OJM Group Monthly Market Commentary, October 2011

The month of September found the markets continuing to sell-off based on fears of recession and uncertainty surrounding the European debt crisis. The S&P 500 fell -7.03% during the month. The MSCI EAFE Index which tracks global developed markets was down -9.49% for September. Commodities also traded down -13.97%. Emerging markets were the hardest hit sector falling -14.57%, while bonds traded nearly flat with the Barclays Intermediate Govt/Credit Bond index down -.12% for the month.

On September 21, the Federal Reserve announced that it would sell $400 billion of short-term debt and buy $400 billion of longer-term debt. The open-market activity has been dubbed "operation twist", as the goal is to flatten the U.S. Treasury yield curve. The intention of the transactions is to bring down longer-term rates, thus providing liquidity to the economy by supporting the mortgage market and house prices, as well as, easing tight credit conditions for households, and small businesses.

Operation Twist came on the heels of the Federal Reserve's "Beige Book" report of U.S. economic conditions on September 7. The picture painted by the periodic survey was one of slowing growth in several sectors of the economy. Given the existing low levels of growth measured for the first half of 2011, this caused markets to begin pricing in a recession. In addition, the uncertainty over the sovereign-debt issues of the European periphery provided a daily catalyst to market volatility.

So, with the major financial news outlets continually barraging consumers and businesses with daily reports of gloom and doom, is there any reason for optimism? We find a number of recent events and economic data points that provide a much less negative picture. Let's begin with recent statements by legendary investor and Berkshire Hathaway CEO, Warren Buffett. Mr. Buffett's company is a massive conglomerate that holds dozens of companies in many sectors of the economy. He recently pointed out that everything he holds related to housing continues to do poorly. However, every other sector of his substantial operations continues to show growth and his five largest businesses "will set records for earnings or just about set records for earnings this year." He also announced that Berkshire Hathaway will be repurchasing shares of their company as the current market value is below his calculated "intrinsic" value of the company. Mr. Buffett clearly sees a buying opportunity.

Other recent data also paints a less dire picture of the current economic environment. The Chicago Purchasing Managers Index reported a September reading over 60. This indicates solid expansion and correlates more closely to the national index than other regional surveys. The most recent weekly jobless claims number dropped substantially to 391,000, the lowest level in six months. Same-store chain store sales are above year-ago levels, 4.2% according to Redbook Research and 2.7% according to the International Council of Shopping Centers. Rail traffic is up 3.8% from a year ago and hotel occupancy is up 4.1%. These numbers simply don't indicate that a recession is a foregone conclusion.

The recently ended quarter certainly put a dent in equity portfolios for 2011. We think it helps to view the quarter in the context of market activity since the March 2009 market low. Since March 2009 Large Cap U.S. stocks have returned 76.3%, Mid-Cap 104.2%, and Small-Cap 94.2%. This has enabled those who've stayed invested to recoup much of what was lost during the turbulent 2008-9 timeframe even after the recent difficult quarter. The upcoming earnings season will give us a better picture of the health of companies and should provide direction to the market. If earnings and commentary are worse than anticipated, we could endure another difficult quarter. However, if companies show resilience we could see some improvement in market action through year-end.

Looking Forward
Underpinning the weakness in global markets has been the seemingly endless news flow of the sovereign-debt situation in Europe. This is certainly a serious matter and will continue to impact markets and economies around the globe. However, it is not a replay of 2008. U.S. banks are much better capitalized and exposures are much better understood. The European Union members have the financial resources necessary to deal with their issues. It is simply a very difficult and painstaking endeavor for individual sovereign nations to come to agreement with each other and with each of their internal constituencies to take the necessary action. As of this writing, there appears to be a renewed sense of urgency and understanding among the European policymakers that substantial action is need sooner rather than later. A unified, coherent and sizable response from Europe's leaders would be a rather nice Holiday surprise.

As we look at investments for the fourth quarter and beyond, we continue to believe broad diversification is critical. Equities appear undervalued in many sectors, with emerging markets and large cap U.S. dividend paying issues particularly interesting. It may take time to reap the ultimate benefits of the current undervaluation, but many prices are compelling. We also continue to emphasize alternative asset classes with low correlation to equity markets. Understanding these often complex investments is critical and we consider our in-house due diligence to be a significant value-add to client portfolios. We continue to be cautious on international developed market equities, but prices are intriguing for those with an appropriate risk-tolerance. Bond prices are very high in some sectors (i.e. U.S. Treasuries), making us downright negative on passive index bond investing, however, experienced active management is showing it's significant worth to a well constructed bond portfolio.

Market Statistics*

* With the exception of the Deutsche Bank Commodity Index, all returns include dividend reinvestments. Source: Bloomberg, LP.
** Year to date through 9/30/2011.

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