Third Quarter 2011

October, 2011

The third quarter can best be described as a perfect storm of events that caused global stock markets to decline by the largest percentage since the first quarter of 2009. In August, as the world economy began to slow and the European debt crisis intensified, the political system in Europe appeared to be in disarray and the U.S. faced political gridlock over the debt ceiling negotiations and budget deficit. Manufacturing data in China, the key engine for the world economy, weakened. As a result, investor confidence took a nosedive leading to panic liquidations of risk-based assets. All of this increased the risk of recession.  Emerging Markets and U.S. Small Cap stocks, two of the most volatile sectors on a historical basis, experienced the largest declines during the quarter. Every other risk-based asset class generated negative returns. The Intermediate Bond sector, led by U.S. Treasury prices reaching all-time highs, was the top performing sector during the quarter. (See Table #1) TABLE #1: 2011 3rd Quarter and 1 Year Ending September 30th    - Asset Class Index Returns Large Cap Equities Mid-Cap Equities Small Cap Equities Int’l Equities Emerging Equities Intermediate Bonds High Yield Bonds Real Estate Commo- dities Cash 3Q 2011 -13.87% -19.88% -21.86% -18.92% -22.49%  2.37% -6.16% -15.07% -11.69% .02% 1 YR Ending 9/30/11 1.14% -1.28% -3.53% -8.87% -16.09% 3.47% 1.36% 0.93% 2.87% .14% *Source: Bloomberg and Merrill Lynch Indices Financial markets hate uncertainty. How and when will a growing Federal deficit be resolved? Will there be higher taxes, lower government spending, and more government regulation? Will Greece default on its sovereign debt obligations? Will the debt crisis in Greece spread to Italy, Spain, and throughout the European banking system? Will there be a double-dip recession in the U.S.? All were questions on the minds of investors, consumers, and businesses during the third quarter. Consumers and businesses responded by not spending, investing, or hiring. Investors respond by selling riskier assets and buying what are perceived to be the safest assets, such as gold and U.S. Treasuries. Aggregate demand for goods and services dropped and a self fulfilling prophecy took hold causing economic activity to stall and stock prices to decline. At its August 9th Federal Open Market Committee, the Federal Reserve vowed to keep interest rates near zero through mid-2013. In pledging to keep the overnight Fed Funds rate at an all-time low, the Fed also discussed a range of policy tools to bolster the economy and stated that it was prepared to use them “as appropriate.” During its next meeting on September 21st, Fed Chairman Ben Bernanke announced what is being dubbed as “Operation Twist”. The Fed will buy $400 billion in U.S. Treasury securities (UST) maturing between 6-30 years and sell an equal amount of UST maturing in 3years or less, by end of June 2012. They will reinvest principal and interest payments from their existing portfolio of mortgage-backed securities (MBS) into new Agency MBS. The Fed reiterated that there are “significant downside risks” to the economic outlook and that the “Fed will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability”. These policy actions are unprecedented and are aimed at keeping interest rates low, particularly mortgage rates, to spur refinancing activity and bolster economic growth.  As a result of the slowing U.S. economy, the continued instability in Europe due to the sovereign debt crisis, and the uncertainty created by the political theater on the U.S. debt ceiling increase and credit rating downgrade by S&P, we moved from a 5% underweight to a 10% underweight in risk-based assets in early August. These trades were designed to serve two purposes. First and foremost, we reduced risk to protect client portfolios from the volatile market conditions. Second, we used the market volatility as an opportunity to re-position our U.S. Large Cap equity exposure and improve the income component of our client portfolios in what we believe will be a challenging economic environment for growth in the near term.    As of September 8th we have added back 5.5% to risk-based assets, primarily through a combination of defensive, income-oriented U.S. Large-Cap sectors and high yield bonds. As of today we are approximately 4.5% underweight risk-based assets vs. our strategic model targets. We believe the equity markets have overshot to the downside. The markets are extremely oversold due to excessive worry and fear that are not supported by economic fundamentals. In the U.S. The recent U.S. economic data is not consistent with a recession and yet the market is pricing for one. We do not believe that this is or will become 2008 all over again. Equities are cheap, monetary stimulus is abundant, interest rates are at historical lows, and the world economy is still expanding, although at a much slower rate than last year. During this period of extreme uncertainty and volatility, it is important to keep in mind the following positive developments. Oil prices have fallen 31% from their April highs. The Institute for Supply Management’s services and manufacturing indices are both signaling expansion. Retail sales are growing at 3.8%. Money supply growth as measured by M2 is expanding. Interest rates are at historic lows. The U.S. banking system is much better capitalized and less leveraged than 3 years ago. Corporate balance sheet fundamentals have never been stronger with cash positions at all-time highs and debt refinanced at historically low rates. Although the U.S. economy is moving at a snail’s pace, it is not contracting. Corporate earnings have held up well throughout the turmoil. We are eagerly awaiting third quarter corporate earnings releases and company outlooks for profits and the economy.  Much of the stock markets’ current anxiety and lack of confidence is due to the political posturing in Europe with what to do about a bailout of Greece and preventing a liquidity squeeze within the European banking system and Italy. At this point in time, we believe the EU finance ministers, the ECB, and the IMF will find a way to restructure Greece’s debt, contain the debt crisis, and recapitalize the European banking system. However, the process will most likely remain slow and volatile. Until signs emerge that this is indeed what will happen, we are remaining defensive and underweight risk-based assets. Andrew Zimmerman – Chief Investment Strategist Notes: The DT Investment Partners’ Market Commentary discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only.  The material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Investments in various asset classes entail different investment risks. For example, small cap equities tend to be more volatile than large or mid-cap equities.  International equities and emerging markets have exposure to currency fluctuations, foreign taxes, political instability and the possibility for illiquid markets. Fixed income investments involve interest rate and credit risks among others. Real estate investing includes risks such as declines in value of real estate, changing economic conditions, tax laws or property taxes. Commodities’ investing is highly volatile and subject to changing economic conditions and the vagaries of speculators among other risks. Further, diversification and strategic or tactical allocation do not assure profit or protect against loss in declining markets. Index performance returns do not reflect any management fees, transaction costs or expenses.  One cannot invest directly in an index.  Past performance does not guarantee future results.