18 Jul 2011 Heartland Funds - Q2 2011 Commentary ( Portfolio )
Three months ago, we reported on the challenges that investors would likely face following the Japanese disaster, Mideast uprisings and Eurozone sovereign debt downgrades. These challenges did in fact crystallize into slower economic growth here and abroad.

Companies with global supply networks linked to Asia, especially in the electronics and auto sectors, have guided down full year sales and earnings estimates to account for disruptions. In late April, Western Texas Intermediate (WTI) crude spot prices peaked at $113 per barrel, reflecting a heightened risk premium associated with the Mideast turmoil, but have since backed off to around $90. Catastrophic spring weather has also been a negative development.

While the effects of the events above are likely of a more temporary nature, the sovereign debt crises in Greece and other peripheral European nations are more structural in nature and are still very much unfolding. We believe the fiscal problems presented in Europe will overshadow the region for some time. US debt markets have responded in sympathy with the 10 year Treasury breaking below a 3% yield for the first time in 2011 while US credit spreads have widened. Completing the picture of a soft-patch, the S&P 500 was recently off around 7% from its early May peak, responding to recently weaker readings in housing, unemployment and consensus forecasted GDP growth.

Now that we’ve sketched a sufficiently bleak outline of current conditions, as long-term investors, we are encouraged for the following reasons. First, since 1928, moderate corrections of 10% or more in the S&P 500 have occurred, on average, 1.1 times per year.1 The selloff we have witnessed since May seems quite normal in the context of market history. Second, investor pessimism is rampant, which has historically been a bullish indicator. A recent investor sentiment survey revealed that 62.5% of respondents had bearish or neutral views on the stock market.2 An index of investor sentiment has shown that periods of extreme pessimism have more often preceded market advances than have periods of optimistic or neutral sentiment.

The end of the second round of Federal Reserve monetary easing, known as QE2, is cause for some concern, but we believe monetary and credit conditions are more benign than they were last year. Broad money supply in the US is currently expanding at over a 6% annual rate while it was contracting at a 2% rate last summer. Furthermore, market valuations do not appear to be stretched as the S&P 500 has recently traded at less than 14x current earnings compared to 18x earnings last spring prior to the correction.

We believe the broad selloff since May has given even strongly performing businesses an unwarranted haircut. The headlines over the summer will most likely continue to give the market worry. But with pessimism high and valuations low, we believe the fundamentals are in place for the market to eventually climb higher.