In the table below, we show the performance of the ten S&P 500 sectors for the quarter-to-date (March 30-June 27). While the overall index has performed poorly for the quarter (down 6%), the most defensive sectors have not done too bad. Telecom and Utilities stocks posted solid gains, while Consumer Staples and Health Care stocks well outperformed the overall index with relatively flat performance. The trouble has come from the highly cyclical and economically sensitive sectors, including Energy, Financials, Materials and Industrials. Each of these sectors posted losses ranging from 8% to 11%. The Technology sector has also performed poorly (-9%), and we would attribute these declines to receding hopes of global economic recovery as well.

Why is it important to periodically look at returns by sector? Because the stock market is a discounting mechanism, offering us clues about the future direction of the economy. In other words, stock investors base their decisions on factors that will influence the future earnings power of companies. The aggregate sentiment about these factors is generally a pretty good indicator of future economic developments (if you believe the Efficient Market Hypothesis). On the other hand, the economic data we receive daily from various government and other sources generally covers past periods of time.

Source: Bloomberg

One quarter’s stock market performance is not enough to formulate an economic forecast. However, the stark contrast in performance among S&P 500 sectors is a pretty good indication to us that market participants believe the global economic malaise will continue for a while. This conclusion confirms our long-held belief that we are in for a long period of slow growth as consumers and governments in the developed economies reduce debt and repair balance sheets. As such, we remain committed to high-quality, blue chip companies that generally hold up better in times of economic uncertainty.

Peace,

Michael

As widely expected, the Fed committed to additional stimulus today. The Fed will extend the size and duration of its existing “Operation Twist” program, whereby the central bank sells its short-term bond holdings and uses the proceeds to buy longer-term bonds. The Fed will have until the end of 2012 to buy an additional $267 billion in long-term Treasuries. The goal is to bring down long-term interest rates in an effort to “make broader financial conditions more accommodative”. In other words, Bernanke & Company are attempting to support a recovery in housing prices by bringing mortgage rates down even more. The Fed did not go so far as to introduce a new round of asset purchases (QE3), but it did vow to stand ready in the event that circumstances call for such action. We have no doubts that an additional program is just around the corner.

The Fed continues to press its bets. In our opinion, however, there are several problems with the strategy of Quantitative Easing.

First, the Fed’s actions have become somewhat counterproductive as the suppression of interest rates has become quite punitive for savers. Putting aside the issue of fairness, many consumers who are dependent on investment income have seen their spending power cut dramatically as a result of the Fed’s actions. The aggregate reduction in spending power is undoubtedly a drag on the economy.

Second, the Fed’s aggressive purchase of long-term bonds, while keeping the Fed Funds rate at zero, has led to a flattening in the yield curve. A flat yield curve is bad for bank profitability. If banks are less profitable, they are less willing to expand the extension of credit - which is a major goal of Fed policy.

Third, it appears that the Fed is pushing on a string at this point. It does not appear as though an incremental decrease in interest rates will improve either the supply of or demand for loans. The supply of loans is being affected by unprecedented regulatory uncertainty at the banks (in addition to the flat yield curve and economic uncertainty). Until the ambiguity with regard to capital requirements and other issues is cleared up, the flow of credit is unlikely to improve. On the demand side, consumers remain over-indebted and must go through a process of deleveraging to repair their balance sheets. Businesses, for their part, are paralyzed by uncertainty ranging from the situation in Europe to future taxes and healthcare costs. Therefore, incrementally lower interest rates are unlikely to stimulate incremental economic activity at this point.

Fourth, the Fed’s initiatives to bring down interest rates do nothing to remedy the problem of tight lending standards for many borrowers. As yesterday’s Wall Street Journal article by my friend Jon Hilsenrath so aptly discussed, only those who don’t need credit are able to obtain credit. Those in desperate need (who are more willing to spend or invest) are unable to find banks willing to lend. Therefore, the Fed’s actions may be having the additional unintended consequence of expanding the wealth gap in the country.

Fifth, the Fed’s actions may have actually inhibited a recovery in housing as lower prices may have allowed the market to clear by now. Instead, huge numbers of properties remain in some stage of the foreclosure process. This overhang will undoubtedly drag out the process.

Sixth, the printing of trillions of dollars by the Federal Reserve will create the risk of widespread inflation down the road some time. As we have discussed in past market commentaries, we believe the Fed must consider the risk of asset inflation as well. Have the Fed’s policies created a bubble in the stock and/or bond markets?

Seventh, the reduction in long-term interest rates is negatively affecting the funded status of pension plans, both at the corporate and govenment levels. As interest rates fall, companies and governments are required to set aside more money to fund these plans. This money could be put to better use elsewhere (hiring and other investments).

And finally, aggressive monetary policy may have the effect of reducing the sense of urgency felt by politicians on the issues of the fiscal cliff and long-term structural deficits.

In a nutshell, we are trying to say that the Fed has become somewhat impotent and should pass the buck to Congress. If only Congress would answer the phone..

The Greek election had the right outcome: they decided to work within the system. The problem is that there just isn’t much of a system, and the system doesn’t have any idea what to do next. Economic fires are smoldering in more or less contained ways throughout southern Europe. There is ample fuel for a heck of a blaze, and European Central Banker finger nails are being bitten to their quicks with worry over losing control.

In the US, talking heads are running their media mouths with anticipation of additional monetary intervention as the Federal Reserve Open Market Committee meets this week. Over the weekend a well-regarded Goldman Sachs economist wrote to expect additional stimulus. Others think that an extension of “Operation Twist” is more likely. Either way, expectations of some action are rising by the day.

The yield on the 10 Year US Treasury note is below 1.6%, and 30 year mortgage rates are below 4%. Even if we agree that the central bank could drive rates another point lower, how much more economic activity should we expect? Is there really a large group of potential homebuyers ready to step forward if and when mortgage rates fall another point? In short, can they do enough to move the needle?

Europe presents a larger puzzle. Certainly a means to centralize fiscal authority would help, but if a country cedes its fiscal and monetary policy-making, how much independence and authority will they retain? If some form of European FDIC can be formed to sustain the European banking system, and a coalition can be formed with resources to issue low-cost debt to fund the kicking of the can down the road, can southern Europe ever establish the workplace and workforce disciplines necessary to achieve the productivity levels of their German brethren?

The US, Europe, and China will eventually face inflationary pressures as a result of all the monetary largesse. Growth alone will not be able to escape the burdens of debt that has reached ponderous levels. So inflation will be a part of the solution.

Our best case view is a long, rolling, bumping recovery. Investors will need to access growth where it occurs around the globe while protecting their investments from the threat of runaway inflation. While commodities offer a hedge, multi-national blue-chip equities offer a hedge as well as the prospect of future earnings growth and dividend income. Greece has simply turned another page in its own economic tragedy. In the words of Yogi Berra, they came to a fork in the road and they took it. Unfortunately, the road ahead for not only Greece, but Italy and Spain as well, remains steep and fraught with danger.

After initial weakness Tuesday during Chairman Bernanke’s prepared testimony to Congress, share price have climbed. Meanwhile, economic data have deteriorated, with Retail Sales figures causing most concern. Earnings reports have been reasonably good. An important bellwether, that we believe will foreshadow much of this earnings season, came from Johnson & Johnson. J&J reported quarterly earnings of $1.30 per share versus an estimate of $1.29. While certain areas of its business showed better than expected results, other areas presented headwinds; but the largest headwind came from currency adjustments. For multinational companies that operate in different economies and currencies, these adjustments can make a difference. That J&J faced these more generic performance drags suggests to us that other multinationals will show similar adjustments.

With economic data disappointing and corporate earnings positive but not fabulous, why are shares rallying? Answer: the Bernanke Bid. We have said for a few years now that markets have been trading on each and every utterance from the Fed, and little has changed. The slightly cloudier horizon signals Wall Street that the Fed must be closer to refilling the monetary punch bowl. A year ago a famous hedge fund manager said, “either the economy improves and stocks go up, or it doesn’t, and the Fed eases, and stocks go up.” He was right, but this logic can’t work forever. It still seems to be working this week, but we are ever cautious of that day when the music stops. We are intensely focused to ensuring that our clients will always have a chair.

Keith Davis and I have just come in from the sweltering DC heat and the Economics Club of Washington luncheon featuring Goldman Sachs CEO Lloyd Blankfein. The presentation was structured as a series of questions posed by ECW President David Rubenstein. David did an outstanding job covering not only the important topics du jour, but also probing into Mr. Blankfein’s upbringing as well as the circumstances behind his ascension to the of most powerful investment bank in the world. After watching Mr. Blankfein field often difficult questions for the better part of an hour and a half, it was easy to understand why he ended up where he is today. He is quite articulate about all the important issues, including the situation in Europe, the fiscal cliff and politics in general. But what struck me as most impressive was Blankfein’s eloquent defense of Goldman Sachs and the investment banking industry at large.

Goldman Sachs is unlike most “banks.” As Blankfein explained, the company has historically operated out of the public’s eye and consciousness. The company does very little business with individuals (except a few very wealthy ones), and therefore Goldman had a marketing budget of zero prior to the financial crisis. But since that time, Goldman has been at the very epicenter of controversy. The company has been accused of everything from betting against its own clients to driving up the prices of basic commodities and helping to create stock market bubbles. And while the most recent scandal involving the manipulation of LIBOR has nothing to do with Goldman Sachs, these never-ending headlines are making it very difficult for the financial industry to repair its reputation and get back to the business of helping America grow.

By Blankfein’s own admission, all of the major US financial institutions (including Goldman Sachs) must now accept the spotlight that has been cast upon them by virtue of their acceptance of taxpayer money during the financial crisis (TARP). Blankfein appears to accept this inevitable scrutiny. However, he also believes strongly that we are at risk of an overly punitive regulatory response to the crisis. The widespread public disdain for financial companies was the impetus for Dodd Frank, and the implementation of Dodd Frank will be affected by ongoing negative developments such as the LIBOR issue. Difficult decisions affecting the country’s future, Blankfein argues, should not be undertaken hastily in the heat of the moment.

As investors, we know that investment banks like Goldman Sachs perform very important functions for the global economy. These banks help companies raise capital and hedge their operating risks, while also providing invaluable liquidity for all types of investors. This liquidity ultimately lowers the cost of capital and helps facilitate economic growth and job creation. It is unfortunate that the functions of investment banks are not more widely understood. Fortunately, CEOs like Lloyd Blankfein and JP Morgan’s Jamie Dimon have been excellent spokesman for the industry and will continue to work to bring more understanding. At the end of the Q&A, Rubenstein asked Blankfein what he would like his legacy to be. We find it quite telling and a sign of the times that Blankfein mentioned that he would like to be known, among other things, for enhancing Goldman’s reputation after such trying days.