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Second Quarter, 2011

  • Economic and market conditions present a “near perfect” domestic stock market environment.
  • Economic growth in emerging markets remains attractive.
  • Unfortunately political posturing within the U.S., Japan and Western Europe regarding sovereign debt issues has the potential to overwhelm today’s favorable investment environment.
  • Fallout from political instability is bullish for gold, bearish for the dollar, and not otherwise quantifiable for our stock market.  Treasury markets are unconcerned by the stalemate in Washington over deficits.

We have written in prior quarterly letters that today’s domestic economic environment remains close to perfect for further stock market gains.  We base this opinion on the following market factors:

  • extremely low interest rates;
  • very low inflation expectations;
  • the highest corporate profit margins in decades;
  • strong corporate earnings growth;
  • unemployment rates conducive to low labor costs;
  • modest stock market valuations by historic standards;
  • a steeply sloping yield curve, indicating ongoing economic recovery;
  • massive amounts of liquidity seeking safe investment opportunities.

Interfering with this near-perfect stock market environment is a vexing problem of ill-defined dimension, being a failure of leadership among our politicians to curb runaway deficits which have set the country down a path of eventual economic pain. Our quarterly letter isn't a political blog, so we aren't taking sides in the raise taxes/cut entitlements debate. But we are deeply concerned that the failure of our politicians to de-politicize the need for fiscal reform may eventually lead to some level of stock and bond market mayhem. No one, however, is prescient enough to know when, or if, it will be time to throw in the towel, or how serious the consequences will be. For example, threats of U.S. Treasury bond ratings downgrades by the three major bond rating agencies have, to date, had no noticeable impact upon either the unfolding budgetary process or, more tellingly, on the bond market's behavior. The inescapable conclusion is that our stock and bond markets do not care at this time about the budget debate.

For portfolio managers, the most fundamental issue of the day is simply this: will domestic and European political ineptitude trump a continuing global economic recovery or not? Does the loss of a AAA rating on U.S. treasury securities imply, for example, that Boeing will no longer be able to compete against Airbus for the sale of its jets around the world?  Will Apple, Inc. all of a sudden experience a crash in the rate of sales of its highly desired consumer electronic products because U.S. Treasury securities become AA credits?

We could raise questions regarding the degree of linkage between changes in U.S. debt ratings and corporate earnings with almost every stock in our client portfolios.  By the way, we note that Apple hit a new stock market high on July 15, and Boeing has recently issued a new long range global forecast which calls for new aircraft deliveries of 33,500 over the next 20 years, valued in excess of $4 trillion.  We invest in companies which we believe enjoy strong prospects for continued profitability from global trade.  It seems to us that our stock and bond markets may also be focusing more on global trade prospects and less upon the actions of politicians at this time. 

In Europe, all of the flaws associated with the creation of the Euro zone are now in plain sight. Creating an economic union among countries with diverse cultures, no cohesion across work ethics, different country economic situations, productivity rates, entitlement demands, etc. appears to be a formula for eventual failure when economic times become difficult as is the case today.

In the face of today's unprecedented political uncertainties the U.S. stock market has enjoyed a positive return for the year and treasury yields are lower today than they were on January 1st. In fact, the yield of the 10-year treasury is less than 3%, well below the 5.5% yield the notes averaged from 1998 through 2001 when the federal government ran budget surpluses, according to Bloomberg News. We cannot however take today's market calmness as a given going forward, and so we believe that some degree of portfolio defensive posturing activities is the prudent thing to do.

What's up with Greece?

"Anyone who isn't confused really doesn't understand the situation."
Edward R. Murrow, Broadcaster

The financial press and large money managers from around the world are in virtually unanimous agreement that Greece will eventually default, followed by Portugal and Ireland.  The larger concern of course, is how will Europe’s banks survive the domino effect of anticipated defaults?  What will be the contagion affects on U.S. banks which have been major underwriters of credit default swaps against Greece, Ireland and Portugal?

It requires some pretty diligent searching to find even a single article that argues that Greece won't eventually default on its debt. The country is shut out of global financial markets (3-month government yields exceed 10% after recently spiking to 20%) and is thus totally dependent upon the International Monetary Fund (IMF) and the European Central Bank (ECB) for billions of euros of new loans every 3-6 months.

Each time Greece goes before these agencies for new money, additional austerity requirements are imposed upon its Parliament, which in return causes increasingly violent reactions in the streets.  No one disputes that this process is forcing Greece into an ever deepening recession coupled with a rising debt burden.  The medicine continues to make the patient sicker.  It’s incomprehensible to the global financial community to think this strategy will result in anything other than an eventual default on Greece’s sovereign debt.

At the same time, European politicians are stridently adamant that Greece won’t be allowed to default.  A default is simply too frightening for the central bankers to behold, as Portugal and Ireland are waiting and watching monetary events unfold.  Belgium, Spain and Italy face similar consequences from rising deficits, low productivity and negative demographic trends, although their economies are presently somewhat better off than the first group.

We believe Greece and European central bankers will eventually work out some type of default on its debts.  It is also likely that Europe’s bankers, the IMF and the ECB will eventually create a mechanism of some sort that categorizes a Greek default as something other than a default thereby preventing a potential collapse of many major European banks.

Taking all of these matters into consideration convinces us that the Euro zone pot will continue to simmer and occasionally boil over into the global investment markets. And every time the pot starts to boil over, the U.S. securities markets and the dollar become the "go to" safe haven. Thus, it appears some degree of cover is being given to the actions of our politicians at home, and this may be the reason our treasury market appears immune to threats of credit-rating downgrades and risks of default when the government "runs out of money" in August.

Some thoughts on the U.S. deficit ceiling debate

Judging from the precedents set from past budgets negotiated between the White House and the Congress, we are anticipating that any serious entitlement cuts, should they occur at all, will be heavily back loaded towards the end of the decade. This of course means they will probably never be enacted, turning much of the present negotiation into a charade. By 2020-21, the current President will be gone as will many of today's members of Congress, and honoring a decade-earlier budget negotiation will be far down the list of importance by politicians at that later date.

So, we are looking for heavy front-end loaded cuts to spending and immediate elimination of various special interest tax breaks as a sign that the ultimate deal will be a serious one. Absent significant front end pain, we think investment markets will quickly see through all the smoke and mirrors as the politicians try to kick a heavily bruised can a little further down the road.

First Hints of QE3?

Quoting Fed Chairman Bernanke from a recent comment: "The possibility remains that the recent economic weakness may prove more persistent than expected . . . implying a need for additional policy support. We have a number of ways in which we could act to ease financial conditions further."

As has been the case in the first two Quantitative Easing experiments, renewed federal easing should be bullish for the stock market.

Bernanke continues to stress the Fed’s dual mandate of insuring full employment and monetary stability.  Of the two mandates, full employment appears to be Bernanke’s greater immediate concern.  We translate that concern into a view that interest rates should remain fairly steady for the balance of the year and that the stock market should continue to encounter favorable monetary policy actions though the balance of 2011.

Equity Markets

Another interesting quarter has passed. U.S. and global stock markets began the quarter with modest gains but then global and domestic economic indicators began turning downward, creating a growing fear that global growth was slowing, or might even turn negative. Investors became spooked that the much feared "double-dip" recession was developing. In its presently frail state of recovery, with few good options available to the Federal Reserve or the Treasury to stimulate growth further, a relapse into recession would indeed be very serious. Just prior to the quarter's end however, certain economic indicators revealed that the recovery was continuing, and now the consensus view is that the U.S., Japan and emerging market economies are looking up for the balance of the year. As discussed elsewhere in this letter, peripheral European Union countries are conspicuously absent from the present improving outlook and instead offer the potential for great mischief in global financial markets.

The broad U.S. stock markets experienced a breakeven second quarter while the global stock market index gained approximately 1%. Political concerns both at home and in Europe caused us to engage in various portfolio hedging strategies during the quarter, and since markets did not crash, our hedging activities acted as somewhat of a drag on client portfolio performance.

Our energy stocks had a particularly weak performance during the quarter as the price of oil pulled back from a high of $114 per barrel at the end of April to a low of $90 per barrel towards the end of June. We continue to embrace the Peak Oil theory and thus we maintain significant exposure to oil market environments.

Fixed Income

Our various individual corporate bond holdings experienced uneventful performance during the quarter, generating a total return across all client accounts of approximately 1%.  Considering the level of investor angst across the country these days, uneventful performance is a pleasant experience!  Much to the great surprise of almost everyone, Treasury yields experienced a modest decline during the quarter.  Thus, for the time being at least, the bond market continues to tell the world that the debt ceiling debate and rising government deficits are a sideshow and of no concern for yet another quarter.

Here again, concerns on our part for possible surges in interest rates precipitated by possible inflation spikes caused us to occasionally hedge client bond portfolios.  In spite of intra-quarter volatility, our hedging activities represented a modest drag against our bond market performance.

Municipal bonds experienced, on average, favorable returns. Finally, the strongest performing fixed income investments during the quarter and the first half were our foreign bonds and/or foreign bond funds, many of which benefitted from rising local currencies during the quarter.


The second quarter saw a decline in the value of most commodities (except gold) in sympathy with concerns that the world might be falling back into a recession.  These fears eased towards the end of the quarter, but insufficient time remained for prices to recover prior to June 30.  The broad agricultural commodities indices fell by approximately 8.8% during the second quarter, dragging down the six month return of our broad commodity index benchmark to -7.3%.  With the world experiencing growing shortages of a variety of basic food staples, it is likely agricultural commodities will resume their upward trend in the near future.


In this period of continuing cheap money and major political uncertainty, gold continues to shine as a safe haven. Client gold holdings increased in value by approximately 4% during this most recent three month period, and by 5.4% during the first half.

Sheffield Investment Management, Inc.


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