A quarter in which global financial indicators began to turn southward ended with a roaring finish on June 29, 2012. As with last year a leading cause for equity market concern was the confused and deteriorating state of balance sheets in Europe. Leading banks in the southern tier as well as governments appeared close to collapse in a scenario not unlike that which dominated the U.S. financial industry from 2007 until 2009. I’m currently reading Andrew Ross Sorkin’s Too Big to Fail, a reminder of how very human the people are making decisions that will affect the well being of billions of people across the globe. In the case of the USA, then Treasury Secretary Hank Paulson and his brilliant team of dedicated public servants shine through for knocking heads together to avoid a domino effect as Lehman Brothers went through bankruptcy. Fed Chairman Ben Bernanke and then New York Fed President Timothy Geithner also did yeoman work.
Europe, however, has no clear central banking and monetary authority. In a sense, they have yet to find their Alexander Hamilton, another brilliant American (actually born in the West Indies) who, as George Washington’s first Treasury Secretary, started the nation on a sound financial footing. He did far more: before becoming Treasury Secretary under the new U.S. Constitution – he was instrumental in getting that Constitution approved by fractious states battling one another for power. Under the Articles of Confederation, the U.S. looked more like Europe today, lacking a strong central government or monetary authority. The Constitution changed that. While opposition to a big central government runs deep in the psyche of many Americans, going back to Thomas Jefferson who detested Hamilton, a strong Federal system is at its best when financial crises challenge the well being of a nation. We are seeing the lack of clear central power negatively effect Europe at this very moment.
The cause for the markets’ rally on Friday June 29 was the apparent willingness by Germany to allow European central funding mechanisms to lend money to ailing banks, especially this in Spain and Italy, backed jointly by all Euro Zone members. The only member that lends credibility to this backing, mind you, is Germany. So Angela Merkel’s concession on this issue was very positive. Ms. Merkel is walking a fine line however, because apparently the average German voter does not feel the pain of its European neighbors. In fact, it is probably safe to say that hard working Germans have little sympathy for their southern neighbors who retire at age 55 and sit in cafes until midnight sipping wine and espresso.
I’m skeptical of the quarter end rally. The Chicago Purchasing Manager’s Index a leading indicator of US economic activity, has established a downtrend over the past three months. This often presages a recession by about 6 to 8 months. As communicated here and to clients, we spent much of the previous quarter selling off stocks we found particularly weak via technical signals. Cash was also raised involuntarily as some of our quality – but-high yielding bond holdings were called or retired by their issuers. We’ve allowed cash to build up in money market funds, awaiting an opportunity to buy cheaply as the market falls.
The one common stock we bought for a good many accounts was Apple. I hated the idea of chasing this wildly popular company higher in the frenzy that drove it up some 30% during the first quarter. Further, I’ve been skeptical about the sustainability of the company’s “moat” now that Steve Jobs no longer inspires the company. I’ve been trying to get a read on CEO Tim Cook, since after all, no one will ever replace Steve Jobs in the idea department. But as Apple shares became cheaper during the past few weeks and as Mr. Cook gives evidence of some rather sensible business acumen, I decided to tiptoe back in, buying about a 3% position for select clients who can handle volatility.
Otherwise, plummeting energy prices on the world market are a mixed blessing for our clients. We entered the quarter heavily committed to energy related issues from pipelines to drilling rigs to the largest multinational energy company, Exxon-Mobil. All were negatively impacted by the unexpected (by me) downturn in price, but my faith in this sector is unwavering. The bright future for U.S. energy independence is, I believe, going to continue to generate generous and growing cash flows to pipeline operators over the long haul. Meanwhile Exxon generated a reliable quarterly dividend, and has actually held up much better than would be expected. Certainly there will be periodic corrections, we’ve seen them before, but there does not appear to be anything fundamentally worrisome for people with an investing horizon of three years or more. What I do know for sure is that falling oil prices which follow record low natural gas levels in North America, will act like a tax cut on the consumer, leaving more money in her pocket to spend. This holds hope of ameliorating the current slowdown.
Investor buying activity was certainly evident in the fixed income sector, especially among our favorite preferred stocks. People are chasing yield, as interest earnings on CD’s, bonds and money funds remain at record lows. This has been great news for our preferred holdings, which represent some 8 to 12% of client portfolios. However, in trying to remain disciplined, we are finding few quality preferrers trading near or below their par or call price.
A review of select client accounts suggests a first time ever phenomena for Trusted Financial: no clear pattern of gains or losses. Each client group is managed according to our perception of individual needs and objectives. Still, there is usually a similar trend shared by most clients, quarter-to-quarter. Not so in the second quarter of 2012! Some folks lost money, some made money, but in each case the change from March 31 was small. There was a slight bias downward, but initial indications are that “balanced value” portfolios gave back no more than 1%, while some folks came out ahead. This compares with indexes of domestic stocks down about 4.5%, international stocks down about 6.5% and bonds up about 2%. Of particular interest, the category “balanced” mutual funds, according to Morningstar, recorded a loss of 2.25% for the quarter and are up only .45% over the past 12 months. Our “balanced/value” client accounts, as stated, were essentially unchanged for the quarter but up mid single digits for the past 12 months. So, I’m feeling pretty good about the results.
Looking ahead, there remains too many ominous variables at work globally to entice me into a larger equity exposure, unless a “steal” becomes available. I try to remain true to the value investing principals of my figurative mentors, Benjamin Graham and Warren Buffet. In equities, we try to own businesses we can understand, with able and committed management that have high returns on equity and a “moat” that appears defensible for at least 5 years. In fixed income, the proposition is simple: own income producing securities from quality issuers whose cash flow stream is sustainable, without relying on the future direction of interest rates to produce a positive return. This approach has been working for some ten years for our clients and for decades for my mentors.
Gary E Miller, CFP
