In the wake of this weekend’s downgrade of U.S. government debt by Standard & Poor’s, and on the heels of last week’s market slide, many investors are feeling the temptation to flee stocks and move to cash and other investments thought to be safer.  Ironically, the list of these perceived safe havens includes U.S. debt obligations, the very securities whose downgrade triggered this morning’s market selloff.

Beyond the repercussions of the move by S&P, investors are worried about the global economy and the sovereign debt situation in Europe.  Over the weekend, the European Central Bank signaled its intention to purchase the bonds of Italy and Spain, after buying Irish and Portuguese bonds last week, in order to prevent the issues emanating from Greece from bringing down the European financial system and economy.

We are watching these developments closely, and we understand the emotional toll of the recent news on investors.  Nevertheless, panic is not a strategy, and we believe a wholesale move from stocks to cash would be a mistake.

One primary reason for our position is the success of many companies, particularly the largest multinationals, to prosper during the slow economic recovery that we are experiencing.  75% of S&P 500 companies that have reported earnings have exceeded analysts’ estimates for second quarter results, and most of these companies confirmed or raised their guidance for the remainder of the year.  Yes, it is possible that a dramatic change in the global economy could dampen earnings momentum for even these strong firms, but we believe it is still most likely that these companies continue to do well even in a slower economic recovery.

The second factor that gives us confidence is the currently reasonable valuation of the stock market and, in particular, the low valuations placed on the high-quality companies that we favor in our portfolios.  Unlike prior to previous major downturns, today’s market is not overvalued, and reasonable to low valuation levels provide protection against major downward swings.

What is our strategy now?  Largely the same as it has been for a long time: owning primarily securities of high-quality, multinational, dividend-paying companies that currently trade for significantly less than we believe they are worth.  We sell our positions when they reach or exceed their true values, not as an emotional reaction to short-term changes in market conditions.  Nevertheless, we are currently reviewing our portfolios for potential opportunities to raise cash by selling positions that are most vulnerable to a deterioration of the global economy, so that we will have more cash available to purchase shares of attractive companies when markets stabilize.

Ours is a strategy designed to outperform benchmarks over periods of years, not days, weeks, or months.  We remain confident that our approach is the best way to prosper, particularly in tumultuous times.

For further reading, click here to view a recent piece from Fidelity titled “Panic is not a strategy.”

My colleagues and I have just completed our Summer 2011 Quarterly Report.  In this latest installment, we review the second quarter of 2011, offer our outlook for the economy and market, and discuss three of the securities we are currently buying: American Express (AXP), Intel (INTC), and Wal-Mart (WMT).

Click here to go to the full report on our website.  Following are a few highlights:

- The S&P 500 index was essentially flat in the second quarter (0.1% return) and ended June up 6% for the first half of 2011.  These results are better than many investors realize in the wake of second quarter market swings and negative headlines.

- Reasonable valuations and strong corporate earnings provided a solid foundation for the market, which faced headwinds from unrest in the Middle East, concerns about European governments’ debts, the debate over raising the U.S. debt ceiling, and the lackluster labor market.

- Several unusual events, including tornadoes and flooding in the United States and supply chain disruptions from the disasters in Japan, also hampered economic growth and the markets.

- We expect the economy to improve in the second half of 2011, as recent indicators point to continued recovery and easing commodities prices relieve strains on businesses and consumers.  In particular, gasoline prices fell as we entered the summer driving season.

- Negotiations over the U.S. debt ceiling will likely go down to the wire.  Failure to reach agreement could have grave consequences for markets and our government’s cost of borrowing.

- We expect the stock market to rise further this year, albeit with greater volatility.  Low interest rates support economic growth and make stocks relatively attractive, and the third year of a Presidential cycle is usually good for the stock market.

- We continue to favor shares of high quality, well capitalized, multinational companies that pay dividends and trade at significant discounts to intrinsic value.

- Income investments we have been buying recently include high yielding equities in the energy and income sectors, such as Energy Transfer Partners (ETP), Provident Energy (PVX), Telefonica (TEF), and Exelon (EXC).  We have also been buying preferred stocks, including floating rate preferreds.

As always, feel free to contact us if you have any questions or comments.  For more information, visit our website.

Jordan Smyth and the Edgemoor Investment Advisors Team

The S&P 500 index rose today in response to good economic news that provided relief from recent weakness.  Since hitting a nearly three-year high at the end of April, the market has now retreated 5.5%.  It is still up for the year, but investors are nervous about signs of a slowing US economy, the upcoming end to the Federal Reserve’s most recent round of monetary easing (QE2), a resurgence of the European debt crisis, and continued turmoil in the Middle East.  We have been watching these developments closely, of course, and I want to briefly share our thoughts.

It is clear that economic growth has slowed from the pace earlier in the recovery.  However, mid-cycle slowdowns are typical, the economy is still expanding, and leading indicators point to a continuation of this trend.  Manufacturing activity remains strong, and declines in gasoline prices should help to ease pressure on consumers.  Also, lower commodity prices will provide relief to producers and help to ease the threat of inflation.  While the Fed plans to end QE2 as scheduled on June 30^th, we believe that it will use other tools, if necessary, to keep the economic recovery going.

The market had been rising steadily for nine months, so a pullback from the highs of April is not surprising.  In fact, according to a recent report we received from Fidelity, the average frequency of market corrections is greater than many people realize: 5% corrections 3 times per year, 10% corrections once per year, and 20% corrections every 3.5 years.

Large corrections normally occur when the economy is in recession and markets are overvalued, neither of which appears to be the case today.  Interest rates remain low, banks are lending, and companies are hiring, although currently at a slower pace than we would like to see.  These and other factors lead us to be optimistic that the economy will pick up steam in the second half of 2011.  Economic reports will be mixed through the summer, though, and volatility in the markets will likely increase.

Meanwhile, stock market valuations are reasonable based on price/earnings ratios and other measures.  In particular, we like large-capitalization, multinational, dividend-paying stocks, which have held up relatively well in the recent downswing.  We will continue to monitor events as they unfold, but we believe that economic growth will stabilize and markets will improve.

Click here to view a report from Fidelity that discusses recent economic trends.

Cleaning out my inbox after several weeks of work travel, I came across recent commentary from Bill Miller of Legg Mason Capital Management.  In this piece, Miller shares views on the market’s performance so far in 2011 and his outlook for stocks.  I found particularly interesting his comments on Microsoft, which he holds up as an example of a U.S. mega cap stock that is currently cheap.  We, too, have described Microsoft in similar terms and believe that this and other domestic large cap stocks are particularly attractive and will outperform the market over time.

Have a look for yourself at insights from a skilled investor.