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Q3 Investor Letter

October 18, 2012

We have been experiencing mixed global economic data over the past several months and in response, the Federal Reserve announced a third round of quantitative easing (QE3). Bernanke commented that in addition to boosting economic growth and thus employment, it’s the Fed’s intention to help savers by pushing asset values higher. The asset values in which he refers are riskier assets such as real estate and equities. While the market initially responded favorably, it ultimately declined through the end of the quarter. 
-HORAN Capital Advisors

"If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.”

— Ben S. Bernanke, Federal Reserve Chairman

 

At the beginning of the third quarter, investors following the “sell in May” strategy felt vindicated as the S&P 500 Index declined over 9.0% from May 1st to June 4th. The June 4th date turned out to be the intra-year market low and the equity rally was almost uninhibited throughout the remainder of the third quarter. The rising tide seemed to lift all markets during the quarter: S&P 500 Index 6.4%, S&P Small Cap Index 5.4% and the MSCI Emerging Markets Index 7.7%. The investment grade bond indices were mostly flat to slightly higher (lower rates) during the quarter. High yield bonds were a standout category as the Barclays High Yield Bond Index returned 4.5% for the quarter and is up more than 12% year to date. The market strength in the third quarter caught some strategists by surprise. Goldman Sachs recommended investors short the S&P 500 Index in late June. Shorting the market means investors would profit if the market actually declined. The S&P rallied over 8.0% between Goldman’s recommendation and the end of the third quarter. 

We have been experiencing mixed global economic data over the past several months and in response, the Federal Reserve announced a third round of quantitative easing (QE3). Bernanke commented that in addition to boosting economic growth and thus employment, it’s the Fed’s intention to help savers by pushing asset values higher. The asset values in which he refers are riskier assets such as real estate and equities. While the market initially responded favorably, it ultimately declined through the end of the quarter. 

The Fed and Corporate America

 

Quantitative easing is an alternative fed policy response used to spur economic growth by anchoring interest rates. Unfortunately, pushing interest rates lower has not significantly improved economic growth or employee hiring. Both of these facts were noted in the Fed’s QE3 statement. “We expect the economy to continue to grow. Our concern is not really a recession. Our concern is that growth will continue but at a pace that’s insufficient to put people back to work.” Interestingly, the Fed’s open ended statements regarding the timing and degree of bond purchases implies QE3 could very easily become “QE-perpetuity.”  Lasting quantitative easing could likely lead to inflationary pressures and we suspect the Fed wants this desperately, but if the Fed thinks they can temper future inflation, just note, inflation is the most regressive tax of all.  A cheaper dollar, by way of inflation, is one alternative to tackling our deficit issues. Our current rate of economic growth has not been sufficient to put much of a dent in the deficit faced in Washington. As the chart on the following next page shows, the gap between government revenues and outlays continues to run at record dollar levels and as a percentage of GDP. This is a path that is unsustainable and must be addressed in the near term.

Maintaining loose monetary policy has not been as effective as the Fed would hope during this household and corporate deleveraging cycle. Companies have been vocal in regard to their greater concern about the future of tax and regulatory policies. On October 4th, The Conference Board released its CEO Confidence Survey results and noted the measure declined to 42 from 47 in the previous quarter. The Conference Board noted, “This latest report reflects ongoing concern about the strength of the economy. CEO assessment of current conditions remains weak and they have grown increasingly pessimistic about the short-term outlook. Sluggish growth and a persistent cloud of uncertainty have played a role in CEOs curtailing spending plans this year….Nearly one-third of chief executives report scaling back on their company’s capital spending plans since January of this year, while less than 10 percent have increased spending based on a supplementary question asked each year in the third quarter. Last year, 22 percent of respondents had increased their capital spending plans and 23 percent had made cuts. A decline in sales volume is a major reason for cutting back on spending plans.” 

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