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Market Commentary
MKG Financial Group, Inc. – July 31, 2012
Has Anybody Noticed that the World is Still
Turning and Some Things are Actually Getting Better?
The macroeconomic and geopolitical concerns we face today are nearly the same forces we have endured for much of the past three years: political quagmire and budgetary constraints both in the U.S.
and abroad – especially from within the eurozone, worries over an economic slowdown in China, and
global growth prospects. While the last three years have witnessed salvation for much of the world
from a period that will historically be referred to as “The Great Recession,” we have been forced to relive these same obstacles that stand in the way of renewed global progress over each of these last four
years without actually solving any of the issues we still face. Does this mean that we are destined to
relive this period over and over again like a chapter out of the movie “Groundhog Day”? Is this what is
meant by taking a long-term period for recovery following a severe occurrence, such as in 2008? Will
we fail to accomplish what is needed and sink back into another downturn from economic exhaustion as
nations from around the world run their course through their own economic cycles?
As we have previously discussed, the macro issues at play as detailed above suggest a new global foundation between nations which resemble participants in a game of three-level chess. For example, the
“currency wars” in which global powers battled across international borders by utilizing economic tools
such as interest rates and bank intervention was an attempt to control their currency exchange rates to
boost global commerce. While many countries have experienced different levels of economic turbulence, the intertwined relationships have become ever more apparent.
The United States has experienced both strength and weakness, depending on the sector and quarter,
as the country moves forward and different parts of the economy recover at a different pace. When we
look at current areas of strength, it is important to realize the scale of inputs to future growth that some
of the really meaningful industries are beginning to show. The housing market is one of these, and even
in its weakened state, it will be a force to be reckoned with moving forward.
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Content
Second Quarter 2012 Performance
2
The Market – Earnings Will Make the Difference 2
Three Points of Reference-Economic Expansion 3
The Economy
3
Housing and Real Estate
3
Employment
4
Manufacturing and the Service Sector
4
The Weather
5
Consumer Spending and Retail
5
Energy and the Commodity Market
6
Interest Rates and Inflation
6
Portfolio Update and Company Comments
7
Conclusion
7
Economic Charts
9
Second Quarter 2012 Performance (CAGR)
While performance during second quarter for
the MKG Firmwide Composite (MKGFC) gave up
ground, the decline had more to do with guilt
by association and less to do with declining valuations of the underlying companies in the
portfolio. Being in companies that temporarily
fall out of favor is the curse of being a contrarian sometimes in the market. For example,
investor fear over a weakening in consumer
spending created concern for auto sales in June.
This, however, proved not to be an issue and
stocks associated within this sector have quickly
rebounded as we have seen this July.
Meanwhile, we may have returned to a period
we referred earlier this year as “normality” –
one in which poor earnings results push stock
prices lower, whereas good quarterly results
will actually bolster consumer confidence and
move stock prices higher. This is something
that has been absent in a market that has become notorious in focusing more on specific
global concerns and events and less on company operating performance.
As we have just recently entered the second
quarter 2012 earnings reporting period, we
would expect to see more of this activity over
the next six to eight weeks. Looking at the
overall performance, we see a return to reality
in terms of investors beginning to realize that
Q1:12
MKGFC*
11.46%
NASDAQ* S&PTR*
18.67%
12.66%
Q2:12
-9.99%
-5.06%
-2.84%
6 mos. 2012
0.32%
12.66%
9.46%
YTD 07-20-12 2.95%
12.29%
9.63%
*Compounded Annual Growth Rate (CAGR). See information
on MKGFC & indiceson pages 20 and 21.
all companies are not created equal and while
economic conditions remain challenging, some
companies are doing quite well. As a result, we
have begun to make up ground as better than
expected earnings entice investors back into
these companies pushing up stock prices and
benefitting our most recent results.
The Market – While the Economy May Dictate in the Short-Term, It Will Be Earnings
that Make the Difference Over Time
While there are always delays and setbacks for
some companies that continue to work through
operational issues, we feel confident that the
majority of the companies we own for our
clients will continue to report good earnings for
the second quarter. In long-term investing, we
have found two important corporate characteristics are competitive strength and fundamental growth.
When investors focus on the eurozone challenges, slowing world economies, like China,
and U.S. politics, they generally lose sight of
what is really going on around them. While
2012 has been less impacted by the extreme
market volatility experienced in 2011, the news
media has relentlessly rung the bell on the
blow-by-blow descriptions of world events. We
are hearing from clients who are beginning to
question why we don’t hear more about some
of the things that are actually getting better –
thus the title of this quarterly report.
The Dow Jones Industrial Average now sits at
13,075 as of the close of Friday, 07/27/12, up
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187.73 for the day. It is only within 1,123 points
of its all-time high reached in October 2007 –
merely five years ago. There is a lot of water
under the bridge since that time, but the one
point that investors may want to take note of is
that a lot of companies are much more profitable, carry large cash positions and are doing
more business, especially on a global basis.
Many companies have long since recovered
from the 2008 economic downturn and during
the next growth period, this should become the
catalyst for future levels in the stock market.
Three Points of Reference to Economic Expansion in the United States
Following on the preceding concept, we felt it
important to point out three of the most important sectors that should continue to help drive
future growth here in the United States. Each
of these three areas, while not only visible in
size and understandable in scope, also can
cause ripple effects in building and strengthening the economy.
1) One of the strongest business environments today exists within the global
aerospace industry where Boeing alone
has backlog orders of over 4,000 aircraft and is essentially sold out through
2016. This does not include additional
orders received during the recent air
show in Scotland. Illustrative of its diversity is a schedule made up of 1,500
domestic and 2,500 international aircraft. In addition, Airbus also has a sizable backlog of orders and recently announced that it will build a production
facility, only the second outside of Europe, in Mobile, Alabama, that will
bring jobs into the United States.
2) Automobile sales remain strong and are
running at an annualized pace above 14
million cars and light trucks sales during
the month of June. This level of sales
was ahead of forecasts. Clearly a strong
and sizable growth engine for the econ-
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omy, it is also very illustrative of consumer spending patterns.
3) Housing, the industry that has been so
absent as a growth catalyst, is finally
visibly bottoming and beginning to
show green shoots which contribute to
growth once again in the United States
(see Economy-Housing section).
The Economy
As mentioned earlier in this report, the U.S.
economy, as well as that of other countries,
wrestles with the constant tug-of-war between
areas of strength and areas of weakness. However, when we compare this year to the significant downturn in economic activity that occurred in the middle of 2011, 2012 is nevertheless experiencing more strength than weakness.
Housing and Real Estate – Housing and commercial real estate development are one of the
largest missing components for growth in the
economy, both in residential construction,
sales, remodeling and financing activities, as
well as commercial development and its similar
ancillary businesses and services. Keep in mind
the tremendous ripple effect that real estate
activity also has on so many other industries.
The housing and commercial development sector is perhaps the greatest culprit in keeping
unemployment stubbornly above 8%. In every
past recovery period, housing has risen in lockstep with improvements in the employment
picture, in general leveraging the benefits of job
creation and rippling through so many other
areas of commerce. Because of the overbuilding that occurred, even as sales slipped significantly between 2005 and 2008, it will take years
to return to similar growth prospects (see “The
End of the Bust” chart on page one).
To best understand why we are not looking for
a full-fledged recovery in real estate, the third
chart on the front page shows the past construction level of housing starts and where it
stands today. However, the size of the housing
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and real estate market is so large that even at a
slower pace this growth is an economic boost to
the economy as it is visibly such an important
part of consumer spending.
The fourth chart perhaps best illustrates the
current transition in housing as it begins to
benefit GDP growth in this country. This should
continue to occur and we look for this area of
the economy to gain slow momentum. Recently, the Housing Market Index survey of home
builders across the country surged 6 points in
July to 35. The monthly gain is the largest in
nearly 10 years while the level, which has been
moving higher all year, is now at its highest level of the recovery since March 2007. All regions
reported gains with strength centered in sales
six months out. The only caution is that this
survey represents building activity that is currently running ahead of the sales levels for new
homes. While the inventory of homes on the
market is shrinking, banks continue to have foreclosed properties yet to be monetized.
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Public employment – before, currently and in
the future – will most likely be a weight pulling
the wrong direction as public jobs continue to
be eliminated under growing budget constraints. Healthcare, however, despite the challenging elements associated with the new
healthcare bill, should benefit and continue to
grow. More insured participants and an aging
population add to the growth prospects for the
industry.
Manufacturing and the Service Sector – As can
be seen in various charts included in this report,
both manufacturing and non-manufacturing
activities weakened in June, but this appears to
have been heavily influenced by a slowing in
export orders brought on by weakness in Europe that has in turn played into a slowing in
Employment – Unemployment sits stubbornly
at 8.2% while recent monthly employment figures have softened in the second quarter to a
total 225,000 net new jobs (subject to revisions), as compared to 677,000 jobs during the
first quarter. The monthly trend, however, has
been moving higher with the June report showing 80,000 net new hires, which is above May’s
77,000 number and April’s 68,000 jobs report.
We have already stated what we believe to be
the strongest reason for higher-than-desired
unemployment in this country: weaker housing
and real estate development. Also, first quarter
hiring was abnormally stronger in response to a
period of unusual warmer weather that shifted
job opportunities forward.
This said, we continue to marvel at the reduced
level of unemployment without the benefit of a
strong real estate market. Stronger manufacturing, albeit with greater efficiencies and lower
onsite employment levels, and the continued
rise in service sector hiring by businesses has
been a blessing during this recovery period.
China, as well. Interestingly, the employment
component of both of these surveys has remained the bright spot for the United States.
And while the decline has been more muted
than what we saw during 2011, concern remains high that without new order activity, this
will lead to a stall in economic growth here as it
has in Europe.
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Equally interesting, however, is that more recent economic reports show a mixture of
stronger economic growth in orders, including
in regional areas of the country, where the
Philadelphia Fed Survey showed a decline in
manufacturing activity while the New York Empire State Survey showed greater strength. It
is, however, the weaker reports that “steer the
fear” among economists and investors.
The recent report for Industrial Production for
June, for instance, was much more upbeat with
a 0.4% rebound in overall production from May.
Aided by a 1.9% jump in auto production, manufacturing increased 0.7% and was significantly
ahead of expectations, while durable goods
production rose 0.8%. This report doesn’t necessarily mean that the economy hasn’t shown
signs of slowing and without a pickup in new
orders, many companies are working through
their backlog and inventory. However, we are
beginning to feel that part of the economic
weakness in the United States may be weather
related and a pick-up in economic activity may
be forthcoming during the second half of the
year.
The Weather – Employment may face issues
that were a benefit earlier in the year during
the unusually warm winter months that may
have stolen hirings from the spring and summer
months. In addition, the current 2012 drought,
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the worst in 56 years that has engulfed 55% of
the continental United States, could be placing
a damper not only on job growth, but consumer
spending and other economic activity, as well.
The drought will have detrimental effects on
farming and agricultural results, except for possibly the insurance benefits farmers may receive. The forecast for this heat wave is that it
is expected to continue through September.
While we do hear a lot about the conditions
being experienced, as with most natural disasters and related weather issues, these generally
take their toll on the economy in the shortterm, yet reverse over time leading to a boost in
economic activity in future months.
Consumer Spending and Retail – As previously
mentioned, without a doubt one of the strongest beneficiaries from consumer spending has
been auto sales. Looking forward, a strengthening in the housing market should benefit consumer spending, as well. The indirect benefit
from aerospace, besides the multitude of benefits that ripple throughout the economy creating jobs and demand for material, is from where
the orders come from: airlines fulfilling orders
for new and replacement planes to satisfy their
need in serving a growing consumer, both domestically and abroad, that is traveling more,
those baby boomers that are retiring and global
business travelers.
As mentioned in the section on weather, we are
starting to believe that some of the softening
recently in consumer spending may be at the
expense of the weather-related conditions experienced throughout so much of the country.
While this will run its course and potentially
inhibit spending activities and patterns during
the current warmer months of summer, we anticipate some bounce back in the latter part of
the year.
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cy/input costs. As a result of the abundance of cheap natural gas stemming from years of new major discoveries, we now have the benefit of
watching a natural gas and coal trade
off, as substitutes, in which each places downward pressure on the others’
pricing.
WTI Crude Oil
07-27-10 to 07-27-12
DJ-UBS Commodity Index
07-27-10 to 07-27-12
Energy and the Commodity Market– One of the
strongest recent indicators of a growing world
economy is the rebound in oil prices, as well as
commodity prices in general. Whether temporarily pushed artificially too low or simply the
consequence of rising demand, the recent price
increases appear to be sustainable, rather than
transitory or a short-term aberration. As the
two charts for West Texas Crude and the Dow
Jones-UBS Commodity Index show, we have
strengthened following weakness during the
first half of 2012. While this could reverse itself
again, we believe it actually illustrates a trend
that is more dominated by both the rise in agricultural prices related to U.S. and global
draught conditions, as well as the renewed shift
in global demand for both agricultural products
and energy.
Coal, on the other hand, has recently been in
the news frequently, and low coal prices are at
the heart of Patriot Coal Company’s recent
bankruptcy filing. Businesses, mills and utilities,
that can readily transfer their source of energy
between the cheap prices of coal or natural gas,
are able to enhance their energy efficien-
Interest Rates and Inflation – Interest
rates have continued to move lower,
including mortgage rates. While we
associate lower interest rates with
Federal Reserve tactical moves, lower
interest rates are also a by-product of
deflation – prices on products and
commodities that tend to drift lower
at times. We still, however, hear
much dialogue about the ultimate
trend reversal on interest rates that
will eventually occur when the economy reaches full recovery. We believe that the
global output gap will need to shrink materially
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to stimulate upward pressure on interest rates.
Given a world of cheap labor, an abundance of
raw material and a growing supply of energy
alternatives, we sense that this would be a difficult course without tremendous global growth –
something that would both solve current sovereign financial hardships and fuel a much
stronger recovery in the world stock markets.
There have been periods of interest rate rises,
either through changes in demand for money
that push interest rates temporarily higher or
action taken by the Federal Reserve as a proactive measure to hold back inflation. Often, inflationary fears are infused into the system as a
result of increases in money supply in the economy – an issue that was more real in the 1970’s
than has been visible during much of the last 30
years as the U.S. consumer has nearly exhausted its consumption appetite and foreign
labor on imports has helped keep prices lower.
As can be seen in the two charts, higher levels
of money supply has lost much of its influence
on pushing interest rates higher, as illustrated
by the chart on the ten-year treasury bond
yield. This has been a similar occurrence in
most matured countries. Not surprising, however, the occurrence of increases in consumer
demand driving up the level of inflation is very
apparent in emerging and developing nations
where countries like China and India raise both
interest rates and bank reserve requirements as
tools to combat inflationary pressures.
Portfolio Update and Company Comments
We are now in the early stages of earnings season
for second quarter when corporations share with
the investors their successes and challenges during the most recent quarter. While this is only
one 3-month segment of their fiscal year, which
may be affected by both internal issues and external conditions, some companies will achieve
success and exceed expectations, which should
have a positive effect on company valuations –
and stock prices. This, in turn, while depending
upon general market conditions that we have become accustom to, should none the less prove
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fruitful over time when the overall market conditions become more favorable.
We have been more optimistic about the current
economic conditions and the future outlook for
the world economies. It has only been most recently, however, as positive earnings have started
to be reported, that investor confidence appears
to be improving and stock prices are once again
on the rise. Many areas of weakness in second
quarter proved to be much stronger than investors had originally anticipated.
During the second quarter we established tax
losses on pullbacks in prices. These will serve us
well, we believe, later in the year should we be
correct in our view that stock prices will rise and
we end the year in a positive position. In addition,
we were also able to increase some positions during the recent market pullback which we believe
may benefit our overall returns, as well.
(The following 8-page section on portfolio positions and comments is available for clients
only and has been excluded from the nonclient edition of this report)
Conclusion
The great global challenge today is coordinated
stimulus to enable countries to grow internally,
while at the same arresting the ill effects of
overleveraged sovereign, municipal, and individual entities. Ironically, as each country works
through these challenges, it is perhaps the benefits of creative, intensely global focused solutions that to date has produced the level of resilience in the global economy that has occurred.
While perceived failings such as missed financial
opportunities or economic warning signs that
the media focuses on while hoping for some
Holy Grail answer make eye catching headlines,
it is both the sovereign cooperation and corporate results, as well as merger activity, that are
indicators of the productive progress that is
bubbling up to create a new economic cycle
that is noteworthy. There is stability underfoot
and positive trends that are successfully moving
economic components in the right direction.
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The United States has bounced back from a devastating economic blow and is gaining momentum as bottlenecks such as a glut of foreclosed
homes are resolved and companies adjust to
the new operating environment. Housing is
beginning to kick in and given the low level of
activity from which it is recovering, the potential improvement is comparatively large.
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As the pendulum swings, the forces at work today have the potential to generate healthy economic growth for American businesses and provide commensurate investment opportunities.
Mark Gaskill, President and Chief Investment Officer
Julie Bryan, CFA, Vice President, Director of Research
July 31, 2012
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Economic Charts
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Any performance shown in this report using MKG Financial Composites or market indices is shown for comparable
purposes and is only for the stated period(s) and should not be construed as an indication of long-term performance unless so stated with appropriate disclosures.
Written by Mark Gaskill, President, CEO & CIO, MKG Financial Group, Inc. (MKG) Member FINRA, SIPC. The material contained herein is based on data from sources considered to be reliable. However, MKG does not guarantee or
warrant the accuracy or completeness of the information. The information is not intended to be used as the primary
basis of investment decisions; nor, because of individual client requirements, should it be construed as a representation by MKG as an offer to buy or sell a security.
The opinions and estimates expressed reflect the current judgment of MKG and are subject to change without notice. This report may contain forward-looking statements, which involve risk and uncertainty. Actual results may
differ significantly from the forward-looking statements, due to economic situations, corporate, market and political
risk. Any reference to past performance of any particular security or MKG composites should not be construed as a
guarantee of future results.
The MKG Firmwide Composite includes all discretionary accounts managed by MKG Financial Group, Inc. The
composition of these accounts may include equities, fixed income, cash or equivalent, and/or other investments
deemed suitable by management; may use margin; and may be the recipient of dividends and interest over time.
Indexes, such as the Nasdaq and the S&P Total Return indexes, are unmanaged compositions of securities that
include interest and dividends and are used for market performance measurement purposes. MKG Financial Group,
Inc. 1500 SW First Avenue, Suite 1000, Portland, Oregon 97201. Additional information available upon request at
503-226-6700.
Member FINRA, SIPC
Research. Performance. Results.
MKG Financial Group, Inc. · 1500 SW First Ave., Suite 1000, Portland, OR 97201
800-760-4933 · Fax 503-226-6726 · www.mkgfinancial.com