Fairport Perspectives – 2011 August

Fairport Asset Management LogoValued Clients,

These are challenging times for sure. From the debt ceiling to the stock market’s floor, investors do not have to look far for items to worry about. This makes it a good time to put your long term investment goals in perspective and remember that these swings are becoming an inevitable part of the journey. We assure you that the Fairport Team continues to diligently research, analyze and review the market and how best to manage your assets. It is our role, particularly as we experience such dramatic volatility, to not let emotions keep us from maintaining perspective.

As you know, our logo includes a symbol of the Fairport Harbor lighthouse. That lighthouse served as the beacon of safety to the large iron ore ships as they navigated the tumultuous Great Lakes. The captains needed to focus on the horizon to stay steady in rough waters. Similarly, we build your portfolios understanding that there will be periods of volatility, often rising quickly. We focus on building and managing client portfolios in a way that helps manage the downside risk associated with the market volatility and that helps position portfolios for upside growth.

We generally build portfolios with an allocation of shorter term, more liquid assets invested in cash and fixed income to provide protection. These assets are readily available to cover a client’s cash needs over (an approximately) three to five year time horizon. The balance of a portfolio is generally allocated to assets with a longer term time horizon that can help capture growth to meet future needs. Remember we have built that shorter term, more liquid “protection pool” to help provide stability and, subsequently, help provide peace of mind at times like these.

From a technical perspective, the S&P 500 Index traded below 1,250 last Wednesday, which is what many considered long term technical support for the market. The S&P 500 declined another 4.78% Thursday to finish fractionally over 1,200, with marginal change on Friday. Today the domestic markets are reacting to the debt downgrade and the global markets concern over U.S. financial strength.

We do think the next few months we be a challenging environment for the markets as investors weigh the events of the last few weeks. It is still our belief that the markets remain constructive and should move higher into year end. However, we admit to being more cautious over the coming weeks.

A few thoughts, both positive and negative on where the market currently stands.

Negatives:

  • The economy continues to show signs of slowing with second quarter GDP growth coming in at 1.3%. This was coupled with first quarter GDP being revised lower to an anemic 0.4%. Recent reports on the manufacturing and service PMI both showed the economy still expanding, but at a declining rate. That, combined with the debt downgrade and the prolonged debt ceiling debate which now will be stretched out over the fall, have investors shifting away from risk.
  • The ongoing sovereign debt crisis in Europe, which seems to have no long term solution, is again coming to the forefront as the fear is it will spread to countries outside of Greece, Ireland and Portugal. Spreads on bonds for both Italy and Spain have widened and the concern is that they will need some sort of assistance in the months/years ahead. Italy has over 25% of its national debt rolling over by the end of 2012 and the ability for them to fund that debt in the open markets is coming into question. Banks across Europe were under pressure last week. We have been underweight Europe versus the benchmark MSCI EAFE Index over the last two years due to the current crisis and should remain so in the near future.
  • From a historical perspective, according to JP Morgan, only one bull market since World War II saw a double digit decline following a 15% or more correction (which we saw last year). All others resulted in the formation of a new bear market. From the high back in April through last week’s close, the market has declined 12%.

Positives:

  • Fundamentals, while are often overshadowed by short term events, remain positive for the S&P 500 Index. The overall market currently trades at 13.1x forward earnings, well below the 10 year historical average of 15.9x. The same is evident on a trailing basis as well, with the current ratio of 13.5x versus the average of 16.9x. The S&P 500 Index operating yield of 6.75%, as calculated by Ned Davis Research, is still well above the corporate bond yield of 5.76%, suggesting that equities as a whole are still more attractive on a relative basis to bonds. Due to the flight to quality, 10 year Treasury yields are under 2.5% which is below the long term inflation average.
  • Corporate earnings continue to rise with second quarter reports coming in 17.9% ahead of last year. Of those that already reported, over 70% of the companies beat the consensus estimates. As a comparison, earnings back in 2008 were declining for much of the year as the creditworthiness of the banking system was called into question. 2012 estimates for the S&P 500 Index are currently at $106 suggesting further growth in the quarters ahead. We continue to focus on high quality companies within client portfolios with solid balance sheets and strong cash flow.
  • Equities are in an oversold condition. As of last week, 81% of the stocks within the index were at a 20 day low, usually indicating that sentiment is extremely negative. This should lead to a rally in equities in the coming days. According to JP Morgan, there has never been a down year in the third year of a presidential term and a third year of an economic expansion.

We use a disciplined approach to portfolio management, diversifying within and across different asset types. This helps protect the volatility in our client’s portfolios. We will continue to use a disciplined and prudent approach during these times to manage risk but also look for opportunities.

As a Fairport client, be assured that we are constantly monitoring current events and analyzing how we believe they will affect your portfolio. If you have any questions, comments, or concerns, as always please feel free to contact a member of your team.

Kenneth J. Coleman and Heather R. Ettinger | Managing Partners