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"Time’s glory is to calm contending kings,
To unmask falsehood, and bring truth to light."
- William Shakespeare

The second quarter was a weak one for ‘risk’ assets like equities and commodities, while defensive assets like fixed income held their own. The mid–year slowdown is reminiscent of the past two years. However, growth is currently slowing in emerging (not just developed) markets and growth is also falling from a lower absolute level.[1] We remain conservatively positioned within asset classes as the US ‘fiscal cliff’, risks in the Eurozone, slowing global growth and the potential for increased earnings disappointments persist.

Patience is a Virtue That’s Been Rewarded

In times like this it is hard not to be distracted by the talking heads on television doing their best to excite everyone about the latest news in Europe. The situation is certainly complicated but reacting to every news headline in a volatile market is a strategy that is doomed from the start. As the graph below shows, since 1950 the total return of owning stocks for only 1 year has ranged from +51% to -37%. Extending the holding period to 5 years narrows the range from +28% to only -2%.[2] In summary, the shorter your time horizon, the higher the likelihood of sustaining an investment loss.

Range of Stock, Bond and Blended Total Returns

Over the last 32 years the S&P 500 has had an average intra-year correction of -14.5% but still delivered positive annual returns in 25 of those years (78% of the time).[2] So far, this year appears to be no exception and we recommend staying focused on long-term results.

S&P 500 Intra-year Declines vs. Calendar Year Returns

Fundamental Opportunities

Macroeconomic headlines have been causing individual stocks and even markets to move in unison over the last few years. As the graph below shows, stock correlations rise dramatically during times of stress and are currently at 40.5%, well above the 27% avg.[2]


This herd mentality can create a dislocation between a company’s intrinsic value and its stock price. A recent study published in the CFA Institute magazine found that “for investors, it pays to focus attention on the fundamental factors that dominate the market’s price-setting mechanism the vast majority of the time – especially when few others are paying attention to those factors.”[3] We believe fundamentally driven investment strategies that have a long-term perspective are best positioned to capitalize on this opportunity.

A Global Perspective on Valuations

The chart below shows that most developed market countries are cheap relative to their own historical valuation (blue diamond vs. grey bar) and, in many cases, are several standard deviations below the average global valuation (blue diamond vs. middle line).


Even the S&P 500 Shiller Cyclically Adjusted P/E ratio, which uses trailing 10 year average inflation adjusted earnings (a very conservative metric), shows stocks are just slightly above fair value.


Inverse Relationship

Continuing our thoughts about interest rates from last quarter, we would like to expound on the risks associated with owning bonds in this low interest rate environment. Below is a graph which outlines the expected return on various bond market sectors if interest rates were to rise or fall by just 1%. For example, if 10 year US Treasury Bond rates rise from 1.7% to just 2.7%, their price is estimated to fall -9%.[2] For an investment that will earn only 1.7% annually if held to maturity, this is a significant asymmetry of risk.


Well known market bear and author of the Gloom Boom & Doom report, Marc Faber, recently noted that “dividend yields on the market exceed long-term interest rates for the first time in 60 years.”[4] He favors dividend paying stocks over US Government Bonds. Sydney Williams of Monness Crespi & Hardt sums up the situation well, noting that the best port in this storm of uncertainty is to “focus on preservation of income by buying high quality dividend paying companies where the opportunity for increases exists.”[5] S&P Dow Jones Indices recently announced that aggregate dividends for 2012 are on track to hit a record $391 billion and actual cash payments in the quarter increased over 14%, with the forward indicated dividend rate reaching a new all–time high.[6] S&P Dow Jones senior index analyst, Howard Silverblatt, notes that yields for dividend paying stocks hit 2.77% at June 30 and, even with the deep concern over the economy, he doesn’t expect companies to significantly delay or scale back their dividend plans.[6] With US interest rates near historic lows, we believe investors should structure bond portfolios to mitigate interest rate risk through a diversified and global approach, and explore using other investments that generate income. If you would like to discuss this strategy in more detail, please give us a call.

Good for Business

Forbes magazine recently released its ‘Best for Business’ rank of 200 U.S. Metro areas, and Fort Collins and Denver were ranked 3rd and 5th respectively. See below for the Top 25 and Bottom 5 cities. Additionally, Denver was recently selected as one of three locations for a satellite branch of the US Patent and Trademark Office, which is expected to have a $439 million economic impact in five years.[7]


Thank You

Thank you for allowing us to be part of your team of trusted advisors. We take this responsibility very seriously, and we remain committed to the service and results you expect from our team.

We would also like to thank all of our clients and the CPAs and attorneys who referred clients to us during the quarter. We sincerely appreciate this vote of confidence.


[1] Morgan Stanley Research  "Cross-Asset Strategy: The Growth Scare."  6/27/12
[2] J.P. Morgan Asset Management "Market Insights: Guide to the Markets 3Q | 2012." 6/30/12
[3] Tom Biwer CFA, Brian Jacobsen CFA, Adam Kurkiewicz CFA "Market Drivers: Fundamentals vs. Technicals." CFA Institute Magazine May-June 2012
[4] Jeff Cox "Shock! Faber, Seigel Agree: Buy Stocks Instead of Bonds." www.cnbc.com 6/4/12
[5] Sydney Williams "How to Weather the Storm." Thought of the Day 5/23/12
[6] Shirley A. Lazo "Payout Parade-S&P 500 and the Dow both put up big numbers."  Barron's  7/9/12
[7] Mark Harden "Denver wins long-sought satellite patent office." Denver Business Journal 7/1/12
[8] Kurt Badenhausen "The Best for Business." Forbes 7/16/12

Disclosures
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: 6/30/2012
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