Second Quarter 2011

The second quarter of 2011 was marked by the combination of the expiration of QE2 and an economy that was stubbornly slow to improve. The prospect of the Federal Reserve taking away monetary stimulus combined with growing signs of inflation and weak economic readings put greater pressure on stocks, especially stocks in economically sensitive sectors.   

Globally, the effects of the Japanese earthquake in March, particularly its disruptions to the global supply chain, continued to be felt throughout the quarter. The U.S. saw its GDP growth slow from 2010. Market prognosticators also cut their growth outlook, citing the risks posed by higher oil prices and the slow pace of recovery in the labor market. Unemployment increased during the quarter, and inflation, especially as measured by the PPI, picked up.

Growth slowed in Europe as well, with doubts about the region’s economic prospects which worsened with a resurgence of the eurozone debt crisis. Here in the U.S., the debt limit was officially reached in May.  Legal maneuvers exercised by Treasury Secretary Geithner bought some time, but if left unresolved, the debt issues here and in Europe could easily derail the fragile economic recovery, as well as cause lasting repercussions.

Inflationary pressures in China have caused policy-makers in the country to continue a series of tightening measures. The country does not want to halt economic growth, so, at the same time, Chinese officials are undertaking certain stimulative measures to keep their economy moving.  These include their own version of the cash-for-clunkers program targeted at the rural population, and widening the range in which they’re allowing the yuan to float. The net result is likely an accelerated pace of the yuan appreciation, which will make it cheaper for consumers and businesses to buy goods.

The growth jitters, naturally, have resulted in the pullback in prices of many industrial commodities, and even silver, a correction we view in the context of an ongoing bull market. Many related stocks (e.g., mining companies) underperformed, producing a gap between commodity and stock valuations that was, in fact, larger than is typical for this type of commodity correction. This kind of divergence is not bearish, however.

The diversion between gold, which remained in an uptrend, and gold shares, created what we saw as a buying opportunity. As governments world-wide continue to devalue their currencies by keeping the printing presses running, gold is the currency of choice. Our outlook for gold remains the same: it is protection from both inflation and deflation – and it’s the essential asset to own in the uncertain environment marked by the combination of economic jitters and debt concerns.

The Fed, in the meantime, remains between a rock and a hard place. While officially they still don’t condone inflation, they have no choice but to accept it as the lesser of two evils. With a still weak labor market, raising interest rates is not yet an option, and the Fed remains accommodative and ready to provide further stimulus.

As we know, high oil prices pose a serious threat to our already uneven economic recovery. So, the modest pullback in oil prices seen during the quarter was actually good news for the economy and the consumer. Seeing an environment of accelerating inflation and faster economic growth (thanks to expectations of continued help from the government), as well as stock valuations that were very reasonable coming out of the second quarter, we have positioned portfolios accordingly.

Growth Portfolio
As QE2 was getting ready to expire in June with frustratingly disappointing results (to paraphrase Chairman Bernanke) accompanied by generally bad economic news, we added to our cash position.  We have since become more invested as the government (this time via a release from the Strategic Petroleum Reserve and direct comments made by the Federal Reserve officials) has made it clear that the economy will not have to stand on its own yet.

That said, our energy and commodity stocks felt the effects of relevant price volatility. Portfolios felt the effects, even with our steps to reduce our weighting in these sectors. Our portfolio diversification efforts into other areas of the market such as healthcare, technology and consumer-oriented stocks helped to counterbalance our commodity-related holdings and improved the portfolio’s performance for the quarter.  

Healthcare’s strength came from a number of factors, including relatively inelastic demand and the success of companies involved in trimming medical costs (e.g., generic drug related companies and firms involved in electronic medical records).  Despite continued wrangling in Washington over “Obamacare,” cutting our country’s healthcare costs is paramount, and those on the right side of that push will likely be winners regardless of how healthcare reform arguments play out.

Our winners in the consumer area (of course, not all consumer stocks are created equal) were those with strong franchises, well-positioned for the current retail environment, including companies catering to bargain-conscious and cash-strapped U.S. consumers.

To turn to another sector heavily affected by politics and government action, defense and related areas appeared to be vulnerable to the cost-cutting pressures generated by calls for paring down the federal budget along with the debate over increasing the debt ceiling. However, this seems to be affecting big ticket defense items, while we believe our investments in cyber-security stocks are largely protected against these pressures and continue to represent a growth opportunity. The high-tech services involved are absolutely essential to the continued safety and welfare of the nation. Our selection of technology stocks, some of which are also set to benefit from the trend, appear well positioned to meet the challenges of tomorrow.

Regarding the health of U.S. financial companies, we still have certain concerns despite the fact that the sector appears to be doing better for the time being. Thus we are focusing only on a select few of the U.S.- and Canada-based financial companies, those firms that are more conservatively managed and/or have clear competitive advantages in this space.

We believe that we are well positioned to face the challenges of this economy, being overweight sectors we believe will be growing faster than the rest of the market and invested in stocks within the sectors with strong competitive positions, better-than-average exposure to growth, and well-capitalized balance sheets.

Income and Growth Portfolio
Second quarter 2011 was volatile but generally positive for most dividend paying stocks, as well as fixed income. Utility stock averages hit their highest levels since late 2008. Master limited partnerships succumbed briefly to renewed worries of possible new taxes from Washington, but later bounced back toward all-time highs reached in April.

Real estate investment trusts were a mixed bag, owing to still unsteady conditions in much of the financial sector. But high quality selections continued to push to new post-2008 crash highs. Dividend paying Canadian stocks enjoyed both local market appreciation and the continued favorable impact of a strong currency.

If there was weakness, it was on the higher risk side of the spectrum, with the worst victims the handful of companies forced by continued economic weakness and over-leverage to cut dividends. That’s always the case in any market, and it’s why we focus mainly on high quality companies with sound and growing underlying businesses, rather than chasing sweet yields that could bring sour consequences.

The single biggest positive for dividend paying stocks remains that we are still near record low borrowing rates for investment grade companies. That’s in large part due to what are still very low interest rates on 10-year Treasury notes, which are considered a benchmark for new bond issues. The 10-year yield has remained this way largely because of concerns the US economy will remain in slow-growth mode at best. That’s more than offset worries about long-term damage to America’s credit standing, should Washington politicians trigger an unprecedented default by failing to raise the federal debt limit before August 2.

A debt deal is still likely, if for no other reason than the dire consequences that could result otherwise. And if there is a default and resulting market-wide sell-off, it would almost certainly be short lived, as even the dimmest bulbs in Congress hear from increasingly frantic constituents. Moreover, a deal will almost surely move the country toward closing long-term deficits, which will be viewed positively by investors.

The upshot is that even if there is a negative market event on August 2, it won’t knock us off our long-term strategy of building wealth from a combination of superior current income and capital appreciation. Strong companies have used the low corporate borrowing rates of the past two years to virtually eliminate near-term refinancing needs, even as they’ve reduced their operating risk by focusing on core businesses. If there is another credit crunch, they can simply pull in their horns, even as revenue remains steady.

That’s the formula for safe and rising dividends going forward, come what may. And while many factors affect a dividend-paying stock’s price in the near term, rising payouts should push up values in the long run. The bottom line is to be sure of the companies you own. As long as they’re strong, you’ll be in good shape to weather even a very unlikely reprise of the 2008-09 market crash/credit crunch/recession. And you’ll be in the best possible shape to build wealth going forward.

Peak Resources and Energy Portfolio
As noted in our remarks regarding the Growth Portfolio, the second quarter of 2011 saw a retreat in commodity prices. Oil, silver and fertilizer stocks were affected, and even gold miners moved sharply lower despite gold staying in a positive trend for the period.  

This was the result of a combination of factors, including the twin natural disasters in Japan and the following nuclear catastrophe, China’s tightening of credit and drawing down of commodity inventories to rein in inflation, and slower growth and debt jitters in developed economies.

Silver was hit especially hard. After climbing to an all-time record, the metal, unique in that it combines the qualities of a precious and an industrial metal, surrendered a very sizeable portion of its gains in only a few days. By the end of the quarter, however, the metal had begun to recover. We see better prices ahead for the metal, stemming from its powerful fundamentals (and especially its role in the future of solar power), and we believe that, at these levels, the upside potential far outweighs the downside risk.

The action in copper was dramatically different. Despite all the volatility, the metal declined very insignificantly, reflecting both stronger demand from China and declining global inventories. In fact, the action in copper confirmed our take on the commodity price rout of the second quarter, which we saw as a much-needed pause in a bull market rather than the beginning of a turn to a bear market. Moreover, at the end of the quarter it became clear that, despite the slowdown in the world’s major economies, resource prices have actually held up very well.  

China’s economy may have slowed, but its GDP still expanded at a 9.5% rate in the June quarter. Furthermore, its growth is likely to remain in the upper single digits for a while – its factory output grew by a better-than-expected 15 percent in June, to cite just one statistic. We fully expect China to continue to soak up resources. Japan’s rebuilding efforts will add to the demand.

The decline in the price of oil from post-recession high was a welcome relief from the point of view of economic growth. Moreover, the highly unusual decision of the International Energy Agency’s (spearheaded by the U.S.) to release 60 million barrels of oil from its strategic reserves to further keep prices in check – that one might call RE1 (“Resource Easing”) – should be considered stimulative and a substitute for a third round of quantitative easing.

It appears this action was meant to serve as temporary tax cut – thus the RE1 nickname. Authorities around the world want economies growing, which means higher demand for resources – and higher prices. We believe the reprieve of the second quarter will prove to be temporary.

We pay special attention to precious metals, especially gold, in our portfolio. We believe the group will remain a safe haven in times of uncertainty. And while inflation is still slow, money printing will go on. Just as in other nations around the world, our policy makers are expected to continue to seek inflation as a way out of our debt problems.

And while gold prices have been setting record after record, the gold miners are priced at a level that would correspond rather to a price of gold at about $1300 per oz. Our research indicates that gold stocks underperforming the metal like we observed in the second quarter is not bearish for gold, but rather the opposite.

Among market-moving events of the year was Japan’s nuclear disaster. It now has many countries rethinking the desirability and true cost of nuclear power. This is bullish for other alternatives such as wind and solar. And, in turn, we believe this is bullish for silver (which is essential for solar power) and the heavy rare earth elements (necessary for wind turbines).

Of course, we remain significantly invested in energy companies. We like growing companies, including oilfield service companies and contract drillers, who will benefit substantially from increased drilling activity for both oil and natural gas. Among large oil companies, we prefer those with the best production profiles. We also favor energy companies with exposure to unconventional plays such as the Bakken Shale.  

Our fertilizer plays represent solid opportunities in a sector with few players operating at a time when food prices are rising around the globe. Greater incomes for farmers mean they have the wherewithal to spend more to maximize yields, too.

Finally, an era of resource scarcity inevitably brings with it heightened security concerns, both in terms of conventional military as well as new electronic and cyber security needs. The very idea of Lockheed Martin being hacked starkly illustrates the importance of this situation. In this context, we have added a top professional services and IT company to the portfolio.