Jerry Jordan Commentary | Third Quarter 2010 Investment Outlook
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The global equity markets suffered sharp losses in the second quarter, after reaching new recovery highs in April. The reversal in investor sentiment was triggered by the return of contagion fears in the wake of the sovereign debt crisis in Europe, the emerging economic deceleration in China, and the shock of the British Petroleum oil spill disaster. Several doses of disappointing U.S. economic news helped to turn investor expectations negative. That said, we believe that this should allow for higher prices over the next six to 12 months in our portfolio companies.
We had entered the second quarter with a cautious outlook, feeling that investor expectations had become too optimistic in light of the gains of the previous 12 months. Despite exceptionally good corporate profits experienced in the first quarter, stocks had risen 75% from the bear market low the previous year. We stated that we expected a volatile price environment to occur. Our aggregate outlook for the year was, and continues to be, positive. Now that the market has experienced a meaningful correction of the previous year’s gains, we believe that the risk/reward relationship for many stocks is becoming positive again. We continue to believe that the stock market may experience higher highs later in the year and into 2011.
While our accounts have suffered modest year-to-date declines in line with that of the market, our relative performance has improved sharply in the last two months after we repositioned the accounts in what we feel are higher quality and more defensive equities. We continue to believe that higher quality and large capitalization stocks have the potential to outperform for the remainder of the year and thereafter.
The Economy and Interest Rates
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“While we expect the stock market to recover from its recent decline, we expect a significant change in market leadership with a sharp tilt in favor of large capitalization growth stocks...” |
Economic momentum abruptly decelerated in the second quarter. The sovereign debt crisis in Greece dominated the headlines, but housing activity, retail sales, employment, and consumer confidence all experienced significant disappointments during the quarter. A big contributor to the sequential declines was the ending of various government stimulus programs, such as the first-time homebuyer credit, along with the general lack of a meaningful increase in loan demand. Also contributing to poor business sentiment were concerns of elevated regulation by the Obama administration, and the prospects of higher taxes in 2011. Additionally, the ECRI Weekly Leading Index, which has been very accurate in forecasting economic activity, suffered a sharp decline in June.
These conditions, along with the overbought condition of the equity markets, caused stocks to experience sharp declines, further dampening consumer sentiment. The bond market experienced another flight to quality with yields on Treasuries dropping across the curve. The two-year Treasury yield has gone to a new low, possibly reflecting low confidence in the continuation of the recovery. Credit spreads and the cost of credit default swaps have risen. Especially noteworthy is the growing credit concern regarding states and municipalities, especially as federal stimulus payments begin to decline.
Despite these worrisome economic headwinds, we expect the U.S. economy to continue to expand this year, but at a more modest rate. While employment has not begun a meaningful recovery, some of the preconditions for a recovery are emerging. The most significant precondition is robust corporate profitability and balance sheets. As noted above, corporate profits in the first quarter were exceptional and significantly above expectations. Profit margins have had a remarkable recovery and troughed at a higher level than usually occurs during recessions. Miraculously, U.S. corporate profits are on track to soon reach the record levels achieved in 2006. Despite worries of deflation (which we share), U.S. nominal GDP is already back at record levels. Further, corporate cash holdings have surged, possibly portending both increases in capital spending, employment, dividends, and share buy-backs.
In the recent Federal Open Market Committee statement following its June meeting, the Federal Reserve noted the recent deceleration in the economy, and continued to indicate that monetary conditions would remain accommodative for an extended period of time. Thus we believe that the interest-rate backdrop should remain supportive of the economy and investments for the foreseeable future.
The Stock Market
The steep declines in stock prices in May and June have caused the evaporation of investor optimism that was so pronounced in the first quarter. The painful declines have also been accompanied by sharp breaks in important moving averages, although generally on light volume. We have witnessed a succession of high momentum days in both directions, with a profusion of 90% up and down volume days. In fact, in early June there was a 120:1 down/up volume day, a rare event.
While the stock market is clearly in a corrective trend, with the S&P 500 having declined 15.5% from its April highs, we believe that the market should begin rising again as investors reset earnings expectations to somewhat lower levels due to the headwinds that we have discussed. The case for higher stock prices is premised on the continuing favorable interest rate environment, good but decelerating earnings growth trends, and cheap valuations. With Treasury bonds yields so low, it is hard to make an argument against owning blue chip stocks selling at 10-13 times earnings, growing at more than 5%-10% and yielding more than 2%. There are abundant numbers of large capitalization equities that fit this description.
We are concerned about the potential for deflation due to the profound debt burdens of the Western economies, in addition to adverse demographics due to aging populations. While a lot of the excessive private debt has been restructured, it has been replaced with massive government debt. The long-term outcome of these imbalances will depend on policy initiatives deployed over the next few years. For now it appears that we will be moving from an environment of fiscal stimulus to fiscal austerity, but with plenty of monetary “quantitative easing” to attempt to lessen the pain.
Strategy
While we expect the stock market to recover from its recent decline, we expect a significant change in market leadership with a sharp tilt in favor of large capitalization growth stocks, and an underperformance of small capitalization stocks and emerging markets. We believe that such a rotation could occur due to the deceleration of global economic growth, excessive outperformance by small caps and emerging markets during the last 10 years, and very attractive valuation and quality characteristics of large caps.
Media- and advertising-related stocks are now among our largest holdings. Advertising rates have only begun to rebound from the lows of the past few years, and recent television ad-rate auctions have been better than expected. The leading media companies all sell below average market multiples, have strong cash flows, and stable dividends. However, what is most interesting about the media companies are the assets they own. They have created the content that is becoming more valuable every day. Technology companies are fighting each other to find new ways to distribute movies, TV shows, sporting events, music, etc. to the consumer. While many new platforms of distribution are being developed (iPads, smartphones, Internet-enabled TVs, etc), there are only a few companies that own the content being distributed. As the scarcity value of this content increases, we expect the creators to benefit through possibly higher prices for content access and greater usage of advertising (especially on mobile devices). While this trend has only just begun, we have seen increasing evidence in support of this thesis recently, including News Corp’s decision to charge for online news access, Hulu’s subscription service, and rumors of Google developing a payment system for premium online content.
Another focus of our large-capitalization strategy is in companies whose earnings can withstand another economic deceleration. We own high-quality stocks with what we believe are strong balance sheets, solid cash flows, and defensible income streams. This group includes consumer staples producers, health care, and select mega-cap technology companies. While the outlook for many health care companies has become more opaque as governments around the world look to reduce spending, we have focused primarily on the beneficiaries of increased health care coverage with less reimbursement risk (diagnostics providers, distributors, and drug manufacturers that serve unmet needs). While technology companies’ earnings are generally more correlated with economic trends, our holdings are in corporations with unique products entering new cycles, which should provide some level of insulation from slower GDP growth. Also, with valuations at or near 10-year lows in many cases, these companies should be able to better weather potential reductions in earnings guidance in coming months.
We have increased positions in value-oriented retailers and apparel producers, which should benefit from any decelerations in economic growth due to the likelihood of consumers trading down to lower-cost brand names (yet ones that still offer a high value proposition). Many of these companies are experiencing revenue growth rates in the high-single digits to low-double digits, which could prove resilient even in a weaker economic environment. In addition, these select retailers’ earnings per share have already met or exceeded the highs from the past few years, while valuation multiples have compressed significantly.
Trends in agriculture have marginally improved recently, and we continue to be bullish on the long-term fundamentals for grain pricing and related machinery manufacturers. Despite excellent planting weather, forecasts for the current harvest have been reduced recently, and inventory estimates for corn and soybeans have been reduced several times in the past month due to lower yields and higher demand. There is also an important catalyst that could occur before the end of the summer: Congress is reportedly discussing a revision to the Biofuels Law and could increase the required amount of ethanol in gasoline from 10% to as much as 15% (over the course of several years). This would materially add to corn demand in the United States, potentially by over 10%. Another important development from the past few months is the sharp increase in China’s corn imports from the United States (their first large purchase in four years). Their commitments have reportedly already come close to one million tons of corn, due to drought conditions, low crop yields, and depleted inventories.
Gold producers are the only other commodity-related stocks in our portfolios, as gold’s unique position as a store of value should allow its outperformance to continue. Fiat currencies worldwide will continue to be printed by governments who need to devalue their debt and support asset prices. Even European leaders may be forced into some form of quantitative easing in coming months, which would help provide needed liquidity to their banks as austerity programs are being implemented. As additional money is printed to purchase toxic financial securities, gold’s relative value should appreciate because new supplies are much more difficult and expensive to find and produce.
The views in this newsletter were those of the Fund manager as June 30, 2010, and may not reflect his views on the date this report is first published or anytime thereafter. These views are intended to assist shareholders in understanding their investments in the Fund and do not constitute investment advice.
Past performance is not a guarantee of future results.
Before investing you should carefully consider the Jordan Opportunity Fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus. Please read the prospectus carefully before you invest.
The Fund’s investment parameters are diverse and as such may be subject to different forms of investment risk such as non- diversification risk, concentration risk, small- and medium- sized company risk, interest rate risk, high yield bond and foreign securities risk, and lastly, the Fund may use derivatives such as options to increase its exposure to certain securities. Please see the prospectus for a more detailed discussion of the risks that may be associated with the Fund.
Click here for fund holdings as of June 30, 2010.
Fund holdings and sector allocations are subject to change at any time and should not be considered recommendations to buy or sell any security.
The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. The Economic Cycle Research Institute, or ECRI, is an independent forecasting group based in New York. ECRI publishes several leading indexes designed to predict changes in the economy. The ECRI Weekly Leading Index is one of these indexes. You cannot invest directly in an index.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.
The Jordan Opportunity Fund is distributed by Quasar Distributors, LLC.
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