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A Market Correction     August 19, 2011

Investor confidence has been shaken by four events over the last month that put financial markets in turmoil resulting in wild equity gyrations for stocks and bonds. On July 21st the European sovereign debt crisis flared up again and, in response, the European Central Bank drew upon the European Financial Stability Facility to do a second Greek bailout to avoid default. Further, faced with soaring interest rates, the ECB bought $32 billion of bonds to prop up markets in Italy and Spain. Worries about contagion for sovereign debt and banks spooked investors and traders and triggered a decline in global markets

In The U.S. Congress and the administration engaged in last-minute wrangling to cut a deal to raise the debt ceiling to avoid a threatened default. Standard & Poor’s acted to cut the rating of U.S. Treasury debt below AAA for the first time in history. On August 9 the Federal Reserve added to the nervousness by announcing that slower economic conditions warranted keeping interest rates low until mid-2013.

Global markets reacted violently to these developments in two downdrafts that left the S&P 500 down 17% from the July high in correction territory with some asset classes having declined more than 20%. The S&P 500 is now down 9% for the year.

Investors ignored the S&P downgrading and sought protection from market volatility by aggressively buying U.S. bonds in an apparent flight to safety. Buying demand has pushed prices up and yields down. The yield on the 10-year U.S. Treasury bond is now 2.10% and the 2-year bond is selling to yield just 0.20%.

In this anxious environment investors are trying to assess what the impact these developments may have on the global economy and financial markets. The reported economic data for the second quarter supports our perspective that the economy is still growing, but at a slower pace. The prospect for earnings is encouraging with current bottom-up estimates for operating earnings of $106 for the S&P Index for the next 12 months.

With the stock prices down on average by 17% from the July high, similar to last year’s decline, we’re been having a market correction which historically happens every year or so. No one ever knows what the market will do next, but Whitnell’s equity approach of investing in quality companies with the potential of showing sustainable earnings growth allows us the ability to look beyond the near-term nervousness in the market.

The odds of a renewed recession have increased but still seem low. GDP is expanding and should pick up in the second half. Job growth is anemic but improving. Earnings are setting new record highs as corporations are benefitting from increased productivity and high margins and balance sheets are strong. Over the short-run, emotions prevail, but over the long-run corporate fundamentals determine the course of stock prices.

Where do investors go from here? It’s an ambiguous environment and markets are volatile, but the S&P 500 is now selling at 11 times expected earnings over the next twelve months, well below the historical average of 16.4. With the drop in bond yields and the sell-off in common stocks around the world, we feel more than ever that equity investments offer a very attractive return potential for investors. Shorter duration fixed income securities may be held for diversification from the volatility of core equity positions, though the yields are historically low.

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