Broker Check

Investor Letter July 11, 2012

Just a brief investment note as we head into the second half of 2012.

As we write the big four bond markets (US Treasuries, German bunds, Japanese government bonds, British gilts) are all benefiting from a continued flight to safety, with yields breaking to new lows. Two year note yields for Germany (Schatz’s) & France (OATS) are negative, which means investors are paying to hold these securities. Clearly it’s about return OF capital that is important to these investors, not return ON capital.

In the foreign exchange markets the Euro has broken to new lows and the US$ is 11% higher vs the Euro than a year ago. The "commodity" currencies (Australian $, Canadian $ and Brazilian Real) are down, with the Real under severe pressure as the Brazilian central bank cuts rates to help support a slowing economy. China’s economy is slowing as well, and as the largest commodity consumer in the world this is putting pressure on commodities and these commodity currency’s.

In the commodity markets oil is down 15% year to date with the drop in the second quarter of 2012 north of 20%. Copper and other industrial metals are down sharply this year, while gold is flat and silver down 3%.

In our opinion the "smartest" markets have always been the bond and foreign exchange markets, where the buy and hold mentality of the traditional equity investor is not the mantra. And these two markets are clearly warning us of trouble ahead.

That said the equity markets are still up for the year and appear not at all concerned by the large headwinds the world faces — Europe’s continued crisis, China’s slowdown (is it a hard or soft landing?) and the political issues here in the states, including the "fiscal cliff". We would add to the list a global slowdown in economic growth and its likely impact on corporate earnings. The strength of the US dollar will also have a negative impact on earnings of the US multi-nationals — a place where many investors have been "hiding" out.

For the financial markets specifically, and their impact on investor confidence, we now have the global LIBOR scandal, the losses at JP Morgan’s London CIO unit and todays bankruptcy of futures broker Peregrine, which now joins Revco and MF Global in this inauspicious club. Who else will be joining them? We will find out. (SIDE NOTE: We think Jamie Dimon, CEO at JP Morgan, will voluntarily break up JP Morgan in order to salvage his reputation, and move on to a role in the public sector, quite likely as U.S. Treasury Secretary.)

Lastly there is one additional issue for the markets to contend with — global central bank policy.

One of the major supports for stocks since the 2008/2009 financial crisis has been proactive & aggressive global central bank policy. The markets have been able to count on easier monetary policy — until now. The major central banks are reaching the limit of what monetary policy can hope to achieve while politicians globally still have not made the hard decisions on reforms that would allow their economies to achieve sustainable "organic" growth. Now the central banks have come to understand that each time they make aggressive policy moves, thereby supporting the markets, the politicians relax and the hard decisions are further pushed off into the future.

We think the central banks now will "allow" crisis, and not be proactive, but only reactive, for only thru crisis do the politicians act.

The equity markets are well valued certainly, but we think equities are ignoring the larger macro issues at its own peril.

What this means for us as investors is that we want to keep a very healthy amount of cash on hand. We want to be long bonds and we want to own defensive stocks, to the extent equity market exposure is appropriate.

We anticipate more downside in stocks, perhaps severe. This will provide us excellent opportunities to put cash back to work and bring our equity allocations back to our targets during the course of late summer and fall.

As always any questions please contact us — and enjoy your summer!

Best Regards,
Paul Brian Gibson
Partner, Harborview Capital Management LLC