Review & Outlook

Summer 2010

Investor's Update
The final two months of the second quarter could certainly be called a reversal of fortune. Investors could do no wrong in risky assets through April. Then, Greece’s economic issues helped ignite a significant reevaluation of risk, as the S&P 500 retreated over 15% from its peak to close out the 2nd quarter with an 11.4% loss. All ten S&P sectors showed declines but less so in the traditionally defensive, high dividend paying areas such as staples, telecommunications and utilities. Materials, energy, financials and other economically sensitive areas declined the most. U.S. Treasuries benefited while corporate spreads widened. This was a complete 180 degree turn from the previous twelve months.

On a total return basis, the Dow Jones Industrial Average recorded a negative 9.4% in the second quarter, while the S&P 500 and NASDAQ declined 11.4% and 11.8%, respectively. Smaller capitalization stocks generally outpaced their larger counterparts with the Russell 2000 posting a negative 9.9% return. The Russell 2000 index is over 700 basis points ahead of the S&P 500 on a year-to-date basis. The U.S. equity markets by and large fared better than industrialized international markets, especially Europe as sovereign debt concerns continued to impose on growth estimates. The MSCI EAFE (international benchmark) index declined 14.9% on a pure price return basis.

Fixed income investors also saw a reversal of fortune as high quality and government debt outpaced spread and municipal issues. The 5 and 10-year U.S. Treasury bonds are now up 6.3% and 9.5%, respectively, for the year. The longer end of the yield curve showed the largest gains. For the quarter, the Barclays Capital Intermediate Government Bond Index gained 3.3%, whereas the Barclays Capital Aggregate Bond Index and Barclays Capital Intermediate Government/Credit Bond Index increased 3.5% and 3.0%, respectively. The abnormal moves in yield to the downside were precipitated by the rush out of the Euro zone.

Economic Outlook
One of the main concerns we have had throughout this economic rebound was what would happen when our Government pulled back their massive spending programs. We are starting to see the negative effects in full force. Auto sales have peaked, home sales have fallen off a cliff since the tax refund ended, jobs are not being created at levels needed, consumers are not expanding their discretionary spending and international economies are slowing. The Government may have to reenter this market with more quantitative easing programs. Investors are realizing that this is not your typical economic recovery. Return “of” principal has replaced return “on” principal in the minds of many.

During the 2nd quarter, money flowed to safe havens due to concerns over the European crisis, namely caused by Greece, Spain and Portugal. These fears together with congress’s attempt at financial reform stocked fear of a potential double-dip recession. As a result, U.S. Government debt along with gold benefited from the flight to quality. The 10-year U.S. Treasury dropped in yield from 4.01% at its peak to 2.95%. Gold advanced over $110 per ounce to close near all-time record highs. Corporate spreads widened relative to Treasuries.

We expect second quarter GDP to come in at the 2% - 2.5% range with the balance of 2010 struggling to meet that number. State and local county cutbacks are expected to worsen over the coming quarters as budgets are prepared for 2011. Longer-term, we have concerns that the over indebted consumer, local municipalities and potentially other U.S. Government will slow growth in the U.S. and developed markets. The less attractive the U.S. markets become, the more investment you are likely to see in emerging markets. However, the economy is rebounding and showing modest improvement. Corporate profits are up, balance sheets have been repaired and some international growth should continue. Private job and income growth remain positive, albeit below historic norms. The European Central Bank appears committed to preventing a worldwide contagion from their unstable members. China has also increased their exchange rate flexibility in hopes of becoming more consumer oriented and able to provide a soft landing for their economy. U.S. based companies have exposure in the faster growing economies. All is not lost!

Capital Market Analysis
The 75% advance from last year’s lows priced in much of this recovery. A sideways, consolidative period could now occur. Bulls say this is the pause that the market needs, while bears say the sovereign debt crisis is the beginning of a larger credit crisis. The markets will likely be range-bound until concerns from both camps subside, hopefully setting the stage for a rally later in the year. This is a normal market response to the excesses that were priced in from those historic lows. The hope is for our growth to continue at this positive pace, even if it is slower than normal.

Although the short-term reassessment of risk by investors has brought all major averages into the red for the year, this is a healthy exercise. No market advance can go straight up and investor expectations about future economic growth got ahead of themselves. We are not getting more bearish as the market declines. However, it is not time to get aggressive just yet; a better buying opportunity should be forthcoming. Growth overseas should still be at healthy levels and U.S. based multinational companies have invested heavily to expand their share of those local markets. Valuations have also come down to the lowest levels in years. Many healthcare and telecommunication stocks have single digit P/E ratios and 5% - 6% dividend yields. Risk / reward is becoming more favorable from a long-term standpoint.

As mentioned, fixed income investors benefited tremendously from the flight to safety during the second quarter. Short-term, there may be some upside in the fixed income arena but our outlook expects higher rates down the road. The U.S. issuance of debt is an ever increasing mountain that requires foreign borrowers taking on very low coupons. Eventually, this should lead to rising rates after the market becomes saturated. This will be a concern for investors, unless the Government finds a way to reduce their spending, which is unlikely. We recommend short to neutral duration investments in the highest of quality.

Summary
Our portfolios have seen an increase in dividend paying companies with clean balance sheets, international diversification and stable earnings predictability. These corporations can weather the storm as new data continues to come in. They should participate if the market resumes its uptrend, but more importantly, their downside protection gives us the ability to preserve principal and become more aggressive when the market presents a more favorable risk/reward scenario. Range-bound markets remain the most likely scenario for the short-term.

We appreciate your confidence and business. Please do not hesitate to call if you have any questions or if we can be of assistance.