Second Quarter, 2010
July 15, 2020
The recently completed second quarter has been witness to a dramatic rise in stock market uncertainty combined with ongoing challenges to the economic environment worldwide. These factors have caused us to take a more cautious and conservative stance with portfolios, most significantly, a reduction in equity allocations during the quarter. A brief discussion of our observations which have led us to this point of view are presented below.
During the second quarter investment risks associated with over-leveraged euro currency and other industrialized countries were reassessed by investors and a financial panic arose. When crafting an emergency rescue package for Greece and other European countries that might need assistance for bailout purposes, the International Monetary Fund (IMF), the European Central Bank (ECB) and many of the members of European Union set out strict conditions for these countries to gain access to new money during the next two-to-three years. Presently, this matter is far from settled; a great deal of concern exists that public resistance to the extreme cutbacks in income and entitlement programs in the most over-leveraged European countries will eventually undo the resolve of their political leaders, causing financial panic to once again take hold.
It’s not so much the fear that countries like Greece or Portugal will eventually restructure their sovereign debt as it is the fear that liquidity in the banking system of Europe will dry up as the banks which own much of the sovereign debt see the value of their assets plummet, resulting in a second round of financial panic that would spread instantaneously around the world. The rest of the world is ill prepared to deal with a second global financial panic at present. Thus, investment markets remain extremely skittish in the face of continuing global growth in developing nations and healthy corporate profits coupled with very reasonable stock market valuations at home.
Speaking of conditions at home, there is growing evidence that the U.S. recovery, which has been anemic from the start, has now begun to show signs of peaking, with third and fourth quarter GDP growth estimates now being revised downward. Virtually every state in the country is experiencing rising financial stress, necessitating increasing cutbacks in services, rising layoffs and reductions in entitlement payments to their employees and other citizens. The year 2011 is expected to be financially dreadful at the state level as the negative trends of fiscal year 2010 (ending June 30) accelerate in the new year. It would take another stimulus package to help the states in their growing distress. The possibility of such is becoming increasingly unlikely in the face of growing voter backlash over rising deficit spending.
For these principal reasons, as well as other reasons enumerated in the bullet point section above, we began reducing the equity portion of client portfolios early in the second quarter. In addition, in most cases, we have partially hedged our clients’ remaining equity percentage through the purchase of an exchange traded fund which moves in the opposite direction of the S&P 500 Index (ticker: SPXU).
Two of the lessons we have learned during our combined 56 years of portfolio management activities are that 1) investors hate uncertainty, and 2) the pain associated with a dollar of loss is much greater than the pleasure associated with a dollar of gain. The current level of market uncertainty is extraordinary primarily because government actions are now the dominant force in markets, and government leverage in support of unsustainable entitlement promises has brought financial markets to the brink of rebellion throughout most of the developed world. If there were to be a silver lining in all this dreary news, it would be that the recent global stock market decline, brought about by this general feeling of market malaise, has resulted in attractive prices for many high quality companies. Investor reluctance to take the plunge into the stock market is, however, understandable given that a global contagion could occur at any time. When this financial contagion risk has subsided and investment fundamentals reassert themselves we’ll return to a more pro-growth investment posture. Presently, we cannot estimate a time frame for a return to market “normalcy”.
Stocks
The second quarter was particularly harsh on our various investment positions and more than overwhelmed the generally favorable results we experienced during the year’s first quarter. We are adamant believers in investing globally instead of just in the U.S. There will always be quarters in which this approach hurts overall performance relative to the U.S. markets alone, and this was such a quarter. Our holdings in the global mining sector, which is considered a proxy for the global economic recovery theme, were also particularly hard hit during the quarter. No other issues of note have surfaced within the stock portion of client portfolios.
Fixed Income
The bond market has many components and performance among these components can exhibit substantial variance depending upon what is going on in the economy during any particular measurement period. For example, U.S. treasury securities are subject to interest rate risk only. Business or economic risk of default is not a factor in the returns generated from U.S. treasury securities, (at least, not at present), so changes in the economy that don’t impact interest rates have no meaningful effect on treasury prices. During the second quarter, interest rates declined for all treasury securities having maturities of one year or longer. As a result, treasuries experienced strong quarterly returns.
High-yield corporate bonds, on the other hand, were adversely affected by the same negative economic issues which brought the stock market down during the quarter. Client bond portfolios contain investments of this type which declined in price during the quarter causing returns to be lower than that of the broader U.S. bond market. Government guaranteed securities make up a majority of that broader U.S. bond market return presented in the table above. In effect, we can say that we took a bet on a portion of the bond market which continues to benefit from improving corporate financial health. However, that positive trend was overwhelmed by the same fear of contagion which impacted the stock market during the quarter.
Other
The brightest area of portfolio’s return for the three- and six-month period which ended June 30 was the gold market. We have written fairly extensively about gold being a place of refuge against government debasement of our currency and a barometer of confidence in government economic policy. There is no limit to gold’s upside price in any currency. Likewise, if the economic environment improves by virtue of favorable economic growth prospects, the price of gold could plummet.
Sincerely,
Sheffield Investment Management, Inc.