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"One of the things we have to be thankful for is that we don't get as much government as we pay for."
-Charles F. Kettering

During the first three months of this year, the S&P 500 was up an impressive 12%, making it the strongest start to any year since 1998.  This followed an 11% gain last quarter, for a cumulative 28% rally since the early October lows, when the situation in Europe looked bleak and US economic data weakened. By contrast, China was up only 2.9% this quarter and Spain actually fell -6.5%.

Is the Party Over?

While we have seen an impressive rally during the last six months, the S&P 500 is still 10% below the October 2007 highs even though operating earnings are at a higher level today.  On a trailing basis, the Price to Earnings (P/E) ratio of All US Corporations is at 12.5x (average=13.7x) and the Forward P/E ratio on the S&P 500 is still only 13x (average=16.2x).[1]  While valuations are not as attractive as they were six months ago, equity markets are still not overvalued.

Importantly, recent US economic data has been improving and may be just in time to help offset the slowdown in China and Europe.  The US unemployment rate dipped to 8.2% in March, reflecting a less than expected 120,000 increase in payrolls and 164,000 decline in the labor force. Federal Reserve Bank of New York research shows the jobless rate may fall as low as 6% by the first half of 2013.[2] Declines in jobless claims helped push the Leading Indicators Index up a sizable +0.7% in February from +0.4% in January. Household financial obligations as a percentage of disposable income fell to 15.9% in the fourth quarter, a 28-year low. Personal consumption expenditures increased 0.8% in February, the largest increase in 7 months. Consumer credit increased $17.8 billion in January for the biggest three-month gain in over a decade. Consumer Sentiment reached 76.2 in March marking the highest level of the recovery.

The strengthening US economy comes just as Euro-zone GDP contracted for the first time since 2009, falling -0.3% in the fourth quarter.  Euro-Zone unemployment rose to 10.8% in February, the highest level in 14 years.  According to the Centre for European Reform, a think tank in London, the ratio of investment to GDP in Europe is at a 60-year low as corporate cash holdings in the Euro-zone are at a staggering $2.64 trillion and $1.19 trillion in the UK.[3] Chinese Premier Wen Jiabao cut this year’s Chinese GDP growth target to 7.5% from a long standing target of 8% and below actual growth of 9.2% last year. Following the recent rally, investors should be braced for a correction/consolidation in the equity markets and likely lower returns for the remainder of the year.

The Chartist, however, does not anticipate a correction of any substance at current levels but says one could come from much higher levels.[4] In other words, sit tight. We believe the markets will need improving economic data to continue grinding higher.

Reversion to the Mean

Corporate profits are currently the largest proportion of national income in post-war history, and there is an increasing number of US companies reporting negative Q4 Y/Y earnings growth and missing 4Q11 earnings estimates.[5] As the graph below shows, corporate profit margin expansion has been a significant driver of earnings growth over the past few years, but at a declining rate. A growing number of market strategists are calling for margins to revert to more normalized levels. However, if the economy continues to improve, the Revenue Share of EPS Growth (green) could increase and help offset some of the declining Margin Share of EPS Growth (gray).

EPS Growth Drivers


Key risks in the latter half of the year are the economic, tax policy and debt-related issues that need to be resolved by year end.  Specifically, the Bush Era Tax Cuts are set to expire this year, budget sequestration calls for $600 billion of cuts to defense and domestic discretionary spending over 10 years, while the US Debt Limit could be reached before year end.[6] Given this is an election year, it’s unlikely much progress will be made on these key issues until after the elections in November.  Economists estimate that if nothing is done, higher tax rates and sharp spending cuts could subtract 3%-4% from US economic growth.[6]  At current growth rates, that would push the economy dangerously close to another recession. Additional political brinkmanship is almost a foregone conclusion and, contrary to popular belief in Washington, this is not good for the economy.

Geopolitical Risk

Recent news headlines addressed the possibility that Israel could make a preemptive strike to prevent Iran from gaining nuclear weapons capabilities.  Despite above average crude oil inventories, this threat has caused gasoline prices to rise.  As the map shows, nearly 20% of the world’s oil supply travels through the Strait of Hormuz near Iran.  A closure of the Strait would almost certainly cause a dramatic rise in oil and gasoline prices.  A recent report by the Milken Institute estimates that each sustained $10 increase in the price of a barrel of oil will reduce US GDP by 0.3%.[7] This is a meaningful amount for an economy growing at only 3%.

Energy Production & Chokepoints

The Winds are Changing

The US Bond market has been in a bull market for the last 20 years, when interest rates peaked in the 1980s. We believe those winds will begin to change. US corporate bond issuance reached a record $427 billion during the quarter, while yields on investment-grade debt in the US declined to a record low 3.4% on March 2nd.[2] Junk bond sales in the US also soared to a record $91.6 billion during the quarter.[2]  Spreads on high yield bonds are near the long-term average of 6%, but yields on junk bonds issued during the quarter averaged only 7.98%, the lowest rate since the junk-bond market was created in the 1980s.[8]  With the 10 year US Treasury yield at only about 2.2%, and consumer prices increasing 2.9% annually in February, US Treasuries currently offer a negative ‘real’ return and are a good way to get poor slowly.  We’re not recommending investors sell bonds completely; however, we believe that an actively managed diversified approach will be important going forward.

US Treasury Rates

The Elevator Speech

As you may know, part of our investment philosophy is that the track record of a mutual fund goes up and down the elevator each day with its investment team.  Essentially, we make investments with specific people, not mutual fund companies.  Several weeks ago we learned that one of our favorite managers (whose funds are closed to new investors), decided to leave the firm. As Chief Investment Officer of his firm, we believe he was critical to the investment process. As a result, we sold our sizable positions in his two mutual funds. We believe actively monitoring investment managers is critical and is just part of the service we provide to our clients.

Thank Your For Inspiring Us Each Day

As we look back on the past few years, we cannot help but think how fortunate we are to be working with such wonderful clients.  We are grateful for the opportunity to work with so many people who share so much of their lives with us, and continue to inspire us each day. Thank you for placing your trust with PCM. Private Capital Management, Inc. would also like to thank everyone who referred clients to us during the quarter.  Referrals are vitally important to our firm and allow us to continue to grow while remaining focused on research.

Index Returns

[1] “Market Insights: Guide to the Markets 2Q | 2012” J.P. Morgan Asset Management 3/31/2012
[2] “Bond Sales Top $1 Trillion on Record-Low Yield” Sridhar Natarajan 3/29/2012
[3] “Firms' Cash Hoarding Stunts Europe” Stephen Fidler 3/22/12 
[4] “The Chartist Newsletter” Dan Sullivan & Steve Mais 4/5/2012
[5] “The First Sign of Weakness in Corporate America” Richard Bernstein 3/19/2012
[6] “Weekly Investment Commentary – Have We Reached the End of the Rally?” Bob Doll 4/2/2012
[7] “Outlook for the Economy” Robert Johnson, CFA 3/27/2012
[8] “Junk Bonds Feed a Hungry Market” Matt Wirz 3/30/2012

Investment Products: Not FDIC Insured – No Bank Guarantee – May Lose Value
Private Capital Management, Inc. (PCM) is a registered investment adviser. Opinions and information presented have been obtained or derived from sources we believe to be reliable, but we cannot guarantee their completeness or accuracy. Opinions represent PCM’s judgment as of the date of the report and are subject to change without notice. This material is for general information only and is not suitable for all investors. It is not soliciting any action from any particular investor. This presentation is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this presentation may be unsuitable for some investors depending on their specific financial position and investment objectives. Private Capital Management and/or its personnel may trade for their own accounts, be on the opposite side of customer orders, and have positions in securities related to issues mentioned in this presentation. Investing in foreign securities presents certain risk that may not be present in domestic securities. Fixed income securities are subject to availability and market fluctuation. These securities may be worth less than the original cost upon redemption. Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. PCM does not provide tax or legal advice. Please consult appropriate tax or legal advisors to determine how this information may apply to your own situation.  The indices and benchmarks mentioned for comparison purposes are unmanaged. You cannot purchase an index. S&P 500 Index is an unmanaged capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.  The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets consisting of 21 emerging market country indices.  The Barclay’s U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.  The Dow Jones Commodity Index is an index composed of the futures contracts on 19 physical commodities. Additional information is available upon request.  Dated: 3/31/2012
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