Quarterly Review

The third quarter began in relatively quiet fashion, as early corporate earnings reports in July confirmed the trend of continued economic growth, albeit at a modest rate. In this environment, we put money to work in the companies with the best earnings reports and the most favorable outlooks. While growth expectations had moderated somewhat from the beginning of the year, we nevertheless found a number of companies with very good growth prospects.

At the end of July, however, the market’s focus turned toward the debate in Congress over extension of the U.S. debt ceiling, as politicians engaged in a very public and closely watched game of brinkmanship on the national stage. Upon passage of legislation on August 2 to increase the debt ceiling and cut $2.4 trillion in federal spending over the next decade, markets promptly sold off due to a mix of disappointment over the lack of significant progress on the U.S. deficit, concern about slowing economic growth in the U.S., and fresh worries about the state of the European banking system.

After markets closed on Friday, August 5, Standard and Poor’s lowered its long-term credit rating of U.S. sovereign debt to AA+ from AAA. In explaining its downgrade, S&P cited its opinion that U.S. federal budget adjustments were insufficient and that it believed the political divide in Washington precluded meaningful progress on debt reduction relative to the firm’s prior expectations.

On August 8, the first trading day following the S&P downgrade, the S&P 500 Index declined 6.7%, the largest daily decline since December 2008, while the CBOE’s VIX Index increased 50% the same day to 48, its highest level since March 2009. Furthermore, in the 11 trading days from July 23 to August 8, the S&P 500 Index declined 16.8%, reflecting the rapidly escalating level of risk aversion in the marketplace. And while August 8 represented the low for the market during the third quarter, the remaining eight weeks of the quarter saw six separate trend reversals in the S&P 500 Index of greater than 5%.

While the U.S. political environment and macroeconomic data created downside pressure on the U.S. equity markets early in the quarter, the sovereign debt situation in Europe was far and away the largest headwind for equity markets during the remainder of the quarter. The list of potential risks emanating from Europe in August and September was both long and significant: the European Financial Stability Facility (EFSF) remained under debate in some countries and therefore had yet to be implemented, the timing and manner of restructuring for Greece’s debt remained unresolved, and concerns about Italy and Spain built to dangerously high levels, as reflected by long-term interest rates in excess of 6%.

The combination of residual risk aversion from the U.S. debt debate and ongoing concern about Europe’s sovereign debt crisis created an environment in which political headlines dominated equity markets. As a measure of how little attention was paid to company fundamentals amid the political crises, correlation among the 250 largest stocks in the S&P 500 Index surged to 81%, well above a historical average of 30%, and which marked the highest level of correlation since the October 1987 crash. As such, portfolio performance in the third quarter depended upon navigating the broad market volatility that resulted primarily from politically-driven headlines, and only secondarily from macroeconomic and company-specific fundamentals.

With few established trends in the equity markets apart from persistent volatility, our process led us to take a relatively balanced approach across sectors and industries. We did lean somewhat defensively within our portfolios during the quarter via increased holdings in the healthcare and utilities sectors. Not surprisingly, we have found that those sectors tend to screen well in our process during periods of slowing economic growth and periods of elevated market volatility. At the same time, we saw outperformance from a few growth-oriented consumer discretionary stocks and select technology stocks, which suggests that some strength remains within the global economy.

By September 30, the S&P 500 Index had posted a loss of 14.3% for the third quarter, including a 7.2% decline during the month of September alone. This represented the worst quarter for the S&P 500 Index since the fourth quarter of 2008, when the index declined 22.6%. In sharp contrast, the Bank of America Merrill Lynch index of U.S. Treasuries with greater than 10 year maturities returned 23.6% in the third quarter, which is the best quarterly return of the index going back as far as 1978. This sharp divergence between equities and fixed income – especially in light of the S&P downgrade of U.S. debt during the quarter – indicates how deep and broad the concerns in the marketplace had become surrounding uncertain political outcomes and fragile economic growth.

Outlook

From our perspective, we believe the equity market has more than sufficiently corrected to account for the likelihood of slower economic growth over the next several quarters. However, the political situation in Europe remains a somewhat unpredictable factor, and one that could precipitate additional downside to equity prices. That said, we have seen signs that European leaders recognize the need for comprehensive and credible policy solutions to address both their banking system and their sovereign debt.

In our opinion, by far the most important factor for markets in the fourth quarter will be the debt situation in Europe. While we do expect a restructuring of Greek debt, which will entail the recognition of losses within the European banking system, the more critical issue is whether and how authorities will ringfence other peripheral countries such as Italy and Spain to contain the crisis. Containment of additional losses with a credible backstop will be crucial to maintaining the stability of the European banking system, and by extension, the stability of the global banking system.

It has become clear that there are deep divisions both among eurozone states and within individual eurozone governments, and that a solution will be neither easy to arrive at nor perfect in implementation. However, given the high costs of bank runs, contagion, or one or more countries leaving the eurozone, we believe the most likely outcome remains an intact eurozone. While we do not believe there will be a quick and comprehensive solution to the crisis, we do believe that European leaders will provide sufficient solutions to ameliorate the crisis over the course of the next 3 to 6 months.

Beyond the impact of the near-term volatility arising from the threat of financial contagion, the growth rate of European GDP is the next issue that we are concerned about. With wide-ranging austerity measures being implemented across the continent, and both more budget cuts and more sovereign debt a distinct possibility, it is likely that Europe’s GDP growth in 2012 will be materially lower than previously expected, and we find it difficult to argue with the current Bloomberg consensus forecast for 1.0% real GDP growth in the eurozone in 2012. This could have a collateral impact on GDP growth in other regions, so global GDP growth in 2012 is likely to be lower than prior expectations.

In the U.S., the heated political climate has cooled off somewhat, but a deep ideological divide between parties and the 2012 election cycle are likely to keep uncertainty at elevated levels well into 2012 and likely beyond. Despite this, we believe the impact of political bickering will lessen over time as the market becomes inured to the current volume and tone of political rhetoric. The downside is that while now would be an ideal time to provide additional fiscal stimulus for a fragile domestic economy, it appears nearly impossible to get any such spending through Congress. While this should not prove to be a significant problem in 2012, it is likely to leave growth lower and unemployment higher than could otherwise be the case.

Looking toward emerging markets, we continue to have concerns about the impact of inflation on economic policy. Of most concern in this respect is China, where inflation remains at elevated levels. While it does appear that inflation in China has peaked, the Chinese government’s tightening measures have slowed growth and caused concern about tightening financial conditions on real estate markets. While there is general consensus that parts of China’s real estate markets are overheated, and cooling them off now is probably a good thing for the long-term, any overshoot in tightening could act as another source of drag on global GDP over the next several quarters. And as we have seen in the U.S. and Europe, concerns about the viability of debt – especially debt collateralized by real estate – can quickly turn market sentiment deeply negative.

With all the headwinds delineated above, we maintained a relatively defensive bias throughout the third quarter. However, with the S&P 500 Index hovering around 1100, we believe that there has been an unusually high amount of value created in the equity market during the past three months. As such, we begin the fourth quarter with a sense of cautious optimism, as we believe the issues discussed above are manageable and are likely to be worked through in the relatively near future. While a worsening situation around the European debt crisis could take the markets even lower than current levels, we see far more upside potential if the European debt situation is contained. While we do not expect the upcoming earnings season to be especially strong from a broad perspective, we do believe that the market has already more than priced in such a quarter. Also, we recently have seen positive stock reactions to what we considered mixed reports from Texas Instruments and Oracle, which lends support to the idea that a subpar earnings season has already been largely priced in.

As it appears that European countries now recognize the need to coordinate their efforts to implement a credible plan to both recapitalize their banking system and to provide a backstop for sovereign debt issues, we are cautiously optimistic that the fourth quarter will see sufficient progress made in Europe to allow markets to return their focus to macroeconomic data and company operating fundamentals as drivers of market direction. In this environment, we are likely to remain relatively balanced in our sector and industry weights and we will look to make adjustments to the portfolios based on where stock strength appears based on earnings reports. However, we have already begun to make a few adjustments to the portfolios to take advantage of extremely low valuations on a handful of stocks leveraged to more stable economic conditions, while lightening our overall exposure to defensive themes. While we suspect that our investment process may soon point us more strongly toward technology, energy and select consumer discretionary stocks, we will be looking for early evidence of this in reported earnings as well as signals from the quantitative step of our investment process.