The fast start the economy and markets enjoyed in the first quarter of 2012 faltered as the year progressed. Stocks fell sharply from April to May only to recover modestly in June. For the quarter the S&P 500 declined 2.75%, but for the first half of 2012, the S&P 500 advanced 9.49%. The fixed income markets continued to respond to Federal Reserve Chairman Bernanke’s stated goal of stable, low interest rates. The 10-year treasury began the quarter at 2.22% and finished the quarter at 1.67%.

Signs of a possible economic slowdown in the U.S. emerged late in the quarter as employment gains slowed sharply, retail sales ex-autos stalled, and capital spending slowed markedly. In addition, consumer confidence fell for the fourth consecutive month in June and the ISM Purchasing Managers Index fell below the critical level of 50 (see chart), which means manufacturing contracted. Put simply, the U.S. economy has been unable to establish a steady recovery pattern, and nobody seems to have a clear explanation as to why the economy cannot sustain upward momentum.

Europe’s economy, already experiencing consequences of excessive deficit spending, worsened further in the quarter. The problems were especially severe in many southern European economies, including Portugal, Spain, Italy, France, and Greece. Ongoing discussions amongst the European Union participating countries called on Chancellor Merkel of Germany to provide a financial lifeline in the form of new credits to the most severely impacted economies. Having recently experienced defaults on loan guarantees by the southern European economic community, the German central bank has proven understandably resistant to extending new credits.

At quarter’s end, we began getting reports of a sharp slowdown in European manufacturing orders accompanied by cancellations of orders booked earlier in the year. This suggests that recessionary conditions are likely to continue in Europe during the second half of 2012. While this will compound the already dicey financial problems being experienced by the European subsidiaries of U.S. multinational companies, these subsidiaries account for less than 25% of consolidated company earnings. Late in the quarter, we began to see earnings estimates for many of our holdings with European exposure being scaled back. So far, these cuts are modest, 5% or so of total projected 2012 earnings; but the 10-12% overall gains we had hoped for in the second half of this year are more likely to be in the 5-7% range. But even these lower expectations are dependent upon things not worsening as the year unfolds.

If this were not enough, there now appear to be indications that the economies of China, India, and Southeast Asia may also be slowing. However, the Asian issue is one of slowing growth from very high levels to more sustainable, moderate rates. The situation in Asia is a normal cyclical correction after a period of extraordinary growth that now needs a breathing spell. Regional demographic trends, savings rates, and sharp increases in the capital spending levels support our confidence of long-term expansion in the region and continued improvement in living standards.

The new growth economies comprised of China, India, Brazil, Mexico, and Argentina now account for approximately 3 billion people of the world’s 7 billion, or 40% of the total world population. The combined 2010 GDP of these five economies was $11.2 trillion of the world total of $63 trillion, and these economies have achieved growth rates of between 8% and 10% annually over the last seven years. Even reflecting a lower forecasted growth rate of 6-7%, these economies will be able to sustain future world growth, adding $750 billion annually to world GDP. Note the European economies with a combined population of 500 million people support economies totaling some $17 trillion. Assuming a slowing of European growth, it becomes apparent that the contribution to world growth by new Asian economies will soon exceed the economic impact of Europe, easing concerns that the European crisis will threaten long-term global economic growth.

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Nobody seems to have a clear explanation as to why the economy cannot sustain upward momentum.

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A surprising development late in the quarter was the unexpected announcement that JP Morgan had experienced losses of approximately $2-4 billion in a series of bond transactions designed to hedge the bank’s exposure to the faltering economic outlook in Europe. The bank’s strategy was theoretically correct; however, the execution proved to be a total failure. Long thought to be immune to the risky trades of exotic securities, the loss by Morgan, though not material to the company’s overall health, was a complete surprise and psychologically unsettling to investors who believed Morgan was staffed by the smartest and most conservative traders on Wall Street. This slip-up added to investor fears and struck at the heart of investor confidence, the critical ingredient to market stability. Investor demands for higher risk premiums for bond investments will lead to greater volatility in our markets. Only time and responsible trading practices can restore risk to desired levels.

On June 28, Supreme Court Chief Justice John Roberts rendered the court’s opinion on the constitutionality of the insurance mandate provisions of the Healthcare Affordability Act. Employing an unusual interpretation of the tax provisions of the Constitution, Roberts opined that the financial mandates of the act were enforceable, therefore upholding the major provisions of President Obama’s healthcare initiative. His ruling essentially declared that it was the electorate’s duty to determine the future of the program through the normal electoral process.

Our concern stems from the practical reality that nearly 20% of our economy relates to healthcare. We are concerned that a comprehensive program that regulates anything as large as 20% of our economy will likely have both unpredictable and unexpected outcomes that could be either positive or negative influences on our economy. The result for investors is added uncertainty that, again, will likely result in greater volatility in our financial markets.

A final concern is the scheduled expiration of the two Bush tax cuts of 2001 and 2003, and the spending cuts required under the debt extension compromise agreed to by Congress last summer. Some have called this a fiscal cliff, which could strike the economy with a large tax increase and big spending cuts just as the recovery is gaining momentum. The tax hikes have been compared to increases in President Roosevelt’s second administration when substantial tax increases were implemented in 1937, which stalled the economic recovery, returning the economy to Depression-like conditions. This economic setback was only reversed by rearmament spending programs forced by the outbreak of WWII in Europe in September of 1939.

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The new growth economies now account for 40% of the total world population.

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We disagree with those who fear a replay of the late 1930s. The tax cuts should not be allowed to expire, but will be modified. We anticipate a phased increase income tax rate over the next several years if Obama is reelected. We also anticipate significant modifications to the tax on dividends. In addition, high earners ($250,000 and above) will be subjected to a new 3.8% tax on investment income, part of the Obama healthcare plan. This new 3.8% tax will be allowed to take effect.

For the balance of 2012, we expect the U.S. economy to post real gains of 2-2.5%.Though not robust, this is an acceptable performance given the state of the world’s economy. We also anticipate moderate inflation levels of about 2%. We continue to expect Dow earnings to be approximately $1100/share, suggesting common stocks are attractively valued at present levels, using our expected range of 11-15x earnings. This would indicate a Dow valuation of between 12,200 and 16,500. Interest rates continue to remain closely controlled by the Federal Reserve, and Mr. Bernanke reiterated his determination to maintain the current interest rate levels for the foreseeable future. Interest rates are at or approaching their cyclical lows, and rates will increase if economic activity picks up to an annual rate of advance of more than 3%. Such improvement, although good for employment and the economy, would result in lower investment returns in bonds. Accordingly, we continue to maintain our stance favoring stocks, particularly those with higher-than-average dividend yields.

Despite all of the issues mentioned above, we cannot overlook the resilience that our economy has shown since the credit crisis of 2008-2009. In fact, one could argue that our economy was strengthened by having dealt with the first-ever major credit-driven recession. Our bank capital ratios are now stronger than at any time in the last 40 years, our personal savings rate, still low by historic standards, is improving, and corporate profits are at record levels. All of this did not come without pain. It would be helpful if our European friends took note of our coordinated efforts and compromises which brought an end to the domestic recession of 2008-2009.

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Only time and responsible trading practices can restore risk to desired levels.

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As we cross the halfway mark for 2012, we do so with a high level of uncertainty, fearful of a European replay of the terrible days associated with the Lehman bankruptcy in the fall of 2008. Yet, these turbulent times spell opportunity to one committed to our philosophy. It may be helpful to remember the mantra of our firm: “be greedy when others are fearful, and be fearful when others are greedy.” As we enter the third quarter, we find many equity values at very favorable levels. The housing market is showing pockets of strength in many parts of the country. It is reliably reported that private equity investors are aggressively purchasing foreclosed properties. A clear sign of recovery is the fact that some smart investors see an end to the housing price slide.

Finally, housing may be responding to low interest rates. The pessimist would say lower interest rates are an indication of a stalled economy, while others (including this firm) would say the rates are offering inexpensive financing to those willing to take the risk to invest in a future recovery. We are inclined to see things in a more positive light, especially as we compare current overall equity values to historic norms. Bond rates, although near their lows of the cycle, will not rise sharply until there is absolute evidence that the economic recovery can be sustained. Accordingly, we remain committed to our allocation between both equities and bonds and see no need to adjust our recommendations.

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We cannot overlook the resilience that our economy has shown since the credit crisis of 2008-2009.

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Although there are issues concerning the ongoing problems in Europe, the slowdown of growth in Asia, uncertainty in the bond market and with healthcare, and potential tax hikes, it appears that the U.S. economy is picking back up. We have a positive outlook for the remainder of 2012, despite the uncertainty and fear that will keep markets down as long as it persists. At some point in time, the problem issues will be resolved, or at least lessened. As the economic clouds clear, the stock market should move ahead, possibly strongly, if the surprises are positive. As we move through the second half of the year, one could recall the wise words of FDR: “The only thing we have to fear is fear itself.”

As a final note, I am both happy and sad to report that Ginny Phillips, a long-time employee of this firm, retired on June 15. We are all happy for Ginny’s retirement, and we wish her well in many productive and relaxing future years. We are saddened to lose a very able employee, a confidant, and a true friend. Happy trails to you, Ginny. JDH