Second Quarter Investment Commentary 2010

"Unusually Uncertain"

The stock market has been nothing short of frenetic over the last quarter. One day it seems all is well and we’re on the road to recovery and the Dow Jones Index will go up a couple of hundred points. The very next day the economic quicksand has us in her grips and there seems to be no way out of our economic sinkhole. Why even one day in May, we had a "Flash Crash” and lost nearly a trillion dollars worth of market capitalization in just about fifteen minutes. So which is it? Quo Vadis?

Federal Reserve Chairman Ben Bernanke testified before the Senate Banking Committee on July 21^st, saying "We also recognize that the economic outlook remains unusually uncertain.” His understatement packs a punch! It is quite unusual for the Chairman to admit so openly to such uncertainty. First quarter Gross Domestic Product was revised downward from a growth rate of 3.0% to 2.7%. The prior two quarters also saw downward revisions after their initial readings. Then the June reading of the Conference Board’s consumer confidence index sank sharply from May. Although the reading was still at a level consistent with modest economic growth, it came in well below most economists expectations.

The Chairman did comment that the Fed remained prepared to take action to aid growth, if needed, and outlined a few options that were available. These options might include reducing the rate paid on bank reserves held at the Fed. They might also include a return to the use of the Fed’s balance sheet for open market purchases, which had been discontinued at the end of the first quarter of this year. However, in his eight page written statement to the Senate Banking Committee, the Chairman spent much of his time discussing the exit plan from the current stimulative stance and less time to potential tools available to stimulate growth.

While I watched the Chairman’s testimony, I was touched by a great sense of empathy. Maybe things are really OK, just not as good as we thought they were at one point. And as I started to tune out his testimony and refocus on the work I had at hand, I found my mind wandering to a concept I was introduced to in college, one that intersected both physics and philosophy.

The concept is called the Heisenberg Uncertainty Principle. In a nut shell, the principle says it is impossible to discern simultaneously and with high accuracy both the position and the momentum of a particle, such as an electron. Thinking about this, I took some comfort in the knowledge that we have a functioning economy, even if we can’t say with certainty or accuracy exactly where it is going or how long it will take to get there. Our friends in Europe are not certain of that.

Flash Crash

On May 6^th, 2010, the Dow Jones Industrial Average lost nearly 1,000 points in less than a half an hour. About thirty stocks listed in the S&P 500 Index fell at least 10% within five minutes. This drop temporarily erased more than $1 trillion in market value. Some stocks even traded as low as $0.01/share during the rout. The episode has come to be known as the "Flash Crash".

Since that day, a new plan of "Circuit Breakers” has been devised by the Securities and Exchange Commission. There were already rules in place requiring market-wide halts in trading if the Dow fell 10%, 20% and 30%, but these failed to stop this rout as orders that couldn’t be executed on the New York Stock Exchange quickly shifted to one of the dozens of electronic exchanges.

Mary Shapiro, the Chairman of the Securities and Exchange Commission had this to say about the crash, which she has chosen to refer to as a disruption, "(It) illustrated a sudden, but temporary, breakdown in the market’s price-setting function when a number of stocks and exchange traded funds were executed at clearly irrational prices. By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational prices."

Under the new rules, trading of any S&P 500 stock that rises or falls 10% or more in a five minute period will be halted for five minutes. The halts would be applied to price swings that occur between 9:45 a.m. and 3:35 p.m. Eastern time.

Consumer Confidence

Consumer confidence in July fell to a level not seen in over a year. The data show that a record low number of Americans expect that their income will go up over the next twelve months. The index of consumer expectations for six months from now also dropped, to the lowest level seen since March of 2009, suggesting that there is little support for any near term pick-up in spending. Consumer spending typically accounts for about two thirds of the economy.

The sentiment report also showed that confidence about the Obama administration’s economic policies continues to fall, reaching the lowest level since he took office. Of those surveyed, the proportion that said his economic policies were unfavorable rose to 42% in July, nearly twice the low of 22% in May of 2009, shortly after the $800 billion stimulus package was approved.

Employment

The U.S. lost 125,000 jobs in June as the government cut temporary workers conducting the 2010 census and private payrolls rose a less than forecasted 83,000, according to Labor Department figures released July 2^nd. The boldly promised and highly anticipated job growth that was supposed to result from the stimulus plan of early 2009 has yet to make its appearance. Hopefully this will change as what’s left of our stimulus money gets put to work.

Twenty-seven states reported a drop in payroll employment in June. Twenty-four states still have a jobless rate above year-ago levels. Sixteen states still have an unemployment rate in excess of ten percent. In Nevada, the rate has risen to a record 14.2 %. In Michigan, the official unemployment rate is 13.2 %.

Meanwhile, many companies are announcing further rounds of layoffs. Recent announcements over the last few months have been issued by Wells Fargo (3,800 jobs), Morgan Stanley (1,200 jobs), Pfizer (6,000 jobs) and Hewlett Packard (9,000 jobs). Ongoing cuts are still occurring from layoffs that were previously announced earlier this year at Merck (15,000 total jobs), Verizon (13,000 total jobs) and WalMart (11,200 total jobs) to name just a few.

Layoffs are also rising in the public sector, as state and local governments grapple with budget gaps that continue to grow from the increasing costs of entitlements and the decreasing revenue resulting from falling property values and diminished tax receipts. New York City recently approved a budget that cuts nearly $1 billion in spending and eliminates about 5,300 jobs from the city’s 300,000 workforce. Job cuts among state and local governments may escalate this year as federal funding that had been worked into budgets for Medicare and Medicaid costs may not come through.

Housing Market

The month of June saw a five percent decline in housing starts as continued weakness in the employment situation presented a persistent headwind to the real estate market. According to the National Association of Realtors, purchases of previously owned homes also fell in June, for a second month in a row, dropping 5.1%. I suspect this is just the beginning of a cooling stage now that the government’s $8,000 tax credit for new home buyers has expired.

Meanwhile the number of homes on the market climbed 2.5% to 3.99 million, or about a nine month’s supply. That does not include the "shadow" inventory of foreclosures and short sales. Home foreclosures increased 38% in the second quarter from a year ago, according to RealtyTrac, putting lenders on track to reclaim more than 1 million properties this year. That may not be the end of it either – The Wall Street Journal estimates that there are still at least 11 million people in the unenviable position of owing more than their homes are worth.

Budget Deficit

On July 13^th, the U.S. Government reported an update to our massive budget deficit through the month of June. The excess of spending over receipts was $68.4 billion for the month of June alone, according to the Treasury Department. The annual budget deficit is projected to reach a record $1.6 trillion this fiscal year, which ends September 30^th. Individual income taxreceipts are down 4.4% this fiscal year to date and have come to a total of $655.4 billion. Fewer Americans are working and consequently fewer taxes are being paid for income.

Looking in to the specific areas of where the Government is spending our income taxes, we find the following information regarding the three largest elements of the Federal Budget: Department of Health and Human Services, which administers the Medicare and Medicaid programs, increased its spending to $631.4 billion for the fiscal year to date. Social Security Administration spending rose to $564.2 billion for the fiscal year to date. Defense Department spending increased to $499.1 billion for the fiscal year to date.

Clearly the largest budget commitments in government outlays over the last nine months have been in entitlements and social benefits associated with Medicare, Medicaid and Social Security. This is not sustainable. President Obama’s 2011 Budget bears the title, "A New Era of Responsibility." What this means to me is uncertain.

Prowling for Value

The Fed Funds Rate remains stuck in the range of zero to one quarter of one percent. Most short term and liquid investment vehicles, such as money markets, reflect these historic low rates. It’s hard to find a safe and liquid place to park cash that will deliver any return to speak of. As we venture out in time along the yield curve, things do not get much better. At yesterday’s close, a one year Treasury bill yielded less than one quarter of one percent, even before any cost to purchase is considered. A three year Treasury Note yielded less than one percent, before costs. Even a ten year Treasury Bond yielded less than three percent.

Rates in the world of corporate bonds are not much better. Most new investment grade issues with five year maturities that are coming to market have yield to maturities of less than three percent.

Where do you go if you are in search of income? One place that has not received all of the attention it deserves is in the dividends offered by stable Blue Chip companies. Below is a short list of selected securities, across many sectors, whose dividends exceed three percent based upon yesterday’s closing prices:

While the past few years have shown us that some dividends can be cut, most of these companies have a history of actually raising their dividends. The far right column shows each company’s three year average dividend growth rate. Not only is the current income on these stocks attractive relative to bonds, the possibility of an increasing income makes them all the more alluring.

The income tax rate is widely expected to go up next year but the most recent talk out of the Administration regarding the tax rate on dividend income is that it may only go up to 20% from the current 15%, for those earning less that $250,000.

Now That’s Big News

In other news, scientists have identified a giant star, twice as large as any that has previously been discovered. The star, which at the moment is known as R136a1, resides at the center of a star cluster in the Tarantula Nebula, in the Large Magellanic Cloud, which is a galaxy about 165,000 light-years away from our own galaxy, the Milky Way.

Astrophysicist Paul Crowther at the University of Sheffield in northern England said of the star, "Unlike humans, these stars are born heavy and lose weight as they age . . . R136a1 is already middle-aged and has undergone an intense weight loss program." In fact, he says, it is burning itself off with such intensity that it shines at nearly 10 million times the luminosity of our own sun. The surface temperature is estimated to surpass 40,000 degrees Celsius (72,000 degrees Fahrenheit). Now that certainly is one hot, bright, big ball of gas. I think it deserves another name than R136a1, don’t you?

Guarding Your Future Today

For more than eighty years, Old Point has navigated through numerous market swells and economic troughs. Our Trust Company’s steadfast strength and stability is based on our commitment to reduce risk, where appropriate, while keeping an eye towards the future. A steady hand at the wheel is necessary to weather a storm successfully. We continue to adhere to our principles of dedicated service and financial expertise as we work through the difficulties of today. Please take comfort in knowing that we are "Guarding Your Future Today".

McKim Williams, Jr.
Chief Investment Officer
July 24th, 2010