Global markets were thrown into tumult in the third quarter of 2011, driven by financial crisis in Europe and the debt ceiling crisis here at home. The latter saw the historic downgrading of America’s long-term credit rating by Standard and Poor’s. The stock market, as represented by the S&P 500 index, fell 14.4% to 1131, crude oil fell 18% to $79 per barrel, and the yield on the benchmark ten-year treasury note fell to 1.92% from 3.16% as investors sought a safe haven from the storm. Gold saw massive volatility rising from $1,500 per ounce to $1,892 before settling at $1625. The net gain for the quarter was 8.3%.

The American economy is moving forward at stall speed, and the market fears that a relapse into recession may be imminent. Three issues are weighing on sentiment. First, the financial crisis in Europe has the potential to send the global economy into turmoil if not handled properly by European authorities. The solutions are relatively straightforward, and Europe has the financial capacity to execute them. The real challenge lies in political will, particularly in Germany. Germany, as the largest economy in Europe, is the de facto leader of the Euro zone countries and must take charge in coordinating any policy response to the crisis. Its electorate, however, is strongly against bailing out profligate Greece, the flashpoint of the crisis. In order to maintain the integrity of the Euro, financial support of Greece is necessary. The alternative could potentially lead to a total meltdown of the European financial system. While German leaders may drag their feet on assisting Greece in order to pander to their constituents, in the end, we believe they will do what needs to be done. In the meantime, Europe will continue to be the prime source of pressure on the market.

Secondly, the American federal political system is in a near state of paralysis. Even the most routine measures, such as funding FEMA to deal with hurricane relief, are contested. In such an environment, it is difficult to envision the federal government doing anything significant to assist the economic recovery. After the fallout from the debt ceiling debacle, neither side is in a mood to hand the other anything that can remotely be construed as a political victory. We cannot see an end to this dynamic at least until after the presidential election in November 2012.

Finally, in the absence of effective fiscal policy, the importance of monetary policy is elevated. Unfortunately, the Federal Reserve is seen by many to have reached the limit of its ability to assist the market and economy. Its last policy maneuver, dubbed “Operation Twist,” involved altering the composition of its security portfolio to further drive down long-term interest and mortgage rates. While helpful at the margin, it is not seen as commensurate with the challenges facing the economy. However, we are more sanguine on this count. The Fed still has the ability to restart outright purchases of securities, i.e. quantitative easing or QE, on a large scale, and reduce the amount of interest paid to banks that deposit money at the Federal Reserve, thus incentivizing banks to lend out money in the real economy. We feel such measures would have a positive market and economic impact.

All is not lost, however. As a support to share prices, there are three significant factors. First, the current environment, as weak as it is in the aggregate, is supportive of corporate profitability. The cost of the two largest inputs of production, labor and capital, are quiescent. With the labor market weak, most employees are generally in no position to push for raises, while the Federal Reserve’s aforementioned moves to lower long-term interest rates have dramatically suppressed funding costs. To the extent the economy weakens further, commodity input prices could moderate and support profitability as well. Secondly, corporations have reacted to the financial crisis by streamlining operations significantly, increasing profitability in the face of chronically weak demand. And finally, corporations have very healthy balance sheets, thanks in part to low interest rates and the disciplined financial management mentioned above. S&P 500 companies are carrying two trillion dollars of cash on their balance sheets. This gives them serious financial flexibility in the face of continuing uncertainty.

We have found the turbulence to offer attractive investment opportunities in many of our equity positions. While the macro environment is perilous, we are confident in the underlying strength of the businesses in which are invested, and as such, have taken advantage of the volatility to invest at favorable rates of return. In spite of the volatility, we remain positive on the long-term prospects for gold. As for the S&P 500, for the remainder of the year we see the index trading in a range of 1000 to 1250. Thank you again for your business and continued confidence. Please feel free to contact us with any questions or concerns you may have.