Third Quarter 2011

The third quarter of 2011 was a period of pronounced volatility and growing fear of a global slowdown.  Analysts cut their growth forecasts as higher energy prices and political debate once again hampered economic growth.  
 
The labor market remained weak, with official unemployment stuck at 9.1 percent, despite interest rates having fallen further during the quarter.  The 10-year U.S. Treasury note finished the quarter with a yield of 1.92 percent, down from 3.16 percent at the beginning of the period. Lower rates, however, have yet to have a positive impact on economic growth.    
 
Inflation picked up in July due to higher rent and energy costs, as consumers felt the pinch of higher crude oil prices.  Manufacturing activity slowed from the second quarter, but managed to stay in positive territory and, encouragingly, staged a turnaround late in the quarter.  
 
The sovereign debt crisis in the eurozone continued to worsen during the period, although by the end of the quarter it started to look as if policymakers were closer to taking action.  The institutional and legal framework of the euro have held back government and central bank support for the crisis, and some observers are rightly worried about the potential for Europe to drag down the rest of the world’s economy with it.  Ultimately, we expect policymakers to take steps to tame the crisis, although the necessary structural reforms for the euro region have not yet been a component of the debate.
 
With the European crisis growing more severe, some economists have also voiced concern of a slowdown in China’s growth.  We don’t expect a hard landing in the Chinese economy to materialize, as rising unemployment would pose the threat of serious civil unrest.  Policymakers there realize this, and we expect them to do whatever is necessary, including accepting higher levels of inflation, to avoid a meaningful slowdown in growth.
 
With governments around the world focused on austerity, monetary support for the recovery is all that is available. In the U.S., the Federal Reserve acknowledged seeing "significant downside risks" to the economic outlook and initiated what has been dubbed “Operation Twist,” a planned selling of $400 billion in short-term Treasurys to buy longer-term notes to drive down rates on the longer end of the credit spectrum. The Fed has also left open the door for a third round of Quantitative Easing if needed.  
 
Gold prices lost some ground during the quarter, although much of the selling appeared to be related to investors raising cash to meet margin calls in their equity investments.  Metals prices have had such an immense run-up to this point, the pullback in gold was destined to arrive eventually.  Looking ahead, any policy support in Europe or the U.S. will likely involve additional monetary stimulus, and gold prices should respond favorably.
 
Growth Portfolio
 
We made several adjustments to our Growth Portfolio during the quarter.  With the situation in Europe and weak economic data here at home giving way to a pullback in resource prices, we scaled back our energy exposure and made several other changes to our holdings.  We continue to see higher energy prices materializing in the long run from supply constraints and emerging market demand.  However, the shorter-term outlook is more volatile.  As energy prices do increase, those companies that are able to grow production will be the winners.  In the meantime, we have focused the portfolio’s energy positions on fewer, more-dominant companies to avoid some of the short-term volatility.
 
In the retail and consumer sectors, we have come to embrace a barbell strategy for exposure to consumer spending patterns.  Income equality is rising and the Middle Class is shrinking – and we see the trend as zero-sum.  We have concentrated our consumer positions on high-quality companies that focus on low-end, cost conscious retail.  On the high end of the spectrum, the ultra-rich have been largely insulated from the weak economy and their incomes have actually risen.  Companies that derive their revenues from this more stable customer base, and also possess avenues for growth, should do well.  
 
Our investments in leading technology companies have performed well during the quarter, and we have added to multiple positions, as well as initiated new ones.  Cost cutting and cyber security continue to be important themes for the sector.  Additionally, a slowdown in true innovation, while perhaps less exciting for the consumer, has allowed large technology companies to establish true franchise businesses with incremental gains.  With strong drivers for growth and high-quality and/or cash rich balance sheets, we increased our portfolio weighting in technology.
 
With global fears of slowing growth, the risk of deflation in the developed countries remains a serious threat.  As investors have sought safety, they continue to turn to the dollar and U.S. Treasurys as a safe haven.  This trend of risk aversion, combined with the Federal Reserve’s Operation Twist, has helped longer-maturity bonds.  Late in the quarter, we took a position in zero coupon bonds as a leveraged hedge to deflation.  Since they have no interest payments, these bonds sell at a substantial discount to face value and are more sensitive to changes in interest rates.  Zeros performed well during the throes of the financial crisis, and should a similar situation materialize, they can help offset losses in other parts of the portfolio.  
 
Income and Growth Portfolio
 
The third of quarter 2011 was one of the more volatile in recent memory for income investments, particularly dividend paying stocks. July was generally steady but by early August, European sovereign debt worries were again front page news. Meanwhile, the US Congress went down to the wire before approving an increase in the federal debt ceiling and avoiding a full-scale default. That in turn led to Standard & Poor’s downgrade of Uncle Sam to AA+, with the rating agency declaring the US political system incapable of restoring fiscal sanity.
 
What happened then surprised all but a handful of investors—mainly a historic rally in US Treasury bonds that took the benchmark yield on the 10-year note down to less than 2 percent. Before the downgrade, the consensus forecast was that a cut from AAA would trigger skyrocketing interest rates across the board and a new credit crunch. Instead, rates plunged again, as deeply worried investors around the world poured funds into the only market considered both safe and large enough to accommodate them—U.S. Treasurys.
 
Treasurys’ gain was, of course, very much stocks’ pain. Investors abandoned even the most recession-resistant companies and markets plunged globally. Dividend paying stocks staged a mild rebound in the rest of August before selling again resumed in late September.
 
Thus far in October, the general direction has been up, thanks to better than expected news on the US economy and aggressive action by the European Union to shore up weakened governments, particularly Greece. Many if not most investors, however, remain convinced that it’s only a matter of time before the economy slips into recession and global stock markets suffer a debacle potentially worse than 2008.
 
Our view is that apocalyptic fears are emotional thinking that will be disastrous if acted on. Rather, this is the same market and economy we’ve been in since early 2009. Economic growth is still sluggish and jagged, with some regions prospering and others mired in a slough of despond. Near-term stock prices, meanwhile, are at the mercy of market sentiment. On bad days, when the worry level is high, investors sell everything across the board and buy US Treasurys, and sometimes gold. And when the gloom lifts a bit, they sell Treasurys and buy stocks.
 
In an environment like this one, it’s hard to make a lot of headway betting on market averages. These are times, however, when we believe that dividend-paying stocks thrive provided they’re backed by healthy, growing companies. Investors have to be prepared to ride out the volatility, which can at times be severe. But if they do hold on and companies stay strong, we believe that they’ll continue to build wealth, as well as enjoy a growing stream of dividends.
Another key driver for dividend-paying stocks and other income investments is they’re economy-sensitive, rather than interest rate sensitive as so many erroneously believe. In fact, the average utility, master limited partnership, real estate investment trust, etc. has been moving in the opposite direction from benchmark interest rates for several years now.
Income investments are constantly re-priced according to perceived risks to dividends. When the economic news is good, all rally. But stocks perceived the weakest rally most. Conversely, when the news is bad enough, even the safest water utilities will drop. But the highest yielding fare will fall farthest.
 
Given the extreme investor bearishness we’ve seen in recent months, it’s no great surprise that the perception of risk has risen as well, and appetite for taking risk is at a low ebb. A real credit meltdown in Europe could tighten things up on these shores and crimp growth, possibly pushing the US into an official recession. On the other hand, that’s what’s been priced into the market. And if that doesn’t occur, we can expect a fairly strong rally in coming months.
 
In a weak environment like this one, there are always companies that stumble. That’s why we attach such great importance to keeping tabs on how our companies are doing by monitoring developments and particularly earnings numbers. We’re also generally avoiding companies with significant near-term debt maturities, which could be caught having to refinance during a near-term rate spike.
 
As long as our companies stay healthy and avoid these pitfalls, however, they’ll keep paying us outsized and growing dividends. And just as their stock prices recovered from the 2008 debacle, so will they recover from the losses of summer 2011, or anything further that happens in the fall.
 
Thinking long-term and exercising patience are the keys to weathering even the worst of times. That is how we pledge to handle your Income & Growth account, come what may.
 
Peak Resources and Energy Portfolio
 
We made selective sales during the quarter of energy and mining companies whose production will likely fail to keep pace with rising resource prices.  For companies that cannot expand production adequately to capture more revenues in the face of higher selling prices for resources, there are forgone profits that will be made up elsewhere.  
 
We also sold stocks that were likely to be adversely impacted by an economic contraction and replaced them with more conservative, income-producing pipeline companies.  The stable streams of cash these companies produce make them an attractive investment in times of energy price volatility.
 
We took advantage of heightened investor fears to add to some of our positions in materials. In some cases, the stocks had become so depressed that they were trading as if the materials they mine were selling below the marginal cost of production.  Taking advantage of the pullback in metals prices, we were also able to increase our positions in several smaller companies with impressive growth prospects.  Scarcity and rising demand for materials should prove to be potent growth drivers for these stocks.  
 
Toward the end of quarter, with stocks under persistent pressure, we added zero coupon bonds to the Peak Resources portfolio as well. With the high weighting this portfolio has in materials, the bonds serve as an excellent compliment to our hefty positions in precious metals.