SECOND QUARTER 2010 REVIEW           

7/6/2010    

Market Summary                                                           

• Stocks: broad losses in Q2, following four positive quarters; S&P 500: -11.9% (Q2) / -7.6% (YTD).
• Treasuries: big Q2 gains on risk shift and lower growth outlook; 10 Yr Yld:  2.95%, dn 85 bps from Q1.
• Corporate Bonds: continued positive trend; lagged Treasuries in Q2. 
• High-Yield Bonds: minor pullback as investors cut risk.
• Crude Oil: $75.63, down from $83.76 at Mar-31.
• Natural Gas: $4.62, up sharply from $3.87 at Mar-31.
• U.S. GDP grew 2.7% in Q1 (annualized); similar growth is expected in Q2. 
  
  

			Average Annual %
Historical Results	Q2	YTD	1 Yr	3 Yrs	5 Yrs	10 Yrs
Short-Term Treasury Fd (Vanguard - VFISX)	1.4	2.2	3.1	5.4	4.5	4.9
Intermediate Treasury Fd (Vanguard - VFITX)	5.2	6.8	8.3	9.1	6.1	6.9
Intermediate Inv Grade Bond Fd (Vanguard- VFICX)	3.6	7.1	16.8	7.6	5.5	6.9
High-Yield Bond Fd (Vanguard - VWEHX)	0.0	3.6	20.3	4.4	5.0	5.5
S&P 500 Stock Index Fd  (Vanguard - VFINX)	-11.4	-6.7	14.3	-9.8	-0.9	-0.9
Small Cap Stock Index Fd (Vanguard - NAESX)	-10.1	-1.4	25.1	-7.4	1.3	5.6
Balanced Composite (50% Treasury Fd / 50% S&P 500 Fd)	-3.1	0.0	11.3	-0.4	2.6	3.0
Data includes reinvested income

Overview

Until late April, financial markets reflected broadening confidence that the global economic recovery, underway since mid-09, was sustainable.  U.S. GDP expanded 5.6% in Q4 on strong inventory rebuilding and advanced 2.7% in Q1, led by personal consumption expenditures; similar growth is expected for Q2.  However, since late April, several issues have raised uncertainty over global growth prospects and economic policies at home and abroad, while fueling a substantial, rapid shift of capital away from risk assets like stocks into government bonds and other less volatile fixed income securities.

Uncertainty is the enemy of both risk assets and economic growth.  It is creating worrisome headwinds for now as investors focus on the possibility that consumers and businesses may hesitate to commit to spending and hiring decisions until policy uncertainty diminishes.  GPM still believes that a moderate, sustainable recovery is the most likely outcome, but we’ve reduced portfolio risk in light of heightened global worries.  Some time is needed.

The Issues:

Continuing	Domestic policy issues: Uncertain/evolving fiscal policy and planned tax hikes and their unintended consequences. More stringent financial regulations that while obviously needed, may reduce institutions willingness to lend. Uncertainty about the burden of healthcare reform, which may be a hurdle to hiring and may be back on the front burner after the November Congressional elections. Uncertainty about government attitudes toward business and the lack of a clearly articulated industrial policy may be causing businesses to delay investment and hiring actions, also until after elections and/or as policy changes become clearer.
Mid April	Gulf oil spill set the stage for pervasive negative sentiment.
Early May	U.S. stocks plummeted 9% intraday on technical breakdown - confidence in markets was bruised.
Early June	Weak U.S. jobs data - private sector employers are reluctant to hire (policy uncertainty?) and are   working employees longer hours instead.  Disappointing data stoked worries that a modest economic   recovery will produce minimal new jobs.  Private sector job creation improved in June over May, but not   enough to really move the sentiment needle.     Note that job creation is a lagging indicator.  Employers normally work current employees longer hours   before hiring new ones.  That raises average hours worked per week (and income), which has risen   from 33.7 in Oct-09 to 34.2 in May.  Reasonable estimates indicate that every 0.1% rise in average   hours worked is equivalent to 370,000 new jobs, which should come eventually.
Continuing	Global issues center on Europe and China: European sovereign credit risks and the impact of austerity measures and fiscal restraint. EU bank stress tests and the ability/willingness of policymakers to address banking system weakness.   Fiscal restraint in Europe will be implemented gradually so the near-term growth impact should be less   than feared.  The impact on risk appetite, however, is clearly negative. China, the world’s third largest economy, has been a key driver of global growth for the past decade.  China’s central bank has been attempting to reduce the rate of economic expansion from a stimulus fueled cyclical peak of 11.9% in Q1 to a more sustainable, but still robust high single digits rate.  Investors are unsettled over the possibility of excessive slowing, which would likely have negative implications for the rest of world.

Against the backdrop of heightened macro uncertainty, several positives are clear.  Corporate profits are high and balance sheets are exceptionally strong; stock prices are attractive by most measures; interest rates are historically low; and inflation, while always a threat, is dormant.  Just as corporations have, consumers are shoring up their balance sheets.   In expanding economies, central bankers have begun to unwind support put in place during the crisis.  Among the first movers so far are China, Australia, Malaysia, Vietnam, India, Brazil and Canada.

GPM believes that incremental additional weakness in Europe should have only a small direct impact on global and U.S. growth.  We also think that growth in Asia, Latin America and other emerging economies will moderate to a healthy, sustainable level and continue to be a key driver of global expansion, U.S. exports and corporate earnings.  Policy tightening is consistent with the rapid rebound in those regions.  The recent decision by China to revalue the renminbi, while adding to uncertainty, has important implications.  It probably means that Chinese officials won't tighten policy further, reducing the risk of downside overshoot.  Market participants will “wait and see” whether China delivers a meaningful move in the currency. 

S&P 500 with 20 & 50 day moving average

10 Year Treasury Yield: 2.95%, -85 bps in Q

GPM Review and Performance

Stocks declined sharply in Q2, following four straight quarterly gains.  After the gulf oil spill and confidence bruising “Flash Crash” in early May, stocks were unable to steady and continued to weaken in the steepest pullback/test since crisis lows were set in March ’09.  The large-cap S&P 500 fell 11.9%  in Q2, following a 4.9% gain in Q1.  Q2 returns on other indices ranged from -21.0% (Australia ETF) to -2.1% (Malaysia ETF).  Nearly all sectors and all market-cap segments lost ground, with notable weakness in energy, biotechs, basic materials, retailers and financials.  Sentiment shifted quickly from cautiously optimistic to highly doubtful.  GPM is reasonably confident that stocks have been oversold.  The stock portion of client portfolios is invested primarily in very solid and profitable businesses - well-run companies, with strong balance sheets and cash flow to finance growth.  Most are substantially undervalued relative to their business prospects.  Our list of attractively priced companies has grown with the market pullback.

GPM growth accounts surrendered all of first quarter gains in Q2.  Early in the quarter we sold several stocks to book gains and then continued to reduce stock exposure in May, through hedging and outright sales.  That helped to limit our losses.  We did some nibbling late in the quarter after prices declined substantially; we could have waited a little longer.  At quarter-end, our net-long position in stocks was about 50% of our long-term model allocation, down from about 80% three months earlier.  Quarter-end market-cap weighting of GPM stock portfolios was about 30% large-caps, 23% mid-caps and 47% small-caps, compared to 30%, 30% and 40% respectively, three months ago.  Non-U.S. stocks comprised about 15% to 20%, similar to Q1.   Portfolios continue to hold fixed income securities, primarily corporate and high yield bonds, which buffered risk in Q2 and contributed positively to full year results.  Portfolio cash levels are unusually high.

GPM taxable bond accounts turned in solid performance in Q2, the seventh-straight positive quarter and nineteenth of twenty-one positive quarters beginning with Q2-05.   We reduced our holdings of closed-end high yield bond (HYB) and floating-rate bond funds in the quarter to book profits and preserve value.  In June, after the market declined, we raised our HYB allocation with mutual funds that are expected to have less volatility than closed-end funds.  We continue to like the HYB market. The substantial yield pickup points to relative value in this class, especially given expectations that default rates will continue to decline over the next several quarters.  High yield and floating rate bonds had a negative impact on Q2 performance that was more than offset by positive contribution from all other fixed income components including short and intermediate maturity investment grade corporate bonds, GNMAs, Treasury Inflation Protected Securities (TIPS) and FDIC-insured CDs.  High portfolio cash flow continues to provide a solid base return.  Portfolio duration was extended during the quarter, but remains relatively conservative.

GPM balanced accounts lost ground in Q2, erasing most of Q1’s gain.  Balanced portfolios invest in stocks and bonds, using a flexible combination of individual securities, ETFs and mutual funds.  Q2 performance was positively impacted by fixed income holdings, which was mostly offset by stock market losses as discussed above. 

GPM tax-free bond accounts turned in solid performance in Q2 and YTD.  High quality municipals rallied with treasuries in Q2.  Portfolio cash flow continues to provide a solid base return.  At quarter-end, portfolio duration was about four years.

Accounts that invest exclusively in mutual funds performed as discussed above.  Normally these accounts are under $100,000 in value.   Growth-oriented accounts lost the most ground due to broad stock market declines. Performance in balanced mutual fund accounts was positively impacted by fixed income holdings, which was offset by stock market losses as discussed above. 

Closing Thoughts

Uncertainty is elevated now.  We believe that risk assets are opportunistically priced for longer-term investors like GPM, with a time horizon measured in quarters and years instead of days or weeks.  As always, we encourage you to contact us for any reason.

Sincerely,

The GPM Team