We had an extremely high cash position in the Reynolds Blue Chip Growth Fund during the period from October 2007 to March 2009 when the stock market was in a correction phase. We started buying near the market bottom in March 2009. We believe that stocks are selling at attractive valuations based on historical valuation measures. One of these valuation measures is a company’s price earnings ratio relative to inflation, interest rates and the economic outlook. Another valuation measure is a company’s price earnings ratio relative to its forecasted earnings growth rate (the PEG ratio). Many stocks of high quality companies are currently selling at PE ratios and PEG ratios toward the lower end of their historical ranges and we believe that they are attractively valued.
The U.S. economic recovery that started in mid-2009 has continued, although at a modest pace, so far in 2012. The U.S. economic recovery continues to be affected by a number of secular factors that are altering the pace and composition of growth. The economy in 2012 is being affected by high unemployment, greater prudence and less speculation in lending, reduced government spending for the last six straight quarters, and weakness overseas. The U.S. economy is growing, but at a lower than ideal rate. For example, growth of 3% or better is needed to meaningfully reduce unemployment which is currently around 8%. The Federal Reserve Board’s (the Fed’s) second round of economic stimulus named “Operation Twist”, which involved purchasing longer term maturity Treasury Bonds and selling shorter term maturity Treasury Bonds, is scheduled to end on June 30, 2012. This stimulus tended to moderately lower longer term interest rates and added a moderate amount to economic growth. There are currently no announced plans by the Fed for a third round of stimulus. Economic growth has recently slowed. U.S. Gross Domestic Product (GDP) expanded at an inflation-adjusted annual rate of 2.2% in the quarter ended March 31, 2012 helped by a strong private sector including strong consumer spending and hurt by a weak public sector. For the next six months the outlook remains for modest but less than ideal growth accompanied by high unemployment, modest inflation pressures, no change in the Federal Reserve policy on the federal funds rate, a strong private sector and a weak public sector. The economy will continue to be characterized by large fiscal deficits. GDP increased 1.7% in 2011 and 3.0% in 2010, after decreasing 3.6% in calendar 2009, after no change (0.0%) in calendar 2008, and increasing 2.1% in 2007. Only modest GDP gains are forecast for the next two years. U.S. GDP is forecast to expand at a 1.8% rate in the quarter ended June 30, 2012 and at 2.1% for the year ended December 31, 2012 and 2.1% for 2013.
U.S. inflation numbers have been helped in the last few years by global competition and technology innovations that are helping to lower production and distribution costs. Inflation, as measured by the Consumer Price Index, increased 3.1% in 2011 and 1.6% in 2010 after decreasing 0.3% in 2009, increasing 3.8% in 2008, and increasing 2.9% in 2007. U.S. inflation increased 2.8% in the first quarter of 2012 and is forecast to increase 2.3% in the second quarter of 2012. U.S. inflation is forecast to increase 2.1% in 2012 and 1.9% in 2013.
There are some current and potential economic and investment negatives at the present time including: (1) unemployment at 8.1% is still high as hiring continues cautious and recent employment gains have been weaker than expected; (2) high oil prices including higher gasoline prices continue to negatively affect economic growth; (3) mortgage rates are low, but mortgage credit is still somewhat tight; (4) business spending has recently slowed; (5) the U.S. deficit needs to be reduced; (6) there are major economic problems with some individual Euro-zone countries such as Greece, Italy, Ireland, Portugal, and Spain which may continue for some time and may spread to other countries; and (7) China’s economic growth projections have recently been lowered.
Some current and potential economic and investment positives are: (1) consumer spending, which accounts for about 71% of the economy, expanded in the most recent quarter at the fastest pace in the last year; (2) employment and payrolls are increasing although at a modest rate; (3) there has been recent growth in commercial and residential construction; (4) auto sales have recently strengthened; (5) there has been an increase in the willingness of companies to commit capital as evidenced by the increase in merger and acquisition activity; (6) the economy has grown in the last ten quarters through the March 31, 2012 quarter and growth should continue in the near term; (7) growth in the service sector is broadening; (8) manufacturing production is strong; (9) businesses have been able to use the credit markets to strengthen their balance sheets; (10) short-term interest rates remain low helped by a low Fed Funds rate; (11) long-term Treasury rates are low; (12) many companies reported revenue growth, not just earnings growth, from cutting expenses in the most recent quarters; (13) the European bailout fund has been expanded; (14) current valuations of stocks are at the lower end of historical ranges; and (15) the U.S. economy currently has better fundamentals than the economies of most other industrialized countries.
The World Economy
The global economic recovery that started in mid-2009 has continued in 2012. Global economic activity slowed considerably in the second half of 2011, but appears to be stabilizing. The World Economy increased 4.0% in 2011 and 4.8% in 2010 after decreasing 0.8% in 2009 and is forecast to increase 3.5% in 2012 and 4.0% in 2013. The Euro-zone is currently the weakest economic area among industrialized countries. Europe has been implementing significant fiscal retrenchment which is slowing their economic growth. The biggest risk to Euro-zone economic growth is related to the potential sovereign government debt crises that have appeared. The Euro-zone increased 1.5% in 2011 and 1.7% in 2010 after decreasing 4.0% in 2009. Euro-zone real GDP has decreased over the last two quarters. The Euro-zone is forecast to increase 0.2% in 2012 and 1.4% in 2013. Several Euro-zone countries including Spain, have slipped into a recession.
The United Kingdom’s GDP increased 0.7% in 2011 and 1.3% in 2010 after decreasing 4.9% in 2009 and is forecast to increase 0.7% in 2012 and 1.7% in 2013. The U.K. has recently slipped into its first double dip recession since the 70’s. Japan decreased 0.7% in 2011 and increased 4.0% in 2010 after decreasing 5.2% in 2009 and is forecast to increase 1.4% in 2012 and increase 1.5% in 2013. Korea increased 3.6% in 2011 and 6.2% in 2010 after increasing 0.2% in 2009 and is forecast to increase 2.4% in 2012 and 3.4% in 2013. Canada increased 2.5% in 2011 and 3.1% in 2010 after decreasing 2.6% in 2009 and is forecast to increase 2.0% in 2012 and 2.4% in 2013.
Some developing countries in the world have been growing faster than the U.S. in the last few years. Their economies continued to grow faster than the U.S. during the most recent worldwide economic slowdown and their economies are continuing to grow faster. Recovery is strongest in Asia with China having the strongest growth among “advanced economies”. Other Asian countries are having good growth rates as well. The biggest developing economies are many times referred to as the “BRIC” economy, which is short for Brazil, Russia, India, and China. China’s population is approximately 19% of the world’s total population of approximately seven billion. In the second quarter of 2010 China overtook Japan and became the world’s second largest economy after the U.S. It is the world’s fastest growing major economy. Many economists believe that China has a particularly good long-term outlook. Near term, however, there have been some cross currents in China’s economic outlook and China’s growth rate has recently slowed to about 8.0%. GDP increased 6.4% in 2011 and 10.4% in 2010 after increasing 8.5% in 2009 and is forecast to increase 8.0% in 2012 and 8.3% in 2013.
India’s population is approximately 17% of the world’s population. It is the world’s second fastest growing major economy. India’s economy increased 6.6% in 2011 and 8.4% in 2010 after increasing 6.8% in 2009 and is forecast to increase 6.8% in 2012 and 7.3% in 2013.
Brazil is Latin America’s biggest economy. GDP increased 2.7% in 2011 and 7.5% in 2010 after decreasing 0.2% in 2009 and is forecast to increase 2.9% in 2012 and 3.9% in 2013. Russia’s economy grew at 4.3% in 2011 and 4.0% in 2010 after decreasing 7.9% in 2009 and is forecast to increase 3.8% in 2012 and 3.2% in 2013.
Many worldwide larger multinational companies should be well positioned to benefit long-term from worldwide growth. To the extent that some of these companies’ U.S. earnings are growing slower, this could be somewhat offset by their possible stronger foreign earnings. The long-term strategy of the Reynolds Blue Chip Growth Fund is to be structured to benefit from this worldwide growth by investing in many of these leading multinational growth companies.
The Blue Chip Fund is positioned to participate in long-term worldwide growth trends through investments in multinational U.S. headquartered companies. In addition, the Fund has investments in leading foreign headquartered companies, whose stocks or American Depositary Receipts (ADRs) trade in the United States. These ADRs are denominated in dollars and they must use GAAP (Generally Accepted Accounting Principles) accounting to qualify as an ADR. The Blue Chip Fund may hold up to 35% of its assets in ADRs.
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