Oil and fear everywhere!  What is an investor to do? 

It’s amazing how many significant events can be squeezed into a brief 90-day window. It’s also amazing to see how quickly investor sentiment can change. As the second quarter started the market was in the midst of a powerful recovery, up about 70% from the lows reached in March, 2009, and investors’ sentiment was soaring along with their portfolios. Only 20 days into a new quarter the Deepwater Horizon drilling rig exploded taking 11 souls and the near-term fate of the coastal states’ regional economies with it to the bottom of the Gulf of Mexico.  It’s as if the crisis in the Gulf was an omen of things to come. The market would turn down 6 days later as the debt crisis in Europe escalated and one statistic after another re-awakened fear of an economic slowdown, or worse, a double-dip recession. 

If anything illustrates our aversion to company-specific risk, it is British Petroleum. BP is one of the largest oil & gas companies in the world, with 80,000 employees and operations in 80 countries. Companies the size of BP convey a certain sense of stability. Yet BP’s stock has lost fully 2/3 of its value from its peak in November, 2007, vaporizing over $150 billion of investor wealth. Some analysts are even wondering if the company will survive as its liabilities increase exponentially with each barrel of crude that gushes into the formerly pristine waters of the Gulf. 

Our clients should know where we stand on this issue. We do not believe it is necessary to assume the risk inherent in concentrated individual stock positions for a variety of reasons, the most significant being that it is avoidable. Free-market capitalism is the road to prosperity. However, to get there you must do a number of things right. One is proper diversification to avoid the fate of over-concentrating in the next BP.  Another is to remain calm, unemotional and committed. Markets go up and down and no one likes to see their accounts drop in value. However, with the proper asset allocation, you should be able to avoid the temptation to sell when stocks are down. If you are overly concerned about your portfolio’s value that could be a sign that your risk tolerance may not be as high as you previously thought. If so, now is a good time to contact us for a review of your current situation. 

Economic Summary 

The economy is not nearly as robust as many had hoped. The engine of our economy is the U.S. consumer, whose spending comprises about 2/3 of our GDP. As the consumer goes, so goes the economy. The problem with the consumer is that over 15 million are still unemployed and those that are working are not very confident about making major purchases. 

In spite of record low mortgage rates, new home sales fell 33% in May to an annual rate of 300,000, which is the lowest number since recording began in 1968. This is partly due to the expiration of the federal tax credit but also due to economic conditions and consumer confidence. Auto sales are down and retail sales dropped in June for the first time in eight months.   

Our economic recovery, which was looking promising, is now expected to slow down in the second half of 2010 as employment fell by 125,000 in June (the first drop this year). Companies added 83,000 jobs but those gains were offset by the elimination of 225,000 census workers. The unemployment rate for June actually improved from 9.7% to 9.5%, but this was due to over 650,000 people exiting the work force after giving up looking for work. Final first quarter GDP came in at an annual rate of 2.77% compared to a 5.6% rate in the fourth quarter of 2009. 

One bright spot continues to be manufacturing as activity expanded in June for the 11th consecutive month. However, the ISM PMI index dropped to 56.2 from 59.7 in June. This is not unusual as companies cut back on new orders as their shelves become replenished. More revealing was the ISM Service Sector index for June which dropped to 53.8 from 55.4 in May. Since service industries make up about 90% of U.S. employment, this index is a better gauge of our overall economic strength. Any number above 50 in the ISM surveys is considered to be expansionary. 

Market Summary 

The initial catalyst for the recent sell-off on in stocks was the April 27th downgrade of Greece’s debt, followed soon after by Spain and Portugal. Large U.S. companies (S&P 500 Index) fell -11.43% for the quarter and are now down -6.65% for the year. Smaller companies (S&P 600 Index) fared better with losses for the 2nd quarter and year-to-date of -8.73% and -0.88%, respectively. International stocks (MS EAFE Index) dropped -13.97% and -13.23% during the same periods. 

Bonds posted gains for the quarter and year as interest rates continued a downward trend due to a slowing recovery and Federal Reserve monetary policy of easy money to help prop up the economy. Government bonds outperformed corporate bonds due to a fear-induced flight to quality and longer maturities outpaced shorter ones. The resulting rates are very low, with two-year U.S. Treasuries yielding 0.60%, five-year Treasuries at 1.75% and ten-year Treasuries only 2.94%.   

What’s next? 

There is certainly a lot to be concerned about these days - increasing U.S. debt and deficits, higher taxes, a European sovereign debt crisis, war in Iraq and Afghanistan, a slowing economy and the oil spill in the Gulf, just to name a few. Regarding U.S. fiscal policy, the lines are clearly drawn over the preferred strategies to economic recovery and the success of the two huge stimulus bills (first Bush, then Obama). Although one can argue that without government stimulus the economy would be in worse shape, another argument can be made that each dollar given to someone in need has to be either taken from someone producing it (via increased taxes) or borrowed (via increased debt) resulting in longer-term problems. The Keynesians believe increased government involvement is the solution to what ails us whereas the free-marketers argue lower taxes and less government intervention will unleash a floodgate of growth and prosperity. 

Will the broader “service sector” economy take hold of the recovery and continue the expansion already evidenced in manufacturing? It’s too early to say. With few signs of inflation, the Federal Reserve is keeping short-term rates at or near zero in an attempt to spur economic activity. This may be great for borrowers, but it’s not too good for investors who rely on interest income. Increasing debt levels and an expanding economy, Taylor Capital Management believes, will result in eventually higher interest rates. As such, our fixed-income policy has been to focus mostly on short and intermediate term maturities, preferring to preserve capital for redeployment at anticipated higher rates down the road.    

The European sovereign debt crisis is a result of rising government debt levels and continued deficits. The G-20 met in Toronto in late June where U.S. and European leaders agreed on a balance of austerity measures. We shall see if they actually walk the walk, not just talk the talk. As stated earlier, we believe free-market capitalism is the road to prosperity. It takes time and there will be many bumps and bruises along the way. There is no perfect investment or investment strategy. Anyone who abandons equities altogether and commits totally to bonds at these record low interest rates will almost certainly see negative real returns (after taxes and inflation) over the next market cycle. That strategy simply replaces volatility risk with the risk of lost purchasing power. 

Success in investing is the result of a lot of hard work over a long period of time. It requires a certain emotional calmness and commitment to your strategy. The main thing is to have a plan that considers what it will take to achieve your life goals within your ability to bear risk and periodically re-assess your position, making appropriate adjustments as your circumstances change. It also pays to have a professional partner on-board with you to help you keep a proper perspective.

Best- Sam