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The Summer Doldrums July 13, 2011
As we begin the third quarter global economies are not off to a good start. U.S. economic data reports during the first half were mostly lower than was expected. Economic activity has been sluggish with little progress seen in housing, employment and manufacturing activity. The position we take on the prevailing gloomy outlook is that it was most likely impacted by the Japanese earthquake and tsunami that upset global supply chains, and higher oil prices from the rumblings in the oil-rich Arab world. The outlook is more encouraging for the economy in the second half of this year. We think the positives continue to outweigh the negatives with low interest rates, continued monetary accommodation and not very serious threats of either inflation or deflation.
Not surprisingly, markets are nervous. Nothing much has actually changed this year. The obvious headlines continue to dominate investor anxiety: jobs, housing, congressional gridlock over the debt limit, Fed policy, and concern over the consequences for the European banking system if losses have to be taken from contagion of sovereign debt problems. What is more important but not receiving much attention is that the U.S. economy has moved from recession to recovery to expansion and profits are reaching a new high. Perhaps things are not as bad as they are headlined in the media and we might see a reaccelerating of growth in the coming months.
Market sentiment as measured by various indicators has moved away from the extreme bullishness of October 2007 and the extreme bearishness of March 2009 and is now in neutral territory. We view the extremes as contrary indicators and tend to be encouraged when Wall Street strategists recommend under weighting equities.
In addition to differing economic views and risk probability assessments, there is also a big debate about valuations and the return prospects for stocks, bonds, real estate or alternative investments. After the partial recovery of the capital losses experienced in the 2007-2009 financial and credit crisis, investors have an understandable difficulty properly evaluating the risks they are willing and able to take.
No one would realistically say that we are facing the likelihood of a rosy scenario where all asset classes are likely to reward investors with returns commensurate with the risks to be assumed. There are those who say that market prices reflect reasonable estimates of the intrinsic values of bonds and stocks, but experience shows that the market often misprices the risks and the probable returns.
Experience teaches us that the safest time to invest is when an investment is out of favor and can be bought at a price that is less than its intrinsic value. The challenge comes in having an objective, non-emotional methodology of assessing the intrinsic value that will give the investor the conviction to stay the course.
Since the start of 2009, 86% of mutual fund inflows have gone into bond funds. Long-term investors including individuals, insurance companies and pension funds are still, if anything, underweight equities. We believe that the much-discussed risks have held down equity prices and that they offer attractive opportunities for investment and, at this stage of the business cycle, they should represent the core of an investor’s asset allocation. Whatever the investor’s risk tolerance, we seek a margin of safety when the portfolio is structured based on the criteria of quality, sustainability of earnings and reasonable valuations.
All of us at Whitnell trust that you and your families will find much to appreciate and enjoy during the rest of the summer.