The returns for the Special Equity Fund were -16.45% for the June quarter and -18.27% for year-to-date versus the S&P TSX which was -5.15% for the quarter and 0.16% year-to-date.  I am very disappointed with the absolute and relative performance.  That being said, this portfolio has not mirrored the index historically and most likely will not in the future.  I still feel that the portfolio is positioned well to take advantage of the back half returns in 2011.

The best performing sectors were Telecom, Health Care and Consumer Staples returning +7.5%, +3.3% and +1.6% for the quarter.  The worst performing sectors were Materials, Energy and Info Tech with returns of -8.6%, -9.1% and -31.44%.

The charts below show the portfolio’s allocation of sectors relative to the S&P TSX Index.

GICS SectorsSector Breakdown

Resource Sectors have been under pressure all year as investors worried about a slowdown in global economic growth and an end to the second period of Quantitative Easing (QE2) in the U.S., which drove down interest rates and supported the stock market and commodity market rally from last August until early this year.  Similar to last year, I believe the pessimism awarded to more aggressive growth and commodity stocks is overdone, and has provided a tremendous buying opportunity.

One of the main reasons for the stock market weakness has been the softness in the economic numbers over the past few months.  However, we continue to believe that this is due to the impact Japan’s tsunami has had on economic data both in Japan and around the world.  You can’t take the world’s 3rd largest economy effectively ‘offline’ for a number of weeks without impacting their growth as well as the global supply chain for many of the world’s key manufacturing industries such as autos and technology.  The impact in Japan was clear as its economy actually shrunk at a 3.7% annual rate in the first quarter as a result of the earthquake and this continued into the second quarter.  As companies throughout the world dealt with shortages of parts and components from Japan they had to start reducing their own production runs and just work down existing inventories instead, which lead to weak numbers around the world.  But with many Japanese companies undergoing a complete or partial resumption of production, economic data over the next few months will be positively rather than negatively impacted by the tsunami effect, reducing growth fears.  We are starting to see improvement already; industrial production in Japan increased 5.7% in June, the largest monthly gain in over 16 years!

Investors have also been worrying about a potential slowdown in Chinese economic growth, which is of key importance since China has really been the backbone of the economic recovery over the past two years.  The worries about China were fanned by the fact that they have been increasing bank reserve requirement and interest rates this year in order to ‘engineer’ a slowdown and reduce inflationary pressures.  The data we see shows that they are executing well on this strategy and that inflation is in the process of peaking and starting to head lower again as food prices subside.  At the same time, even though economic growth has slowed, it has remained within the target range of 8-10% annual growth.  We are also starting to see China come back as a buyer for key commodities such as copper, where they had run down their inventories over the prior few months.  This improved optimism has been showing up in the past few weeks in a rally in Chinese stocks, the same market that lead the way out in 2009.  The bottom line for us is that growth should accelerate again in the 2nd half of 2011, much like it did last year, but without the necessity for further Quantitative Easing by the US Federal Reserve (i.e. there will be no QE3 in our view).

The other headline issue that has shaken investor confidence in the past few months has been the credit crisis and need for economic austerity in Greece.  While the Greek problems are ongoing, we don’t see this as a serious risk for the global economy or a ‘crystalizing event’ that is a harbinger of other defaults.  The situation is confined to Greece and we don’t see other European economies facing a similar crisis.  This is nothing like the fall of the two Bear Stearns Hedge Fund in the summer of 2007 which were a very early indicator of the problems both in the US housing market as well the market for financial derivatives.  None of the other European economies mentioned as potential trouble spots has anywhere close to the same level of debt/GDP or excessive spending as Greece.  Other news should soon start to take over the headlines soon.  The next major event that investors will be paying attention to will be second quarter earnings, particularly in the U.S. where many of the major companies are great bellwethers for global growth.  While the U.S. preannouncement season has been the third mildest compared to this point in each of the last 10 years (i.e. fewest disappointments), the earnings news should get even better still when the earnings season begins in three weeks, reducing investor fears further.

The shaky investor sentiment is shown in the chart below which is the Investors’ Intelligence Bull/Bear Ratio.  Traditionally a high level of bullishness (higher ratio) has been a good indicator of higher risk in the stock market since it indicates too much bullishness and, hence, the probability that investors are fully invested.  Conversely, a low or negative ratio has been a good time to own stocks since it usually indicates that most investors are sitting on cash and therefore cannot become sellers of stocks.  The movement of this indicator to -1 last August ended up being a great time to buy stocks as that was the beginning of a 6-month rally.  The sharp sell-off over the past two months (stocks fell in 7 out of 8 weeks) has removed all of this excessive bullishness and sentiment has returned almost to the low level of last August.  This reinforces our view that stocks are currently looking like a good investment for the balance of 2011.

Investor Sentiment

At this juncture, I am comfortable that the recovery is still in place, and expect the returns in the back half of 2011 will be directionally similar to 2010.