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2012 Second Quarter Investment Letter

Concerns of a global economic slowdown cast a pall on financial markets in the second quarter. Worsening news from Europe, weaker than expected economic data in the United States, fears of a potential hard landing for the Chinese economy, and the approaching fiscal cliff in the United States weighed heavily on the markets in the second quarter. Despite the poor second quarter performance, equity markets in the United States remain positive for the year.

The S&P Index fell 3.3% in the second quarter and is now up 8.3% for the year. The Dow Jones Industrial Average was off 2.5% for the quarter and has gained 5.4% for the year. European stock indexes continue to lag. The Stoxx Europe 600 index, which is a broad equity index that represents stocks in the Eurozone, is down 10% from a year ago. Meanwhile markets in Asia dipped in the second quarter. China's Shanghai Index dropped 1.6% and Japan Nikkei index fell 10.9% for the quarter.

The second quarter saw a comeback of the flight to safety trade in the fixed income market. Investors sought to preserve capital by buying bonds in safe haven countries. Yields on government securities in the United States reached record lows as the European debt crisis escalated in the quarter. The 10-year treasury yield traded as low as 1.45% and finished the second quarter at 1.66%, down from 2.21% at the end of the first quarter. Bond yields in Germany and the United Kingdom also reached record lows. This is in contrast to the record high yields reached this year on the sovereign bonds in the less stable, riskier European countries of Italy, Spain, and Greece.

Market sentiment continues to take its cue from Europe. Worries that Spain and Italy would require a bailout coupled with the concerns that Greece would elect a government that would withdraw from the Euro sent markets into a tailspin in May and June. By mid-June the S&P index was negative for the year before finishing the month strongly as European leaders agreed on the latest steps to keep the Euro intact. The agreement relaxes restrictions on emergency loans to Spanish banks and allows a single (to be formed) banking entity to recapitalize European banks directly. More importantly, the accord shows willingness to compromise by Germany to save the euro and keep the Eurozone together. The agreement exceeded market expectations and produced a strong equity rally on the last trading day of the quarter. The S&P rose 2.5% and the Spanish stock market was up over 7% on the day. It seems clear that Europe is determining the fate of the capital markets in 2012.

Another consequence of the European debt crisis is the potential of slowing growth in world economies. There are signs that this is indeed happening. The European Union is the largest trading partner of both the United States and China. Second quarter economic data in both regions were weaker than expected. In the United States, employment growth slowed in the second quarter. Nonfarm payroll employment in May rose only 69,000, following monthly increases of more than 200,000 in the 1st quarter. In China, quarter to quarter growth grew only 1.8%, increasing fears that Chinese growth will not be able to boost global economies.

In addition, the oncoming fiscal cliff looms over the markets. The United States could be pushed into a recession if the tax hikes and spending cuts take effect as scheduled at the end of 2012. It appears this will not be dealt with until after the November election.

Despite these headwinds there are some reasons to be optimistic on the economy and financial markets. European leaders are now proposing serious solutions to ease the European debt crisis. Central bankers around the world are stimulating economies through monetary policies and may do more. The housing industry in the United States is showing some signs of growth.

Against this backdrop the strategy at Schemco continues to be one of buying high quality, dividend paying US equities when market conditions warrant. I would avoid buying treasuries or municipal bonds, as I believe they are expensive when you compare the 10-year treasury yield of 1.66% with the 2.03% dividend yield of the S&P Index. There are opportunities in higher yielding corporate bonds. I continue to be short the euro and I am adding small allocations of gold to portfolios on market selloffs.