disappointing investment return of only 0.5% during the period. By comparison, the Dow Jones
Industrial Average and Standard & Poor’s 500 Index showed roughly similar respective returns
of 1.4% and 0.1%. However, the benchmark composite index (60% S&P 500 and 40% Barclays
Gov’t/Credit Bond Index) performed slightly better with a 1.0% return. The Fund performed in
line with a peer group universe of other balanced funds reported by Lipper in the Wall Street
Journal, which also turned in a similar average return of 0.5%. For the entire first half, the Fund
achieved a return of 5.7% compared to somewhat better respective returns of 8.6% and 6.0% for
the DJIA and S&P 500. However, the composite index and the Lipper Balanced Funds Index, a
peer group universe of comparable balanced funds, both produced a somewhat lower average
return of 4.7% for the same period.
Economic growth during the second quarter continued to be relatively weak with recently
reported real Gross Domestic Product showing only a slight 1.3% increase (preliminary basis)
compared to an even weaker 0.4% gain in the first quarter. The disappointing performance
resulted primarily from a negligible improvement in consumer spending due largely to
continuing high unemployment as well as a declining level of confidence. Business spending
continued to show reasonable growth with non-residential fixed investment rising at a 6.3% rate.
Government spending slipped a slight 1.1% with all of the decline occurring at the state and local
levels. Although down somewhat from recent periods, exports continued to be an area of
strength, rising 6.0%.
Interest rates remained relatively stable during the quarter with Federal Reserve policy
continuing to be highly stimulative. While longer term rates did slip modestly as most
economists pushed out their forecasts for higher rates due to the continuing economic weakness,
the overall bond showed only minor changes during the period.
The disappointing stock market performance mirrored the overall economy despite the fact that
most corporations reported better than expected earnings growth. Reflecting the growing
concerns over economic growth, the more defensive sectors of the market such as consumer
staples, health care and utilities performed the best, while the more cyclically sensitive areas
such as basic industries, capital goods, energy and technology performed the worst. A notable
exception was the financial sector where loan losses and increased government regulation have
reduced the growth potential for most companies. Among individual holdings in the Fund, the
best performers included American Express (+14.4%), H. B. Fuller (+13.7%), Johnson &
Johnson (+12.3%), Graco (+11.4%) and Baxter Int’l (+11.0%), while the poorest performers
included Bank of America (-17.8%), TCF Financial (-13.0%), Corning (12.0%), Wells Fargo
(-11.5%) and JPMorgan Chase (-11.2%).
The stock market has recently experienced significant weakness (-14% over the first part of
August) along with heightened level of volatility primarily in response to growing fears of a
“double dip” recession. These concerns developed rather quickly in response to weaker than
expected economic reports, together with the sharply divided debate over raising the debt ceiling
and implementing budget cuts. The lack of substantive progress toward reducing the Federal
budget deficit also led Standard & Poor’s to reduce the U. S. Treasury’s AAA credit rating to
AA+. At the same time, European debt problems resurfaced with respect to Italy and Spain after
an even worse situation in Greece seemed to have been resolved, at least for the time being.
Although the U. S. economy most certainly has experienced a recent slowdown, such an
occurrence is not without precedent in past recoveries following recessions, especially those
brought on by a crisis of one kind or another. The case can also be made that while the current
recovery coming out of the 2007-2008 recession has been slower than past recoveries, it may
also be of longer duration than most past recoveries. In any event, indicators such as recent
employment trends, home sales, retail sales and strong corporate balance sheets all seem to
suggest continued slow but, nevertheless, steady growth. While sluggish European growth
remains a problem, we believe the question of sustainability of a faster rate of growth in such
countries as China, Indonesia, India and Brazil is the more important issue when assessing the
prospects for future economic growth in the U.S.
Given the recent commitment of the Federal Reserve to keep interest rates low, it seems that
monetary policy will remain highly stimulative over the foreseeable future. Because of the
apparent ineffectiveness of quantitative easing, the Fed also seems unlikely to undertake any new
initiatives unless the economy does, in fact, slip into a recession. Consequently, no significant
changes in the bond market are expected, at least over the near term.
Considering such factors as 1) the continuing strength of corporate earnings growth, 2) a
historically low level of interest rates and 3) reasonable valuation levels (12x estimated 2011
S&P 500 earnings), the stock market appears to be quite attractive. However, volatility may
remain at elevated levels for some time to come in light of continuing economic uncertainties
both here and abroad.
William B. Frels
President and Lead Manager
Ronald L. Kaliebe
Vice President and Co-Manager