Investment Outlook

3rd Quarter Letter 2011

When you dissect the stock market action of the last 60 days, fear is the dominant theme. Only the safest assets held up. The third quarter was a rout with the S&P 500 falling 14%, its worst quarterly performance since the final three months of 2008, following the Lehman Brothers collapse.

The FTSE All World Index has fallen more than 20% from its high in May. This deep and broad correction in stock prices is due to serious concerns about the possibility of a global recession.

Commodity prices have fallen sharply, oil and copper for example. The prices of commodities are highly sensitive to any change in the outlook for economic growth.

At South Texas Money Management, we had poor relative performance for the quarter, after very good outperformance in the first quarter of this year and a neutral second quarter.

Large capitalization stocks were the best performing area of the stock market in the third quarter. For that reason, our discipline of broad diversification with value and growth stocks, both US and International stocks, large cap, mid cap and small cap stocks made the S&P 500 impossible to beat. By its inclusion rules, the S&P 500 is generally a large cap growth index. In the most recent quarter, our diversification hurt – it did not help. Over the long term, however, diversification has been a significant contributor to our relative performance. Non US indexes, value indexes, mid cap and small cap indexes significantly underperformed the S&P 500.

The level of intraday volatility has been extraordinary. As outlined in our email last month, we do several things to try to mitigate that volatility, and we do not sell stocks simply due to their volatility. At initial purchase, we limit every stock’s exposure to between one and two percent.

The sell off was broad and deep and we have now gone through a bear market correction. Our discipline of broad diversification did not help during the most recent 60 day period, but that discipline will not change. That has been a strong contributor to our long term performance. Indeed, some of the most attractive prices are in those non US stocks, value stocks, mid and small cap stocks that have sold off so sharply.

Our worst sectors were energy, with holdings such as Denbury, Baker Hughes, Patterson Energy, and Marathon Petroleum; industrials, with holdings such as Bombadier and ABB Ltd.; and consumer discretionary stocks with holdings such as Netflix and Sony. Quite frankly, there is not a good or great sector in stocks worth talking about in this “capitulation” quarter. These sectors—energy, industrials, consumer discretionary— are very economically sensitive. Again, commodity prices are signaling a growing possibility of either a global recession or a significant downshift in China’s growth. The good news is that the US is not in a recession and the US dollar has been a “safe haven” during this rout.
High quality bond prices have continued to be a consistent “hedge” in a falling stock market. Our bond strategy has been a very good complement to stock volatility. We have said over and over that a balanced asset mix is a good one for this reason. We have also consistently predicted continued high unemployment and low gdp growth. That has been correct. No, we did not predict that Greece’s fiscal policies would threaten to unravel European banks. In hindsight, we were too sanguine about that.

What is our current strategy?

1. To remain diversified.
2. To remain only with liquid securities – despite the volatility, the cost of giving up liquidity by investing in partnerships, hedge funds, alternatives, etc. is too dear. Fees in those venues are too high, and they are not immune from this environment. Commodities and real estate have been among the worst performers. Keep your assets liquid: stocks, bonds, money markets.
3. We will focus on attractive dividend yields and low debt balance sheets. Yes, we expect some non-US countries will suffer recessions and in the US, and growth will be so slow as to appear nonexistent. We will be defensive, but not non-diversified. We buy growth and value stocks, US and non US stocks and large, mid and small caps.

The yield on stocks is very attractive relative to US Treasuries. Focusing on yield, balance sheets and diversification is our strategy. When this market has discounted prices enough, we feel that much like the 1st Qtr 2009, there will be a fast and steep recovery.

Thank you for your patience and understanding during this very challenging quarter. We encourage you to watch our third quarter webcast.

Sincerely,
Jeanie Wyatt, CFA Chief Executive Officer Chief Investment Officer


This letter is not intended to constitute investment advice. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this report were or will be profitable. Securities identified in this letter do not represent all of the securities purchased, sold or recommended for advisory clients, and you should not assume that the recommendations made in the future will be profitable or will equal the performance of the securities identified above. A complete list of all equity recommendations made by STMM during the past year is available upon request. This letter, excerpted from STMM’s quarterly letter to its clients, is for general informational purposes only and sets forth the personal opinions of its author as of its publication date. This letter contains no recommendations to buy or sell securities or a solicitation of an offer to buy or sell securities or investment services or adopt any investment position. This letter is not intended to constitute investment, legal or tax advice and should not be relied upon as such. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this letter were or will be profitable. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed.