The Markets	6/30/11   Close	3/31/11    Close	2nd   Qtr.  Change	6/30/10    Close	12 Mo. Change	YTD       Change
Dow	12,414	12,320	+0.76%	9,774	+27.01%	+7.22%
NASDAQ	2,774	2,781	-0.25%	2,109	+31.53%	+4.56%
S&P 500	1,321	1,326	-0.38%	1,031	+28.13%	+5.01%
MSCI EAFE	1,708	1,703	+0.29%	1,348	+26.71%	+3.52%
10-yr Treas. yield	3.16%	3.45%	-0.29%	2.95%	+0.21%	-0.15%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

For much of the quarter most of the talk concerned how the already fragile recovery was slowing down, and the market cooperated, falling 7% from its April high (NASDAQ actually hit a 10-year high before falling). But then the crisis in Greece eased and the market recovered to basically flat for the quarter.

This roller coaster was also evident in the housing market. Pending home sales were battered by bad weather, a national home price index fell for the eighth straight month to 2002 levels and new home sales were at about 40% of the level needed for a stable market. Then the May figures showed improvement, with the national home price index up slightly but still weak, pending home sales strong (without the tax incentives from the prior year) and new home prices bottoming out. Average home equity was only 38%, down from 61% 10 years ago, and 60% of homeowners have mortgages, with a quarter of those mortgages underwater, or having a balance higher than the home’s value.

Jobs, the other driver of the slow recovery, were sluggish with new weekly unemployment claims stubbornly staying well over 400,000 and far above February low levels. Despite April having the most nonfarm new jobs in two years, unemployment rose to 9.1%, 8.5 million part-time workers would like to be full-time and 2.2 million other unemployed workers have just stopped looking for a job. It’s no surprise, then, that consumer confidence sagged in May and hit a 7-month low in June.

The Fed indicated that monetary tightening would begin when the Fed stops reinvesting the income and maturities from their bloated securities portfolio, with no hint of when that would be. Chairman Bernanke acknowledged the loss of momentum in jobs as well as the slower-than-expected recovery, but insisted that the factors holding the economy back would be temporary. The Fed and everyone else lowered growth estimates for 2011 by 0.4%. In anticipation of the debt ceiling gridlock, S&P put US government credit on a “negative watch” (although retaining a AAA rating) and the Congressional Budget Office predicted a national debt crisis within 10 years without action to reduce the deficit.

Inflation remained within the Fed’s comfort zone and both manufacturing and service sectors continued to show slow but steady growth. Gold hit a new high above $1,500 before slightly pulling back.

Greece wasn’t the only international development. China’s inflation rate remained relatively high at 5.5%, easing fears that growth would be slowing there. In the aftermath of the Japanese nuclear problems, Germany reversed its plans and announced it would abandon all its nuclear plants by 2022. The European Central Bank raised its rates by 0.25% for the first increase since 2008. And the killing of Osama Bin Laden was long-awaited good news in advance of announced plans to draw down US troops in Afghanistan.

Looking Forward

Despite the recent approval by the Greek parliament on an austerity package, there are still hurdles to resolve the crisis. Not only do protests continue and the cuts still have to be implemented, but the actual method to deal with Greece’s debt has not been determined. Some approaches such as extending the debt incur less immediate pain while writing off some of the debt could present greater problems to already weak banks. It is also unclear whether the Greek episode has exhausted the patience of the more wealthy euro countries, especially Germany, so it remains to be seen what will happen if Portugal stumbles next.

Of more immediate concern is how the US debt ceiling debate will be resolved. The cynical view is that the two sides are in fatal disagreement and that the Republicans see an opportunity to break down the government and start over. Still, the debt ceiling has been raised over 60 times in the last 50 years or so and there is still plenty of room for negotiation. There is also a huge difference between a technical default in which some payments are delayed and a true default in which the current debt is greatly reduced in value and must be renegotiated. It would indeed create a global financial crisis if all US government goes into default but that possibility seems extremely remote, despite the rantings of the doomsdayers.

Overshadowed by the debt debate is the end of the Fed’s quantitative easing, known as QE2, which was a program of buying Treasuries to inject even more money into the financial system, ease lending, keep interest rates low and make other assets like stocks and homes more attractive. The influence of QE2 was muted and was overshadowed by eroding confidence, although the Fed believes QE2 helped quell concerns about deflation. QE2, among other programs, increased the Fed’s balance sheet to a record $2.84 trillion and there is still no indication as to how or when the Fed will begin to sell all the securities they own. It is likely that the end of QE2 has already been digested by the market and inflationary concerns are fueled more by commodity prices than by Fed action.

Our Portfolios

With the daily hand-wringing over foreign government defaults, the price of oil, employment and housing numbers and random developments in companies and sectors, it is well worth confirming the value of diversification. Diversification means the overall portfolio allocation (bonds, stocks and cash) as well as the degree of concentration within that broad allocation.

Take oil as an example – the civil war in Libya has disrupted supplies, governments have announced that they will release oil from strategic reserves to relieve price pressure and there is a raging debate over whether and how to develop new shale oil reserves. Add in a fluctuating economic outlook and the price of oil gyrated 20% in the last quarter. But despite Exxon Mobil’s status as the largest US company by market value, energy stocks (including oil and natural gas) make up only 12% of the broad US stock market. Even in a broad value index, where energy stocks would be expected to have a significant role, less than 17% is allocated to energy stocks. Some commodity funds can become heavily overweighted in oil (or precious metals), depending on their benchmark index and methodology. We prefer commodity funds with a benchmark index that balances major commodity groups (industrial and precious metals, energy, agriculture and livestock).

The same is true of the European countries facing debt crises. Even combining Spain, Italy, Portugal, Ireland and Greece represents less than 8% of developed international markets. Emerging markets do show some concentration, with China at 18% and Brazil and Korea each around 15%, but emerging markets are a volatile sector which should be part of a broader international allocation.

We do utilize actively managed funds and rely on the managers to use their skills and discretion to identify areas of opportunity that deviate from the indexes. Still, we are vigilant of concentration and the inadvertent risks it can pose, and we strive to maintain diversification to manage risk.

There Is a Way

There is no question we live in an increasingly polarized world, with thoughtful debate usually cut short by media reinforcement of intransigent “sound bite” positions. A good example is public pensions; while few would deny long-term public employees a reasonable pension, the combination of very poor pension plan design (that is, overly generous benefits) and irresponsible financial management (not properly funding the plans) has led public employees to be unfairly viewed as greedy and undeserving. There is at least a $1 trillion gap between these plans’ projected obligations and their projected assets.

A recent study by the National Institute on Retirement Security analyzed well-funded state pension plans and identified the practices that kept these plans financially strong. These practices helped plans weather two recessions and less-than-expected investment returns in the period studied from 2000 to 2009. (The Arizona State Retirement System’s assets fall short of meeting its projected pension obligations to the same extent as the average state plan. On the plus side, ASRS is at least keeping up by making 100% of its calculated annual contributions, which is better than the 88% average contribution level of state plans. Participants in ASRS share the plan’s cost and required participant contributions have been increased.)

• Employer (government) contributions paid the full amount of the annual required contribution as determined by actuarial forecasts of future benefits. (Many other governments cut contributions as their finances became strained.)
• Employee contributions helped share the cost of the plan. (Most states have a fixed contribution by employees, increasing the burden on taxpayers.)
• Changes in benefits were valued before they were implemented, and were properly funded upon adoption. (Often benefit increases are negotiated separately and put in place without a full financial impact analysis.)
• Anti-spiking measures, designed to eliminate loopholes which disproportionately increase pension benefits for some employees, were in place. (A common “spiking” provision is to base pensions on the last year’s salary, with that last year’s salary inflated just to get a higher benefit. Benefits based on the last 3 or 5 years of salary are more reflective of the employee’s career earnings.)
• Cost of living adjustments were used responsibly and were also factored into future funding requirements.
• Reasonable economic assumptions were used. (Many plans have not adjusted their expected investment returns or local economic growth assumptions.)

These practices seem reasonable, don’t they? The employees get a greater assurance that their pension is secure and the comfort that all employees are being treated fairly and equally. The state and its taxpayers are assured that the pension plan is fair and does not create a huge liability that will have to be covered down the road. (By comparison, private pension plans, which are dwindling in number, have government-mandated funding requirements and shortfalls are included on the company’s financial statements for all to see. If a private pension plan is taken over by the government pension insurance program, benefits are capped at a level that is often well below the prior benefit.)

Instead we get government shut-downs and Greece-style employee protests to any proposed changes to pension plans. It seems that there is seldom a genuine, concerted effort to acknowledge and fix an obvious problem.

Compromise, restraint and cooperation are not signs of weakness but are rather often the best ways to solve problems. Let’s hope those qualities ultimately prevail.