to invest in plants or equipment or to hire.  Perhaps the cash will be used to acquire other companies or buy back their own shares. While not contributing to economic growth, these uses would increase earnings per share.

Several factors stubbornly offset a lot of the positives.  At 9.4%, the rate of unemployment remains a lingering problem.  A still-bloated supply of real estate on the market holds back values.  Recently the issues related to the work-out of government deficits on the State level have been in the spotlight.  For the last decade or so, the Federal government has “passed the buck” of funding and services from Federal to State governments.  This is now coming home to roost at the State level.  Unlike the Federal government, States are generally not empowered to simply issue more debt to cover their deficits.  To balance their budgets, State governments are required to confront and act on deficits; they are forced to lay off employees and cut back on services, contributing to unemployment.  The recent up-tick in the economy has helped restore some State revenues, but this effect has been limited.  Compounding the problem for States and some utilities is the expiration of short-term bank letters of credit, issued during the credit crisis of 2008.  This requires issuers to refinance this source of debt at a time when AAA muni-bond rates have climbed to 5%, increasing their cost of debt. The municipal bond market is in disarray at this time and we hope these issues are resolved soon.

Looking Ahead

How slow will the recovery be?  From the giddy contingent, a recent WSJ survey of economists estimates that GDP (Gross Domestic Production, a measure of our overall economy) is expected to steadily increase at the healthy rate of 3.2% throughout 2011.  That would be a very positive year.  Sound pretty good so far?  Let’s look at it another way:  employment is inextricably tied to the economic recovery. The housing market is inextricably tied to employment.  Economic recovery, employment gains, housing gains: the three are joined at the hip.  While signs point to some progress in hiring, Fed Chairman Bernanke recently voiced the expectation that it will take five years before unemployment is reduced to its long-range “normal” rate of 6.0%.  That is one slow recovery, but stated in a way that helps set more modest expectations.  While the number of bankruptcies was recently reported as declining, Moody’s chief economist Mark Zandi was quoted in the WSJ as expecting foreclosures (including home auctions and short sales) to increase in 2011. Other economists feel real estate could bottom out and begin to recover late in 2011.

Increasing prices and commodity shortages—especially in food resources—are a concern. Many feel we are in a “La Nina” condition which is limiting food production around the world.  Should recent food riots--due to shortages or unaffordable prices--continue, it could cause political instability in affected countries. Should oil prices (up +16.1% in 2010) and other raw materials continue to increase, it will be a drag on economic growth.

We continue to see the U.S. markets as an opportunity for the long term, but we feel the rate of growth will continue to be slower than past recoveries.  We anticipate modest but healthy gains in stocks but increased risk in bonds--especially in the mid-to-long term maturities. Interest rates will likely remain somewhat stable before trending up.  The continued pace of recovery is by no means assured. The past year’s Korean episode reminds us that unforeseen, non-economic events can impose themselves on an otherwise positive investment environment.  While we hold the expectation for opportunity, we will continue to exercise prudence with client assets.

As always, please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP, EA                                                

George S. Middleton CFA, CPA-PFS