A great novel opens with a now well worn phrase about the present day being both the best and worst of times. So far in 2010 there has been good news as well as bad on the economic front, but when combined with a seemingly escalating deterioration in the relations between nations and rising uncertainty on both the political and economic fronts, the financial markets closed with a rush away from risk in the second quarter. Although we believed a correction could easily occur, U.S. equity prices lost about 10-12% over just the last 90 days and, though performing far better than many foreign indexes, finished the first half of the year at or near their lows. Nearly all world stock markets suffered some sort of dramatic pullback during the last 3 months as the largely unexpected surge from 2009 lows ran out of steam. We are, however, pleased with the performance of our strategies and most of our equity composites outperformed or matched their benchmarks during this very difficult quarter.

With the flight to safety gaining speed as pessimism grew, it was a good period for U.S. Treasury bonds and gold.  It is worth noting however, that the rise in the price of gold in virtually all currencies reflects a rising fear regarding the debasement of the fiat money printed by central banks everywhere and the concomitant rise in future price inflation pressures.  So a decline in interest rates and rise in T-bond prices makes for an interesting odd couple given the simultaneous rise in the price of gold and T-bonds, as T-bonds reflect growing fears of the risk of deflation.  We fear the gold markets are more likely to be right on this one.

It does not seem to us to be fruitful to detail the plethora of real or feared problems. Many of the issues which have recently roiled the markets have been beaten to a pulp in the vast worldwide 24/7 information stream readily available to all. Few expected the extent of the Euroland crisis, particularly given that Greece represents only about 2% of the EU’s GDP, but everyone surely has a reason to believe it is the beginning of a bigger crisis. Is China’s growth going to slow? Has the domestic economic recovery entered into the dreaded double dip? How will all this reform legislation affect health care, financial services, energy companies? Where are the new jobs? Is the mortgage default wave over? Who’s on first…Obama or Sarah? All valid concerns with no clear consensus but much fear and uncertainty and the markets are reacting accordingly. Certainly the ecological disaster in the Gulf of Mexico has served to exacerbate the climate of frustration and anger directed at the inability of regulators to actually regulate successfully. As we anticipated, the election campaigns in the U.S. in 2010 so far are not soothing the situation.

We continue to be more optimistic than the consensus for economic growth into 2011 and a better earnings environment for corporations in the intermediate term.  Now that markets have discounted a continued worsening of the environment, we believe valuations of many stocks have become quite attractive. Since we manage funds for long term investing clients our challenge is to continue to apply our portfolio construction discipline within the proper universe of undervalued securities which we believe we can accomplish even within a less than “normal” economic environment. Among the positive factors being largely overlooked are the strength in the domestic manufacturing sector; the vast amount of cash which has been added to corporate balance sheets; the improvement in profit margins due to aggressive cost cutting; the switch from inventory liquidation to accumulation; a possible revival of trade agreement negotiations that could boost the growth in international trade, and the improvement in hiring, albeit a volatile monthly data series (with reports on new employment from the employer survey improving more slowly than the household survey, which has shown a faster gain in new jobs), which we believe mask a trend toward rehiring of workers in several sectors such as retail, health care and machinery.

We have adjusted our economic outcome probabilities to allow for higher possibilities of both stagflation and recession but the overall results from our analysis continue to favor the ongoing recovery well into next year and the likelihood of 3-4% growth in GDP as well as higher earnings for the S&P 500. This so far remains a sub par recovery and we have a way to go before we return to historic levels but pessimism has driven equity prices to levels where new opportunities present themselves. There are going to be dramatic structural changes in the domestic economy and some industries will continue to face substantial headwinds. At the same time innovation remains the hallmark of our system which adds vitality and opportunity for new investment. Hence the best of times for some; the worst for others but the closing of the gap through further opportunities for advancement of the standard of living over the longer term.