mo 2009 q3 commentary

A S S E T M A N A G E M E N T

Third Quarter 2009 Review

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An Economic and Market Commentary

We have just completed another record-breaking quarter in the equity markets, a sharp contrast to the anniversary of the near collapse of our (and the global) financial system and the worst month in the recent equity markets performance history. In October 2008, each of the Russell 1000 Growth, Russell Top 200 Growth and the S&P 500 indices declined by more than 15% (after reaching an intra-month trough of -26% on October 27th).

An analysis of the significant amount of information now available about what happened during September of 2008 clearly shows how unprepared both the US Treasury and the Fed were in reacting to events that they never imagined would come to pass. Despite Bear Stearns’ collapse in March of 2008, there is, as of yet, little evidence of any serious preparation for a potential collapse of another major financial institution. It is clear that Europe’s financial regulators have benefited from a number of “war game” exercises, simulating a Europe-wide financial crisis caused by a collapse of a big bank with operations in several large countries. After the first of such war game exercises, held in early April 2006, the post-exercise report identified a

possible housing market crash, bird flu pandemic and high oil prices as potential sources of risk and pointed to hedge funds and credit derivatives as “potential sources of systemic risk.” When the time came to face the potential failure of major European banks in the aftermath of Lehman’s collapse, the European reaction was swift, despite the complexity of the EU’s multinational financial system. One would hope that the US would be much better prepared should such a scenario occur in the future.

Consistent with the old Wall Street proverb that stock markets “climb the wall of worry,” the third quarter of 2009 proved to be the most consistently positive quarter of this year. After a volatile end to the second quarter of 2009, the equity markets experienced another decline in the first two weeks of July. However, after that initial decline, the equity markets staged a nearly uninterrupted recovery through the end of the month, ending July with solid gains (7.1% for the Russell 1000 Growth Index, 6.83% for the Russell Top 200 Growth Index and 7.56% for the S&P 500 Index). August proved to be the most volatile month of the quarter. After a non-directional first half of the month, the equity markets bounced from negative territory to end with a 2.07% positive return for the Russell 1000 Growth Index, 1.72% for the Russell Top 200 Growth Index and a 3.61% positive return for the S&P 500 Index. September, thought of historically as the worst month for the equity markets (it is the only month

to drop more than 50 percent of the time since 1929), bucked the trend with equity markets continuing their recovery, ending the month with solid positive returns (4.25% for the Russell 1000 Growth Index, 3.71% for the Russell Top 200 Growth Index and 3.73% for the S&P 500 Index). Despite many investors’ fears and a multitude of negative predictions, the third quarter of 2009 proved to be one of the best quarters in the last 10 years, once again leaving those who remained on the sidelines with a large lost opportunity cost and a difficult position to be in, with only a few months left before the end of the year. The Russell 1000 Growth ended the quarter with a 13.97% return, the Russell Top 200 Growth Index with a 12.70% return and the S&P 500 Index finished with a return of 15.61%. Each of the S&P 500 sectors realized positive returns during the quarter. Financials continued their recovery, and once again outperformed all other sectors with a 25.14% return, Industrials finished up 21.24%, Materials up 21.00%, Consumer Discretionary up 18.85%, Information Technology up 16.70% and Consumer Staples up 10.50%. Most sectors realized double digit returns, with the lowest performing sector, Telecommunication Services, still ending the quarter with a 3.94% gain.

Michael Obuchowski, Ph.D.Managing Director, Chief Investment Officer and Director of Research

Table 1 FEAM50 Composite, Russell 1000 Growth Index, Russell Top 200 Growth Index and S&P500 Index performance during 2009

*Total return, inclusive of dividends**Since inception (12/31/03)

FEAM50 Net* -1.00% 18.17% 9.44% 2.42% 4.59% 17.24% 37.17% 2.44% 9.93%

Russell 1000 -4.12% 16.32% 7.10% 2.07% 4.25% 13.97% 27.11% -1.85% 6.79% Growth Index*

Russell Top 200 -4.39% 14.73% 6.83% 1.72% 3.71% 12.70% 23.63% -2.33% 2.71% Growth Index*

S&P500 Index* -11.01% 15.93% 7.56% 3.61% 3.73% 15.61% 19.26% -6.91% 6.77%

FEAM50 Gross* -0.74% 18.45% 9.44% 2.42% 4.84% 17.52% 38.17% 3.52% 15.64%

Q1 2009 Q2 2009 July 2009 Aug. 2009 Sept. 2009 Q3 2009 YTD 2009 Trailing 12 Total Months Return**

By Michael Obuchowski, Ph.D.Managing Director, Chief Investment Officer and Director of Research

For more information...about our investment advisory services, please contact Jennifer Vernier at 631-630-2500, email [email protected] or write to First Empire Asset Management, 100 Motor Parkway, 2nd Floor, Hauppauge, New York, 11788.






Senate elections, and all 435 seats in the US House of Representatives will be contested as well. Depending on their political affiliation, the politicians’ focus will be either on the trends strongly suggesting an emerging global economic recovery, or on the unpredictable individual data points, which provide conflicting information, and on the lagging indicators, especially on the high unemployment level that is likely to persist throughout next year.

Notwithstanding the soon-to-be-heard loudness of political spins, the economic forecasts continue to be upgraded. The sustained increase in demand for raw materials and the increase in industrial production are no longer limited to the emerging economies in Asia. These trends have started to spread to exporters of raw materials (Reserve Bank of Australia was the first one among the G-21 countries to increase target interest rates for the first time since March of 2008), and even to Germany, the largest manufacturing-oriented export economy in Europe.

In the United States, it appears that the economic crisis has bottomed and that a recovery is in its early stages. The US government programs have boosted spending. Personal consumption expenditures have been fueled by purchases of durable goods, driven partly by the “Cash for Clunkers” program. The housing market is finally appearing to be finding a bottom. Lower home prices and affordable mortgage rates, in conjunction with the government’s first-time-buyer tax credit, have helped to revive the market. The first-time-buyer tax credit is scheduled to expire at the end of November. With rising fears of the negative effect of its expiration (similar to the slowdown in car sales after the cash for clunkers program expiration), there are discussions suggesting that the program will likely be renewed, and possibly expanded, at least until the upcoming midterm elections.

It is no surprise that employment conditions continue to lag the rebound in economic activity. This is normally the case and, given the depth of the recession, we should expect an even slower revival of job growth in this economic cycle. Many economists point to the limitations of the headline unemployment numbers. In fact, while the official unemployment rate (U-3:

First Empire Asset Management’s FEAM50 Large Cap Growth Equity strategy finished the quarter up 17.24% (net of fees). Those of our clients who were invested in the FEAM50 strategy benefited from its consistent performance throughout the third quarter and its outperformance of the Russell 1000 Growth benchmark in each month. The primary driver of the FEAM50’s excellent performance during the quarter was my decision to remain fully invested, with the largest exposure to Information Technology, Health Care and Industrials sectors. In addition, stock selection within the Telecommunication Services, Financials, Information Technology, Energy, Industrials, Consumer Discretionary and Health Care sectors had a positive contribution to the FEAM50 strategy’s third quarter outperformance of the Russell 1000 Growth, Russell Top 200 Growth and the S&P 500 indices. It is important to note that I still consider the overall Financials sector in general to be too risky for our large cap growth strategy, therefore, there is only minor exposure to the Financial sector in non-US companies.

Despite the seemingly never ending debate over the shape (and even the existence) of the economic recovery, increasing evidence suggests that the economic crisis has bottomed and that we are in the early stages of a global economic recovery. The inherent volatility of the mountains of economic data analyzed daily by the financial media, have contributed to the suspicion many of the investors are still exhibiting towards the idea that the recession has ended and that the economic recovery could be a sustainable one. Despite significant improvements in the majority of the early economic indicators, persistent unemployment reaching all time highs has contributed to investors’ inability to shake off their cognitive biases and acknowledge the validity of positive economic trends (see the previous quarterly reviews for more details on the cognitive biases and their effects on the psychology of investors). This focus on data that lags behind an economic recovery is not only consistent with the solidly established attitudes of investors over the last several quarters, but it is also becoming an increasingly important data point that will be fully explored in the upcoming 2010 elections. There will be at least 36 seats contested in the November 2010 US

Total unemployed, as a percent of the civilian labor force) reached 9.8% in September 2009 (see Figure 1), the most liberal alternative measure of labor underutilization (U-6: Total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force, plus all marginally attached workers) reached 17% in September 2009, 6.4% higher than its September 2008 level (see Figure 2). With average weekly hours worked dropping to a record low of 33 (from 33.8 before the recession), companies are likely to more fully utilize their existing resources before they start hiring new employees.

It will be necessary to closely monitor the health of the labor market over the next six to twelve months to better understand where we are in the economic recovery process, as the size of these underutilized labor resources will likely keep the official unemployment rate from declining any time soon. While negative for those who

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Figure 1 - U-3 Unemployment Since 1948Source: Bureau of Labor Statistics, Bloomberg.

Figure 2 - U-6 Unemployment Since 1948Source: Bureau of Labor Statistics, Bloomberg.






are currently under or unemployed, the slack in the labor market makes the threat of a wage-driven inflation remote for the time being. One of the indicators that generally need to continue improving before the unemployment rates start to decline is the Initial Jobless Claims measure. Since this Labor Department sourced measure is typically very volatile and subject to big revisions, it is best to evaluate it as a moving average rather than in terms of individual weekly data points (even though the latest number was the lowest since January 2009). While still at the highly elevated levels, not seen since the 1980s, the Initial Jobless Claims four-week average has been steadily declining since the end of August (See Figure 3).

The inventory cycle in the US is likely to contribute to growth as destocking reaches its trough. In the first two quarters of 2009, US firms kept running down inventories at a furious pace, significantly contributing to the decline in the GDP growth. Now, as inventory reductions decline, there should be a significant boost in overall growth. Additionally, with the inventory-to-sales ratio falling rapidly from its recent 1.59 high in February 2009, higher demand will eventually have to be satisfied by an increase in output rather than continued inventory drawdown. Continuing weakness of the US dollar should support growth in US exports to the currently fastest growing economies in Asia. In addition to their increasing internal demand for finished goods, the majority of high-tech manufacturing is located in Asia. This creates a positive demand feedback loop that should, at some point, spread

outside of the emerging Asian markets and start to improve revenues and earnings for the large export-oriented US companies. Policy makers in almost every corner of the world are dedicated to continuing the stimulus programs to ensure that the recovery does not falter. I believe there is little risk at the present time that they will be hasty in unwinding these expansionary policies. With the lack of any visible inflationary pressures and a significant slack in industrial capacity and labor utilization, the probability is high that policymakers will maintain the stimulus packages for too long, overdo the stimulation, and face a lot of political pressures when attempting to reverse the course. This may result in the expectation of inflation being revised upwards, particularly if the output gap is overestimated. In such a case, rising interest rates would most likely crowd out private-sector investment spending, hurt the still-recovering housing market, and compromise a true recovery.

This is certainly true in the US, where the Federal Reserve Chairman, Ben Bernanke, seems determined to avoid the mistake of the 1930s when stimulative policies were reversed too early, leading to a renewed weakening of the economy. With the US policy stance generally focused on promoting maximum growth, the timing of stimulus withdrawal will likely cause as much conflict as its enactment. Chairman Bernanke has already started preparing the ground for the future, writing a rare Op-Ed in The Wall Street Journal with an outline of the Fed’s exit strategy, and stating at the Board of Governors conference in Washington on October 8, 2009, that while “accommodative policies” will be in place for an extended period, the central bank will be prepared to tighten monetary policy “to prevent the emergence of an inflation problem down the road.”

While Ben Bernanke and the Federal Open market Committee (FOMC) acknowledge the future need to tighten the monetary policy to prevent the emergence of an inflation problem down the road, the fear of withdrawing the stimulative policy tools too early will likely keep them from acting until early signs of inflationary pressures begin to emerge.

Since last fall I have repeatedly emphasized that one of the core requirements for an economic turnaround would be effective functioning of credit markets. Last quarter I had hoped that it would be the last time I would have to focus on the measures of credit market health, and that my attention could shift to the timing of the Fed’s withdrawal of accommodative policies. However, while the credit markets stabilized, it is still too early to focus on inflation, interest rates and the Federal Funds Implied Probability. My current expectations are that the low interest rates and the accommodative policies will remain with us for the time being.

Over the last several quarters, I have presented a matrix of economic indicators that I believe offers insight into the early stages of economic activity. These indicators are the result of my research into the empirical evidence of shifts in economic activity. This focus on empirical evidence was driven by my desire to limit the emotional and cognitive biases usually present after an extended period of consistent economic growth or decline. The interpretation of the results of these early indicators was a significant factor in my investment decisions during 2009.

During the last quarter, the six early economic indicators included in the matrix continued to present compelling evidence of an early economic recovery. I will quickly summarize the current status of the indicators, referring readers to the previous quarter’s update for a more extensive description of the indicators and how I have interpreted their respective historical patterns.

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Figure 3 - Initial Jobless Claims October 2008Source: Labor Department, Bloomberg.

Figure 4 - The Core Crude Goods Producers Price IndexSource: Bureau of Labor Statistics, Bloomberg.






The Core Crude Goods Producers Price Index, which I believe is one of the best leading economic indicators for insight into the early stages of capital goods production, continued its recovery during the quarter, ending August at 263.60, up 18.31% from its December 2008 trough.

The Baltic Dry Index (BDI), published daily by the London-based Baltic Exchange, provides an assessment of the price of moving raw materials by sea. It covers 26 shipping routes worldwide and is a composite of the Baltic Capesize, Panamax, Handysize and Supramax dry bulk carrier indices. While staying above its 2008 trough, the BDI declined during each month of the third quarter, beginning to slowly improve in the first week of October. The most common interpretations of this quarterly decline focused on a decrease in demand from China, after the initial surge related to their economic stimulus package. With the Chinese economy continuing its improvement, most analysts expect the BDI to increase for the rest of 2009.

The Architecture Billings Index (ABI) is a leading economic indicator of commercial construction activity, capturing the approximately nine to twelve month lag between architecture billings and actual construction spending.

Last quarter was a particularly volatile one for the ABI, with a steep drop in June, followed by a large gain in July and a small decline in August, remaining below 50. The related Inquiry Index, which tracks an architectural firm’s capacity to take on additional work, remained above 50 during the last three months, reaching its recent high of 55.2 in August. A score above 50 indicates an increase in billings. The Inquiry Index’s score above 50, for the sixth consecutive month in a row, is suggesting the possibility that the ABI might emerge from its recent volatility and begin moving towards recovery.

The Primary Metals Index is one of the indicators included in the Advance Report on Durable Goods Manufacturers’ Shipments, Inventories, and Orders (M3). The Primary Metals Index captures information about raw materials being ordered by large manufacturers. The increase in orders for primary metals suggests that industrial production is likely to increase in the near future.

The Primary Metals Index has been one of the last of the indicators I have been following to start moving higher. The last three months were its best months since the middle of 2008, bringing the index close to its December 2008 level.

The Core Capital Goods Orders Index (New Orders of Nondefense Capital Goods Excluding

Aircraft) is another indicator selected from the Advance Report on Durable Goods Manufacturers’ Shipments, Inventories, and Orders (M3). The Core Capital Goods Index is considered to be one of the best leading indicators of business investment spending.

After reaching its trough in April 2009, the following three months provided more evidence of a bottoming-out pattern, indicating a real possibility that we are seeing the beginning of a turnaround in business spending.

The Private Housing Authorized by Building Permits Index is an early indicator of residential housing industry activity, and typically one of the first sectors to turn around in an improving economy. While the economic crisis had continued to severely affect the housing industry,

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Figure 5 - The Baltic Dry IndexSource: Bureau of Labor Statistics, Bloomberg.

Figure 6 - The Architecture Billings Index (ABI)Source: American Institute of Architects’ Economic and Market Research Group, Bloomberg.

Figure 7 - The Primary Metals IndexSource: US Census Bureau, Bloomberg.

Figure 8 - The Core Capital Goods IndexSource: US Census Bureau, Bloomberg.

Figure 9 - The S&P/Case Shiller Home Price IndexSource: Standard & Poors, Fiserv, Bloomberg.






the latest July 2009 S&P Case-Shiller Home Price Index for 20 metropolitan markets declined the least on a year-to-year basis (-13.30%) since February 2008. This slowing rate of this year-to-year decline was the result of two months of sequential monthly increases, something we have not seen since the middle of 2006.

The recovery in housing prices seems to be a necessary precursor of construction activity. The slowly improving house pricing was clearly reflected in the Building Permits Index, finally ending the bottoming-out process and beginning a turnaround with an increase in three of the last four months bringing the index above its December 2008 level.

These six early economic indicators presented above have continued to successfully add another layer of information to my critical thinking toolset. The interpretation of these indicators assisted me at the end of the first quarter of 2009 with my decision to move away from a large cash positions and back to a fully-invested status. During the first few months of this year, these early indicators had presented information suggesting that the global efforts aimed at stabilizing the financial system have begun to work, and that the ferocity of the economic crisis is waning. With strong evidence that the global financial system has been successfully stabilized, several of the economic indicators suggested the bottoming of economic activity and even some signs of a potential beginning of a recovery. Current evidence supporting the emerging recovery is becoming increasingly

stronger, with only one of the indices presenting a pattern of decline during the last quarter.

While global demand is increasingly visible in statements from many of the multinational companies, this quarter’s earnings reports will provide us with real evidence as to the actual improvement in demand and expectations for the next several quarters. I believe it is likely that technology, commodities and transportation-related companies will be the first to feel the full impact of the improved demand. Their guidance for the rest of the year will be an important factor in the continuation of the equity markets’ recovery.

In addition to improving global demand, the US is still in the early stages of spending the $787 billion economic stimulus package enacted at the beginning of the year. Political pressures will likely help in accelerating the current schedule of spending 70% of the funds by the time of the 2010 midterm elections.

As in the previous quarters, I continue to believe that it is very important to put our emotions aside and to focus on the empirical evidence of patterns of economic activity. With the expected continuing volatility of individual economic

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Figure 10 - The Building Permits IndexSource: US Department of Commerce, Bloomberg.

Firm Update

First Empire Asset Management continues to grow. With the addition of a large institutional client, FEAM’s assets under management now exceed $3 Billion. In addition, Michael J. Miller has joined the firm as FEAM’s Sales Manager. In this capacity, Michael is responsible for the ongoing relationships with the network of platform providers and for the development of new products. Michael has nine years of industry experience having started his career at UBS Financial Services/Paine Webber in 2000. After transferring to the west coast, Michael remained with UBS until 2004 when he joined LPL Financial Services. At LPL Michael was responsible for recruiting and transitioning experienced financial advisors to the firm. Upon returning to the east coast in 2005, he rejoined UBS serving in several management capacities, most recently as the Long Island Market Area Sales Manager. Michael received his B.A. in Business Administration with a Concentration in Finance from Villanova University in 1999.

For more information, visit us at: www.1empiream.com

datapoints, it will be important to take notice of their longer term trends. The expectations of positive US GDP for the rest of 2009 will be an important factor in turning the tide of pessimism around. For the time being, the continuing recovery will largely depend on the effectiveness of stimulative measures and on the consistency of any increase in demand from the developing countries. We are still facing many issues that may slow down the economic recovery in the US. They include continuing credit tightening by the banks, related difficulty in obtaining credit by small business owners, and the US consumers’ increasing savings rate. However, I believe that the biggest risk we are facing at the present time is the potential for legislation that would tax the US economy back into a severe recession. As we close in on the midterm elections, the probability of Congress being able to pass such legislation decreases. Moreover, the likely political deadlock in Washington after the midterm elections may be one of the brightest events on the horizon.

Michael Obuchowski, Ph.D.First Empire Asset Management, Inc.






DISCLOSURES

The foregoing letter is qualified by the following notes:

1. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Index is one of the most widely-used benchmarks of U.S. equity performance.

The Russell Top 200 Growth Index measures the performance of the especially large cap segment of the U.S. equity universe represented by stocks in the largest 200 by market cap that exhibit growth characteristics. It includes Russell Top 200 Index companies with higher price-to-book ratios and higher forecast growth values. The companies also are members of the Russell 1000 Growth Index. The Russell Top 200 Growth Index is constructed to provide a comprehensive and unbiased barometer of this larger cap growth market. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

The indices referred to herein are unmanaged and therefore do not have any transaction costs, advisory fees or similar expenses to which a client account would be subject. It is not possible to invest in these indices. The indices are for comparison purposes only. It should not be assumed

that a composite will invest in any specific securities that comprise the indices. The composites managed by First Empire Asset Management, Inc. may not be as diversified as the indices and may experience differing degrees of volatility. Performance for all indices includes the reinvestment of dividends.

2. All net performance figures include the reinvestment of dividends and other income, and reflect the deduction of actual advisory fees paid quarterly in arrears and actual trading and other costs incurred by each account in the composite, which varied based upon the client’s directed broker or custodian. Differences in client trading costs will affect each client’s actual returns. Only clients invested in the FEAM50 composite with balances above $100,000 are included in the performance figures. The amount below $100,000 was not significant and has no material impact on these numbers. Performance up to September 30, 2008 was achieved while Chief Investment Officer, Michael Obuchowski, Ph.D., was at Altanes Investments. Dr. Obuchowski continues to remain the principal investment officer for the composite, and the investment strategy of

the composite has not changed in strategies, policies or objectives.

3. There is no guarantee that the matrix of economic indicators (or each indicator individually) can accurately predict profits or losses in the markets or the composite. The matrix of indicators discussed herein is not intended to determine investment decisions. Such indicators were chosen by First Empire Asset Management, Inc. among many potential economic indicators. Other indices or economic indicators may reflect differing or contrary results. There is always the potential for gains as well as the possibility of losses.

4. Past performance should not be construed as an indicator of future returns or results. These results should not be indicative of the skill of FEAM and do not guarantee that similar results can or will be achieved in the future. As with any investment vehicle, there is always potential for gains as well as the possibility of losses.

5. This letter is not an offer or solicitation.

mo 2009 q3 commentary

Economy & Finance

growth index

worst month

volatile month

positive quarter

potential collapse

stock markets

intramonth trough

near collapse