Investors look past short-term market concerns, recognizing economy's underlying strengths
The market's recent rise appears to signal a change in market leadership as the arguments for a commodity-driven market have waned in the face of broader recognition of the economy's underlying strengths. Our portfolios continue to benefit from this shift in thinking, as we have long maintained that we were entering the middle growth phase of the economic cycle, and have been positioned for a period of fairly stable growth, even when this positioning did not gibe with the market's short-term outlook.
Our approach to portfolio positioning looks six to 12 months ahead and identifies what we believe to be the most appropriate opportunities based on our best assessment of the upcoming economic and market scenarios. This approach steered us away from the thinking that dominated the markets earlier this year as some market watchers foretold a weakening economy overwhelmed by rising commodity prices. From our point of view, to adopt this mindset would be to adopt a short-term trading mentality that tried to capitalize on timing price spikes in materials and energy holdings. We instead saw underlying fundamentals that foretold an economy progressing at a healthy pace (albeit moving slower than the sprint coming out of the market's trough), and positioned our portfolios accordingly.
While the same big three worries - rising oil prices, inflation fears, and concerns about an economic slowdown - loomed, it appears that during the second quarter, investors dug deeper into the economic fundamentals and noted that indicators such as GDP, household net worth, unemployment, inflation, and interest rates were all healthy when compared with long-term averages. Sensing that the economy was indeed more normal than depressed, the market broadened its gains to include more growth oriented sectors such as Health Care, Financials, Technology, and Telecommunications. Among equities, we continue to find ample opportunities that befit our outlook, and believe that the market's appetite for deep cyclical companies may be past its peak. Our focus on companies with more stable, sustainable growth prospects would be well served should the mid-growth phase of the economic cycle continue as we believe it will.
The convertible market performed in line with the equity market in the second quarter, and the uptick might have been greater if not for the fact hedge funds practicing convertible arbitrage were heavy sellers during the period. The net effect was that more convertibles were available at prices as attractive as we have seen in nearly 20 years. In terms of performance, the market made only a small distinction between investment-grade issues and speculative-grade securities, but did favor equity sensitive issues, matching our portfolio's bias.
The current undervaluation situation has created a great deal of opportunity to increase the upside potential of our convertible allocations. We have been taking advantage of the valuation gap created by hedge fund selling to move away from more fully valued positions to those with more attractive risk/reward characteristics. Our bias remains toward equity sensitive securities issued by larger, more established growth companies that can benefit from the current economic expansion which, in our view, could last for years. In terms of quality, we continue to favor higher-quality securities more so than the broad market, and remain positioned for greater equity sensitivity.
For the quarter, high yield was slightly ahead of convertible securities and well ahead of stocks. Spreads did widen a bit during the quarter, but still remain fairly tight, typical of a strong economy in which real interest rates are relatively low, default rates are moderate, and evidence of corporate profitability is becoming more apparent. At this stage of the economic cycle, we anticipate that spreads will continue to fluctuate, but within a fairly narrow band: any extreme spikes would indicate the potential for future concerns, but we believe this middle phase of the economy has the capacity to progress for many more quarters. The downgrading of Ford and GM bonds in May generated the most talk among high yield investors, but the huge impact of these bonds in the market that some expected did not in fact materialize: lower issuance, relative to last year, turned out to be a more relevant factor.
Even with yield spreads being relatively tight, we still think this asset class offers investors adequate compensation for the additional risk they are taking on. Reflecting our own attitudes toward risk, we are concentrating on the higher quality areas of the high yield market, avoiding the lowest quality credits, looking for companies with strong and sustainable cash flows, and seeking out issues with the potential for credit quality upgrades and other improvements that may stem from an expanding economy.
Unlike the market, which has swung back and forth from concerns over recession to overheating, our outlook remains essentially the same. Believing that the economy is in the middle part of the cycle, we continue to emphasize equity sensitivity across our portfolios, usually with growth companies that offer a compelling balance of risk and reward. Our emphasis is on companies which provide other businesses ways to enhance their own productivity, as well as companies that can benefit from sustained consumer spending. Although it appears that the market now agrees with this positioning, at times we may underperform the broad indexes during short-term periods when our outlook differs from the conventional wisdom: we believe that if we can get the big picture mostly correct and have the convictions to stick to our discipline, we will add value over the long term.