Following six months of strong gains, stocks posted moderate losses during the April-June period.  Domestic ‘blue chip’ benchmarks fell less than 5%, though small-company stocks, as a group, as well as most overseas markets fared somewhat worse.  The prices of most commodities – including gold – also declined.  Bond yields continued their remarkable five-year descent (the benchmark 10-year Treasury rate ended the period at a miniscule 1.66%, compared with 2.22% in March), resulting in solidly positive returns from most fixed-income investments.

Among U.S. stocks, relatively better results came from companies in the Communication Services, Consumer Staples, Health Care and Utilities sectors.  Meanwhile, Capital Goods, Consumer Cyclical, Energy and Financial Services stocks were generally weaker.  Small-company stocks slightly underperformed their large-cap counterparts, while growth-oriented stocks, on average, posted better results than those in the ‘value’ category.

Benchmark Performance – Equities

  Second Quarter 2012 Last Twelve Months
     S&P 500 Index -2.8% +5.5%
     Large-Cap. Core Mutual Fund Avg. (Lipper) -4.0% +1.7%
     Small-Cap Stocks (Russell 2000) -3.5% -2.1%
     Non-U.S. Stocks (MSCI ACWI ex-U.S.) -7.2% -14.1%


Benchmark Performance – Fixed Income

  Second Quarter 2012 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +1.7% +5.4%
    Barclays 1-5 Year Municipal Index (tax-exempt) +0.7% +3.1%



Reversing trends of the prior six months, the April-June period saw renewed financial tensions emanating from Europe and a slackening pace of economic growth in the U.S.  Meanwhile, evidence continued to mount of a distinct slow-down among emerging market ‘growth engines’ (China, India and Brazil).  Given the persistently downbeat news, the declines recorded by U.S. stock market benchmarks were perhaps surprisingly modest.

The European debt crisis entered a new, more worrisome phase during the period.  The relative calm ushered in by the European Central Bank’s December/February liquidity injections into the region’s banks came to an abrupt end as evidence emerged of major problems in the Spanish banking system.  Despite (or, perhaps more accurately, because of) an early-June agreement to lend the Spanish government up to 100 billion euros from pooled rescue funds in order to recapitalize the nation’s banks, government bond yields in Spain and Italy (the Euro zone’s third and fourth largest economies) rose alarmingly to levels that earlier forced Ireland, Greece and Portugal to seek bailouts.  As available rescue funds are insufficient to finance full-fledged bailouts of both Spain and Italy, this was a sobering development: absent meaningful new steps, a full-scale breakdown of the currency union loomed.

At the June 28-29 European Union summit meeting, however, newly elected French president Hollande joined forces with the prime ministers of Spain and Italy to yield potentially important concessions from Germany (allowing the direct recapitalization of banks using pooled rescue funds; plotting a road-map toward a transnational banking union).  Although many important details remained to be worked out, the summit agreements eased pressure on both the banking systems and government bond markets in Spain and Italy.  And unlike previous ‘break-throughs’ in the two-year old crisis, immediate market gains were not frittered away in ensuing days (at least not yet).

In the U.S., economic data that had been surprisingly robust during winter and early spring showed a clear deterioration.  Most important was a markedly slower pace of job creation in April, May and June compared to the preceding four months.  A less pronounced slowing was also evident in surveys of purchasing managers, measures of consumer confidence and spending, and the index of leading economic indicators. (A bright spot – discussed in the Outlook section below – was a noticeable firming in data from the housing market.)  The apparent downshift led many economists, including those at the Federal Reserve, to ratchet back their projections for economic growth in 2012 and 2013.


What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

            * based on forecast earnings for next 12 months (Source: S&P Outlook

So, what changed during the recent quarter to give us the -2.8% S&P 500 total return?

Second Quarter (April-June) 2012
Dividend Income +0.6% -2.8%
+ Change in Earnings +3.2%
+ Change in Valuation -6.6%
= Total Return -2.8%

Our read
:  The change-in-earnings component seems likely to level off or even turn negative over the remainder of 2012; at ~13-times earnings, however, we think prices can withstand the deceleration.

 Overseas, signs continued to emerge of a distinct slow-down in China, Brazil and India – the emerging market giants that have accounted for a growing share of global economic growth in recent years.  In China, both official and private estimates of economic activity declined throughout the period, indicating that earlier policy tightening intended to head-off an incipient property-price bubble was weighing on other parts of the economy.  Meanwhile, first-quarter GDP figures for India and Brazil both showed growth slowing to the lowest rates in years.

In addition to derailing the October-March stock-market rally, rising Euro-debt fears and slowing global growth also pushed commodity prices and interest rates lower.  A basket of industrial commodities tracked by The Economist magazine dropped more than 14% in dollar terms during the quarter; gold was off nearly 7%.  The remarkable performance of high-quality, safe-haven bond yields was an under-reported story of the quarter: U.S. 10-year Treasury rates briefly dipped to all-time lows below 1.5%, easily eclipsing last year’s nadir of 1.7%.


Although recent developments have been less supportive of the financial markets than earlier in the year, the outlook for the remainder of 2012 has actually changed relatively little since we wrote to you in April.  Now, as then, the key drivers of near-term market performance are likely to be the ‘temperature’ of the simmering European crisis; the pace of economic activity in the U.S. and major emerging markets; and political developments in Washington.

While the evolving European crisis will retain the potential to move markets abruptly (in either direction), developments closer to home may be more important in the second half of the year.  On the economic front, a number of observers have concluded that a good portion of the uptick in activity during the winter was induced primarily by unusually warm weather.  To the extent this is true, the more recent downshift may reflect ‘pay-back’ following an artificially strong winter (though surely increased uncertainty regarding Europe and the pace of global growth played a role, as well).  Statistics released since around mid-June have seemed somewhat less dour than earlier in the period; data printed in coming weeks should help investors discern whether this year’s slowdown is a repeat of those experienced each of the past two summers – both of which were accompanied by a growing chorus of calls for a ‘double-dip’ recession – or something less worrisome.

As noted above, an important bright spot has been the housing market, which has shown tantalizing signs of stabilizing after more than five years of decline.  During the second quarter, the National Association of Home Builders confidence index rose to its highest reading in more than five years, while both nationally-recognized indices of house prices rose in April (the latest month for which data are available) and a third survey indicated gains for May, as well.  Rising (or even stable) prices, if sustained for more than a few months, would reverse the destructive psychology keeping many would-be buyers waiting on the sidelines for lower prices down the road.  Moreover, rising prices would gradually reduce the number of ‘upside-down’ mortgages whose principal balances exceed the market value of the underlying property.  These would be hugely important developments.  As we have noted on several occasions over the past several years, residential real estate represents a preponderant fraction of most American families’ net worth, and the multi-year contraction in house values has been a major impediment to consumer confidence and spending.  This will be an area that bears close attention in the months ahead.

Developments in emerging markets also continue to attract close scrutiny.  Here, the most intense focus will be on China, largely because of the sheer size of its economy (second only to that of the U.S.), but also due to a suspicion among many observers that official Chinese data are being ‘massaged’ in order to understate recent weakness.  On the positive side, global inflation has been receding, which will give authorities breathing space to enact stimulus policies to support growth over the remainder of the year.  And, as we have noted in past letters, decelerating emerging-market growth also comes with the significant silver lining of lower prices for industrial commodities, not least oil and, by extension, gasoline.  Combined with historically low interest rates, cheaper raw materials and energy will be a boon to companies and consumers around the world.

Returning home, we suspect that investors – depending on how much they are distracted by events across the Atlantic – will become increasingly concerned with a possible reprise of last summer’s Washington showdown over raising the federal debt ceiling.  The central character of this year’s drama will be the so-called ‘fiscal cliff’ – sharp spending cuts combined with tax increases scheduled to take effect in January that could easily derail the fragile economic recovery.  This could be a big deal; or not.  Most observers predict that some sort of short-term extension of existing policies will be agreed to, thereby putting off any major changes until after the November elections.  But we have learned that it is easy – and sometimes costly – to underestimate the ineptitude of our elected representatives in matters such as these.

Speaking of November… though it seems uncontroversial to say that investors, on balance, would be receptive to a change in the occupancy of the White House, it is also worth noting that U.S. markets have performed better than most global counterparts despite the supposedly anti-business policies of the current administration.  American stocks also enjoyed some of their all-time best performance during the eight-year presidency of Bill Clinton.  The market’s apparent ideological ambivalence was also on display in late June, when stocks rallied (albeit briefly) immediately upon release of the unexpected Supreme Court ruling upholding key provisions of the Affordable Care Act.  So, while the news in coming months will surely be full of seemingly important stories detailing the changing fortunes of the two political parties, we would not be surprised to see the markets take these developments pretty much in stride.

Despite debt troubles in Europe and wobbly emerging-market growth, U.S. corporate profits – which are a more important determinant of stock prices than is the pace of economic growth – continue to be solid.   First-quarter (January-March) profits for the companies in the S&P 500 Index were up more than 7% from 2011; a similar gain is projected for 2012 as a whole.  With profit margins hovering at historically high levels, however, we should be prepared for disappointment in this area in the period ahead (margins have historically been predictably ‘mean-reverting’, meaning that a sustained high level is often followed by a period of lower profitability).   Record-low bond yields and falling commodity prices suggest a subdued growth outlook that might further restrain profits.  But with the S&P 500 trading at just over 13 times current earnings, a modest decline in profitability need not pose a major obstacle to stock prices.

As mentioned in the Review section above, we have been somewhat surprised at the relatively calm market reaction to renewed turbulence in Europe, especially as it coincided with gathering evidence of faltering global economic growth.  The single-digit U.S. stock-market correction and, even more surprising, subdued signs of alarm within global credit markets and measures of investor anxiety (such as the ‘VIX’ volatility index) suggest that investors have been less anxious than the drumbeat of negative headlines might seem to warrant.  We can’t be certain whether this nonchalance is an accurate reflection of the real (i.e., lower) risks threatening the markets or, rather, akin to whistling past a graveyard.   Although we are inclined to trust the markets’ collective rationality, as long as turmoil in Europe poses even a slight chance of unleashing a second ‘Lehman-Brothers’ market seizure, we believe it is prudent to maintain a relatively conservative portfolio posture, with below-average exposure to stocks and higher-than-normal cash reserves.

As always, we encourage your comments and questions regarding our management of your investments.

Alan Purintun, CFA                                                             Robert W. Phelps, CFA
Principal & Portfolio Manager                                          Principal & Portfolio Manager


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