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Non-Client Copy 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. Non-Client Copy Page 2 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 Non-Client Copy 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- Page 3 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 Non-Client Copy 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. Page 4 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. Non-Client Copy 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, Page 5 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. Non-Client Copy Page 6 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 Non-Client Copy 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 Page 7 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. Non-Client Copy 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. Page 8 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 Non-Client Copy Economic Charts Page 9 Non-Client Copy This page left blank intentionally. Page 10 Non-Client Copy This page left blank intentionally. Page 11 Non-Client Copy Page 12 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