Commentary Archives - Investment Management of Virginia

3rd Quarter 2011

Summary:The Paradox of Thrift

Money appears to be accumulating selectively throughout the financial system. Savings and checking deposits are surging at mid-teens growth rates, and the broad money growth aggregate (MZM) is expanding at a high-teens rate, with the aggregate balance now surpassing $10.5 trillion. Corporations appear to be strengthening their balance sheets as well. Similarly, refinancing by individuals accelerated during the last quarter. Together, these data reflect the ongoing deleveraging process that originated in 2007 and the “paradox of thrift” – as cash piles up throughout the financial system, receiving negative real rates of return, it is not being reinvested in ways that promote economic growth and job creation.

Recent equity market “bullishness” registered only 25%, while “bearishness” reflected 48% – quite a change versus earlier readings of 63% and 16%, respectively. Of course, sentiment is viewed as a contrary indicator. Perhaps the most dramatic swing can be seen in the S&P 100 volatility index (VXO), which has surged to an extreme level, matched only three other times over the last twenty-five years. Ultimately, each of these periods/readings reflected attractive equity market values and presaged attractive future market returns. However, in each case, the market’s advance was slow to materialize.

Fresh economic results offer glimmers of hope that the current fear and loathing in the markets are overblown. Valuations screen attractively, but improvements in equity prices depend largely on earnings growth. Only a decade ago, exuberant investors, who had high expectations of the “New Paradigm”, seemed happy to pay 30x equity market earnings. Since then, earnings have doubled, dividends have increased, and the market P/E ratio is now only 12x (based on trailing earnings).

Download the full Investment Management of Virginia Third Quarter Commentary in PDF.

2nd Quarter 2011

Summary: Navigating The Unexpected

A number of unexpected, exogenous shocks arose throughout the first half of 2011 to temper expectations and actual growth trends. On the whole, U.S. economic growth trends remain well below historical norms, particularly in housing and employment, and have been further challenged by the global disruptions of early 2011. Nevertheless, most forecasters anticipate GDP growth’s accelerating into the mid-2% range in the back half of the year.

Financial conditions remain extraordinarily accommodative with historically low borrowing rates available to corporations and individuals. Access to credit among individual consumers and small businesses, however, remains more challenging. Nonetheless, household balance sheets appear to be mending; consumer credit quality scores have improved; and, in May, consumer borrowing increased for the eighth consecutive month. As long as economic growth remains sub-par and unemployment remains high, the Fed likely will continue trying to prime the pump with an accommodative policy, based upon artificially low interest rates.

With both expected trends and unexpected events constraining global macro-economic growth, economies generally appear to be addressing numerous challenges and stumbling forward. While the stepping-stones toward future growth may appear less neatly arrayed, generally sound management and improving financial strength of corporations likely continued to drive profits to higher levels, albeit at a decelerating rate of growth. Assuming that recent economic trends and anecdotal data remain supportive, then earnings growth should be able to support current market valuations and, furthermore, drive underlying intrinsic values higher into future quarters.

Download the full Investment Management of Virginia Second Quarter Commentary in PDF.

1st Quarter 2011

Summary: Third Year Challenges

Most measures indicate that the U.S. economy is now entering the third year of its advance, perhaps slowing a bit from the recent trend. Equity markets, long seen as a leading indicator of economic activity, generally have moved up, albeit in fits and starts, ahead of the pace of economic expansion. Most economists anticipate that U.S. growth will continue but decelerate into the 2% range by mid-2011.

Thus far, the monetary stimulus by the Federal Reserve appears to be achieving its intended results. Equity markets have risen, corporate profits have expanded, business and consumer confidence have moved higher, domestic consumption has improved, capital spending has accelerated, and the unemployment rate has declined. Another intended consequence of quantitative easing was higher inflation. FOMC members are mindful, however, that commodity prices have risen and that global turmoil has increased, driving energy prices higher.
Lending conditions appear attractive for both individuals and institutions. Demand for commercial and industrial loans is rising, and large corporations appear to be returning to the commercial paper market. Consumer credit is also expanding, albeit at a more measured pace and with several, unique distinctions.
Third-year recovery years often are challenging for the stock market. During the current stage of economic recoveries, market emphasis generally shifts away from the beneficiaries of rapid economic repair, rotating toward businesses that historically have delivered more consistent business performance. Against this backdrop, we believe equities remain attractive for the long-term, especially when comparing total return potential with that of fixed income alternatives. We do, however, anticipate greater volatility

Download the full Investment Management of Virginia First Quarter Commentary in PDF.

4th Quarter 2010

Summary: In Search of Goldilocks

U.S. economic growth has turned positive, but it remains below trend and reflects high unemployment, portending low interest rates for an extended period. Taking from its playbook for 1958, the last time the U.S. faced serious deflationary pressures, the Federal Reserve has instituted aggressive policies that target economic stimulus and a core inflation rate of 1.5%-2.0%.

The initial stages of the recovery were largely attributable to an inventory rebuilding cycle, uncharacteristically driven by manufacturing and export orders. More recently, domestic economic growth has accelerated, perhaps moving from recovery into modest expansion.
Financial lending conditions remain accommodative for corporations. Even with a sudden upward shift in the yield curve, rates remain below the highs of early 2010. More significantly, as Treasury rates increased, trading among lower quality corporate bonds improved, and spreads versus Treasuries declined, all indicating that an appetite for risk had returned. The combination of a steepening yield curve, declining Treasury spreads, and an increased risk appetite, serve to suggest that Fed policy is working.
Current prices for the various S&P indices appear fairly valued. The price-to-earnings multiple for the S&P 500 Index is near its long-term average. Earnings have advanced nicely from the low of 2009, and the S&P 500 Index earnings estimates are expected to rise 14% in 2011. Continued strength in earnings should provide the markets with longer-term strength and support. Moreover, equities appear attractive versus other asset classes, e.g., fixed income.

Download the full Investment Management of Virginia Fourth Quarter Commentary in PDF.

3rd Quarter 2010

Summary: Bumping Along The Bottom

Household deleveraging has led to increased savings and lower consumption. These responses, though rational long-term objectives, are harmful in the short-term, as one person’s spending is (was) another’s income. As sparse sales have created an abundance of capacity, hiring trends have suffered, and disinflationary, if not deflationary, pressures have arisen.
Current financial conditions are extremely accommodative for major corporations. However, for many small businesses, which traditionally borrow from local and regional banks, liquidity remains a challenge.
In the most recently reported data by the Fed, both M2 and MZM (Money of Zero Maturity), which are monetary aggregates measuring U.S. money supply, indicate a surge in growth dating back to April of this year. As of September 30, 2010, U.S. money in circulation with no maturity (MZM) has risen to $9.6 trillion.
It has been said that the Fed does not create jobs, earnings do. So far, corporate earnings have been advancing, and as of now, indications point to a continuation of rising earnings. The Fed, concerned about a weaker than normal recovery and the prospects of deflation, appears poised for continued accommodation for an extended period.
The economic recovery seems to be “bumping along the bottom” with sub-par growth. Some short-term market indicators suggest high odds for a rotation or pause, but longer-term indicators and valuation metrics remain supportive.

Download the full Investment Management of Virginia Third Quarter Commentary in PDF.

2nd Quarter 2010

Summary: The Good, the Bad, and the Ugly.

The reactions to economic and market news have become somewhat ugly over the past couple of months, as some market participants now are discounting high odds for a “double dip” recession. The good news is that positive economic growth, albeit subdued growth with a slowing trajectory in the second half of 2010, appears to remain on track. Presently, we remain in the camp that anticipates a muted, sub-par economic recovery.
The character of this economic recovery is significantly different from past recoveries. Autos, housing, and retail normally lead a recovery, backed by strong, pent-up, domestic demand. Currently, however, U.S. economic growth is being driven broadly by manufacturing-led and export-oriented trends with a below-average revival in domestic final sales.
For the most part, financial conditions remain accommodative for global corporations. Ironically, events in Europe have produced a “flight to quality” in both the U.S. Treasury and corporate bond markets. Since early April, the yield on the 10-year U.S. Treasury has declined to 2.93%. Domestic, investment grade, corporate bond yields have followed suit, lowering the cost-of-capital for corporations.
On a price-to-earnings basis, we believe that equity valuations may represent among the best opportunities in twenty years, excluding the market bottom of 2009. The trailing twelve-month earnings yield (earnings/price) on the S&P 500 Index is 7%. When compared to the 10-year U.S. Treasury rate of 2.93%, equities appear to represent the best comparative value in more than thirty years. The key determinant, however, will be earnings growth, which needs to continue for these valuation levels to be proven “attractive.”

Download the full Investment Management of Virginia Second Quarter Commentary in PDF.

1st Quarter 2010

Summary: Climbing The Wall.

The U.S. economy has delivered two consecutive quarters of positive Real GDP growth. Robust export orders and inventory restocking have driven this growth. Still, various concerns persist, and a “Wall of Worry” remains in place. Nevertheless, growth is expected to continue, albeit at a below trend pace.

Financial conditions are accommodative, as indicated by spreads in the credit markets. The commercial paper market has shown signs of improved health, and even subprime mortgage debt instruments have exhibited improved pricing strength. However, most of the Federal Reserve’s stimulus programs have now come to an end, and the Fed is weighing various options for withdrawing excess stimulus. Trends related to these measures would imply that the Fed has good reasons for withdrawing stimulus at a measured pace.

Technical and sentiment indicators reflect short-term “overbought” conditions within the equity markets. Longer-term measures remain constructive. Ultimately, the current upward bias could prevail as long as improving economic and corporate growth, rising earnings, and rising earnings estimates continue. Thus far, the corporate profits/earnings recovery has been progressing at a healthy trajectory.

We view current economic/market conditions as generally positive, and we remain optimistic. Real growth has returned to the economy, and corporate sales and earnings continue to improve. The steepening of the U.S. Treasury yield curve continues to signal stronger growth, and assuming modest inflation in the future, conditions may remain favorable. A hand-off of the Fed’s monetary support to self-sustaining, financial intermediaries would be the next step toward health in the economy and markets.

Download the full Investment Management of Virginia First Quarter Commentary in PDF.

4rd Quarter 2009

Summary: Slow Motion Economic Recovery.

Throughout the year, economic activity transitioned from Real GDP of –5.4%, the worst since 1982, to positive growth of 2.8% in thethird quarter. Stronger growth is expected when fourth quarter figures are reported. At some point during this cycle, governmentstimulus should be supplanted by a self-sustaining economy.

Since 2007, the Fed’s balance sheet has expanded to over $2.2 trillion. Federal policy makers agree that indications of economic growthstrengthened in the fourth quarter, and that downside risks to the outlook for growth diminished. Consequently, it appears that the Fed isstrategically laying the foundation for withdrawing stimulus money before it triggers inflation. Interest rates should rise marginally byyear-end. However, unemployment is expected to remain elevated, presenting a difficult challenge for policy makers.

If the economy can continue to transition to self-sustaining growth, as we expect, equity market returns could be favorable. Thereobviously are a wide variety of serious economic, fiscal, and geopolitical challenges, but as long as these issues are getting properattention from corporate managements, government authorities, and market participants, asset prices may be able to continue to recoverfrom the depths of 2008 and early 2009.

History indicates that the tenor and character of the markets change near this stage of the economic and market recovery cycle. Typically,the early phase of a market recovery is characterized by stunning stock appreciation from low quality companies. Assuming that currentconditions and trends remain favorable, and that earnings estimates actually materialize, the environment for equity holdings appears toremain favorable, especially in the absence of compelling alternative investment opportunities.

Download the full Investment Management of Virginia Fourth Quarter Commentary in PDF.

3rd Quarter 2009

Summary: Slow Motion Economic Recovery.

Given its strong third quarter performance, the stock market has started to discount an economic recovery. While we believe that aneconomic recovery will occur, the rebound likely will be sub-par because the economy faces multiple structural, fundamental and policyheadwinds. However, that profile is not necessarily bad for the equity markets. In fact, we may be in a situation similar to the early1990’s, which was characterized by slow but sustainable growth, low inflation, and healthy equity market appreciation.

Our independent evaluation of 121 economic indicators reveals that 54% of the measures we track are demonstrating improvements ineconomic activity, a marked increase since earlier in the year and a positive for the equity markets. Credit markets also have normalized.Low interest rates for good credits, as well as the steepening yield curve, indicate that credit markets once again are allowing companiesto access capital.

Technical market indicators suggest that the market is overbought in the near-term. However, the trend clearly is upwardly sloping fornow. We expect a “rotational correction” in the markets as long as the underlying fundamentals are progressing positively. In addition,we believe that investor sentiment is neither overly bullish nor overly bearish at these levels.

Finally, valuation and earnings trends remain favorable for equity markets. Earnings estimates for 2010 have turned higher afterdeclining for the past six quarters. Based on valuation methodologies other than price/earnings, the markets still appear to offer some ofthe lowest valuations since the mid 1990s.

Download the full Investment Management of Virginia Third Quarter Commentary in PDF.

2nd Quarter 2009

Summary: The first steps to recovery appear in place.

Despite the dramatic decline in GDP during the first half of the year, the economy did stabilize during the second quarter. Layoffs decreased, motor vehicle sales stopped falling, factory orders increased, and existing home sales improved. While “less bad” is not “good,” it is the first step towards a broader economic recovery. We are optimistic that the economy will rebound in the second half as it enters an inventory restocking cycle.

Credit markets have yet to normalize completely, but most indications suggest that they have returned to pre-crisis levels. Low interest rates for good credits, as well as the steepening yield curve, indicate that credit markets are once again allowing companies to access capital. These signals typically foretell an improving economy.

While we believe that an economic recovery will occur, the rebound will likely be sub-par. Record declines in personal net-worth will cap the consumer’s ability to borrow and spend. Therefore, deflation remains the biggest threat to the economy. While excess monetary stimulus could lead to commodity inflation, the severity of the downturn makes continued deflation the bigger problem.

We believe that the market is in the process of forming a bottom, which will take time and keep stock prices volatile. Expectations for an earnings improvement in the back half of the year seem reasonable. Sentiment is cautious and valuations remain attractive. Our long-term enthusiasm is only tempered by the potential for rising interest rates.

Download the full Investment Management of Virginia Second Quarter Commentary in PDF.

1st Quarter 2009

Summary: The tide of negative data may be slowly turning.

Fourth quarter Real GDP declined 6.3%, and the forecasts for first quarter Real GDP are similarly weak. The flow of negative economic data has been self-reinforcing. Negative growth accelerates job losses, and uncertainty surrounding job security further curtails spending. Simultaneously, households are reducing debt and accelerating savings. Even as personal consumption, while still negative, is showing modest improvement, positive growth likely will remain elusive over the near-term. For now, stabilizing the financial system, finding the trough, and building confidence are the first steps to recovery.

When the recovery does materialize, it likely will be sub-par. Record net-worth contraction, in the form of simultaneous home value and equity market declines, may cap the consumer’s desire and ability to borrow and spend. Lending standards have tightened, further reducing credit, particularly for risky borrowers. Furthermore, the structural problems in the financial system cannot be repaired quickly. The medicine may be worse than the cure if new regulation, taxes, and potentially protectionist policies are not implemented judiciously.

Equity markets, on the other hand, may be in the process of turning before the economic and earnings data become positive. Repeated shocks and unmet expectations have given most investors little hope for sustained economic improvement. This dynamic has produced equity valuations that currently appear to be discounting a level of S&P 500 earnings last seen in 1996. Consequently, with cash balances high and expectations low, any scent of a normalization and eventual improvement in corporate earnings may be very positive for the equity market.

Download the full Investment Management of Virginia First Quarter Commentary in PDF.

4th Quarter 2008

Summary

Third quarter Real GDP declined 0.5%; and the just completed fourth quarter is expected to be down significantly, with consensus estimates of Real GDP declining 4.3%. The fourth quarter should be the worst negative quarter during this cycle, followed by continued contraction during the first two quarters of 2009. Indications are pointing in the direction of improved positive growth in the back half of the year and going into 2010, albeit with below historical average growth. Ongoing weakness in housing and falling equity markets have resulted in the most rapid decline in household net worth onrecord. Additionally, rising unemployment is raising the fear of job instability. Consequently, personal consumption isexpected to be lethargic as consumers retrench, reduce debt burdens, and rebuild personal balance sheets.

In total, between the Federal Reserve and the U.S. Treasury Department, the U.S. government has pledged $8.5 trillion toward various programs and guarantees designed to free capital and credit flows, reflate asset prices, and ultimatelystimulate growth. While the process is slow, evidence indicates that credit is easing and mortgage rates are falling, leading to positive developments. High inflationary pressures have diminished, energy prices have fallen (particularly gasoline),and personal savings rates are being restored. Additional government stimulus plans are anticipated in the near-term.

Market panic and deleveraging drove the 2008 S&P 500 Index return to the lowestsince 1937. A worldwide flight to “safe” assets drove U.S. Treasury rates to generational lows, yielding negative real returns (and negative absolute returns in somecases), and investor and consumer sentiment measures fell to levels never recorded. Equity market valuations are the lowest and cash on the sidelines the highest since 1990, and the S&P 500 Index dividend yield is more than that of the 30-year U.S.Treasury. Historically, these conditions favor significantly improved equity market returns looking forward.

Download the full Investment Management of Virginia Fourth Quarter Commentary in PDF.

3rd Quarter 2008

Summary

The dismantling of Wall Street’s leverage has pushed the U.S. into recession. The current credit squeeze, and consequent deleveraging, has reached crisis proportions, with the Federal Reserve and U.S. Treasury stepping into the breach, as best they can, to calm the markets. The seriousness of the situation is not lost on consumers, who are retrenching and re-capitalizing following a decade plus of high consumption. Elevated inflation and rising energy costs also have served to crimp consumer appetites worldwide. U.S consumption is expected to be sub-par in light of low pent-up demand; therefore the cyclical economic recovery, when it arrives, is expected to be slower, lower, and longer than historical averages.

The once robust and seemingly never-ending growth in foreign markets, developed and emerging, appears to be vulnerable to U.S. economic weakness. Central banks around the globe quickly have turned from raising interest rates and tightening policies toward reducing interest rates and aggressively injecting monetary stimulus in order to address the global credit squeeze, declining exports, and decelerating growth. China’s Shenzhen stock market index is down 58% YTD, and China’s GDP growth is expected to slow.

Market panic and flight to quality has driven U.S. Treasury Bill rates to generational lows and significantly below inflation, yielding negative real returns. In this latest quarter, U.S. equities have declined and, in the short-term, remain hostage to high-risk aversion, short-term liquidity fears, and government action or inaction. For the long-term investor, U. S. equity market valuations imply significantly better market returns going forward, as we emerge from the current credit crisis and cyclical economic downturn.

Download the full Investment Management of Virginia Third Quarter Commentary in PDF.

2nd Quarter 2008

Summary

Recent Economic Developments Although the Federal Reserve appears to have solved many liquidity issues as the financial system de-leverages, recapitalizing financial institutions and providing a free flow of credit will be an ongoing challenge.

International Economic Strength The positive aspect of the current trend is that it encourages U.S. exports and a slowing growth rate in imports. Over the past year U.S. exports have increased by 17.8%, while imports have only increased by 13.2%.

Tipping Point Midway through the second quarter of 2008 something changed; the choke point appears to have been rising food prices and oil’s surpassing $125-$130 per barrel.

Looking Forward It appears that most of the current inflationary pressure is based in commodities, particularly oil; so any downward move in oil prices could serve as a positive catalyst for better than expected economic growth.

Second Quarter Performance Investors were whipsawed during the quarter with the S&P 500 rising 12% off March lows, only to retrace to within seven points of the March trough at quarter’s end. We now have had three successive quarters of negative returns in the S&P 500 Index. That has only occurred three times since 1980.

Extreme Fear - Market Implications We believe conditions are setting the foundation for a recovery in the equity markets. However, before market sentiment can turn with any sustainability, we likely will need to see a catalyst from improved confidence in banking or housing, the U.S. dollar, and/or energy prices.

Download the full Investment Management of Virginia Second Quarter Commentary in PDF.

1st Quarter 2008

Summary

Navigating the Volatility The U.S. economy rapidly deteriorated in the first quarter and appears to be in, or on the brink of, recession. However, in general, the further one gets from Wall Street, the better business trends appear to be. Business activity outside of the U.S. remains solid.

Unconventional Measures – Unconventional Times Fed assistance is in place, and progress has been made. Liquidity is abundant; however, credit availability remains restrictive for lesser credit quality borrowers. On the other hand, the credit facilities for creditworthy non-financial institutions are working normally.

Unconventional Recovery – This Time is Different The unwinding of the massive institutional and personal leverage created in the past several years will continue to take its toll. Due to the complexity of this current downturn, the character of the eventual recovery is likely to be unconventional.

Glass Half Full - Corporate earnings, ex-financials, have performed well, predominately driven by strength in global and emerging markets. It is clear that, in the wake of U.S. weakness, global economies have been more resilient than history would imply.

Extreme Volatility/Fear - Market Implications Daily changes of 1% or more in the S&P 500 Index have occurred on 53% of trading days this year, the most since 1938. Investor sentiment has been low, by almost any measure, throughout the quarter. Cash is abundant.

Equity Valuation-We expect volatility to remain elevated, but we reiterate our view that much of the downside risk in the equity markets has been discounted. The real risk is in earnings, which will require close observation on a company-by-company basis.

Download the full Investment Management of Virginia First Quarter Commentary in PDF.

4th Quarter 2007

Summary

Fourth Quarter Summary Against the backdrop of Federal Reserve rate cuts and monetary injections, the equity markets rallied to new highs early in October. These gains were relinquished in November and December as a result of deteriorating earnings, rising energy prices, and softening economic conditions.

The Federal Reserve’s Two Problems The Fed faces two major challenges: 1) slowing growth in a maturing economic cycle, and 2) deterioration within the financial system that may restrain economic growth.

Rates and Central Banks U.S. Fed rate cuts and European Central Bank intervention are providing liquidity to the credit markets.

Recession Recent reported and anecdotal economic data indicate a continued weakening in economic conditions, raising recessionary risks.

Housing Update The housing downturn continues with no visible, near-term end in sight. With inventories high and pricing continuing to weaken, housing affordability is rising once again.

M&A, Fund Flows, and Buybacks De-leveraging in the U.S. financial system has curtailed mergers and acquisitions activity. Mutual fund outflows have been reported at the highest levels since 1987-1988. Thus, support for the equity markets has declined, even though reports indicate record corporate share buybacks during 2007.

Equity Market Performance The S&P 500 Index(total return) advanced 5.49% in 2007. The S&P 400and S&P 600 indices were up 7.98% and down 0.30%, respectively. Growth re-emerged as a leader over Value across all size categories.

Equity Market Valuations Corporate profits have been deteriorating, owing largely to massive write-offs in the financial sector. Nonetheless, equity valuations appear attractive at 15.8 times trailing earnings and especially attractive when compared to a 3.73% 10-year U.S. Treasury yield.

Download the full Investment Management of Virginia Fourth Quarter Commentary in PDF.