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Second Quarter 2009 Review ASSET MANAGEMENT

An Economic and Market Commentary By Michael Obuchowski, Ph.D.

Managing Director, Chief Investment Officer and Director of Research

Michael Obuchowski, Ph.D.

Managing Director, Chief Investment Officer and Director of Research

Equity markets started the second quarter of 2009 by continuing the recovery that began on March 10th. This time, however, unlike during the first quarter, the recovery continued for the entire month of April, with equity markets gaining close to 10% for the month (9.6% for the Russell 1000 Growth Index and 9.57% for the S&P 500 Index). The month of May was not nearly as consistent as April, but, after a dip in the middle of the month, equity markets registered another solid gain, with the Russell 1000 Growth Index finishing up 4.96% and the S&P 500 Index ending the month with a 5.59% gain. The last month of the quarter was the most volatile. After gaining more than 3% by June 12th, the equity markets dropped more than 5%, and eventually recovered to end the month in positive territory (1.12% gain for the Russell 1000 Growth Index and 0.20% gain for the S&P 500 Index). Despite the intramonth volatility, the second quarter has been the best quarter since the end of 1999 for the Russell 1000 Growth (16.32% for Q2 2009) and the best

quarter since the end of 1998 for the S&P 500 Index (15.93% for Q2 2009). The impressive gains during the quarter finally brought the equity markets into positive territory for the year, with the Russell 1000 Growth Index finishing up 11.53% and the S&P 500 Index up 3.16%. While all sectors had positive returns within the S&P 500 Index, Financials outperformed all of the other sectors with an impressive 35.08% return for the quarter. Information Technology (19.35%), Industrials (18.01%), Consumer Discretionary (17.65%), Materials (15.53%) and Energy (10.06%) registered double digit gains, while the worst performing S&P 500 Index sector, Telecommunication Services, gained 1.90% for the quarter. First Empire Asset Management’s FEAM50 Large Cap Growth Equity strategy finished the quarter at 18.17% (net of fees). Those of our clients who were invested in the FEAM50 strategy benefited from its outperformance of the relevant benchmarks during April and from its consistent performance through the rest of the quarter. The primary driver of the FEAM50’s excellent performance during the quarter was our decision to return to a fully invested status on March 30, 2009 from a 22.1% cash position at the end of February. This

resulted in an increased exposure to several of the best performing sectors during the quarter, including Information Technology, Industrials, Consumer Discretionary and Materials. In addition, stock selection within the Telecommunications Services, Industrials, Health Care, Energy and Consumer Discretionary sectors had a positive contribution to the FEAM50 strategy’s outperformance of equity benchmarks for the quarter. Despite the success of the various central banks’ efforts to stabilize the financial system (see the TED Spread update on Page 2), the economic numbers that most investors focused on during the last quarter did not provide much reason for optimism. In my opinion, some of the negative interpretations of the last quarter’s economic data were caused by the confirmation bias that made it difficult to acknowledge the ideas of any potential economic recovery (see our Q1 2009 Review for more details on the cognitive bias and its effects on the psychology of

about our investment advisory services, please contact Jennifer Vernier at 631-630-2500, email jvernier@1empiream.com or write to First Empire Asset Management, 100 Motor Parkway, 2nd Floor,

Table 1 FEAM 50 Composite, Russell 1000 Growth Index, Russell Top 200 Growth Index and S&P500 Index performance during 2009

For more information...

Hauppauge, New York, 11788.

Q1 2009

April 2009

May 2009

June 2009

Q2 2009

YTD 2009

FEAM50 Gross*

-0.74%

12.05%

4.50%

1.16%

18.45%

17.57%

FEAM50 Net*

-1.00%

12.05%

4.50%

0.92%

18.17%

16.99%

Russell 1000 Growth Index* Russell Top 200 Growth Index*

-4.12%

9.60%

4.96%

1.12%

16.32%

11.53%

-4.39%

7.90%

4.87%

1.39%

14.73%

9.69%

S&P500 Index*

-11.01%

9.57%

5.59%

0.20%

15.93%

3.16%

*Total return, inclusive of dividends 100 Motor Parkway, 2nd Floor • Hauppauge • New York • 11788 Tel: 631.630.2500 • Toll Free: 888.620.5736 • Fax: 631.622.0168 www.1empiream.com • info@1empiream.com


Second Quarter 2009 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

investors). I believe that another reason was the tendency of investors to focus on economic data that typically lags behind an economic recovery. Many investors, economists, politicians and especially the financial media outlets chose to focus on the continuing rise in unemployment that reached 9.5% by the end of the quarter. Others focused on weekly initial jobless claims which stubbornly remained above 600,000 during the quarter. I believe that instead of emphasizing lagging indicators like unemployment, we should continue to focus on early economic indicators and attempt to minimize any emotional or cognitive biases that affect our investment decisions. This is especially important when the daily or weekly volatility of economic reports combine with a thirst for sensational news consistent with many investors’ beliefs of a continuing recessionary economic environment. Despite the continuing negative bias, however, some of the evidence related to unemployment is showing tendencies that will be difficult for the “permabears” to ignore. As I am writing this update, the just released initial jobless claims for the week of July 4th have declined more than the expectations of the economists and have dropped below 600,000 for the first time since the January 23rd report. What might be even more interesting to at least some of the market followers, this decline in the weekly initial jobless claims resulted in what technical analysts define as a “golden cross”; when the 50-day moving average crosses the 200day moving average (see Figure 1). I do not recall any technical analysts noticing the initial jobless claims forming the “silver cross” that occurred at the end of May (when the 40-day moving average crosses the 150-day moving average). However, they did notice both the silver cross and the golden cross events for the S&P500 Index that occurred on May 15th and June 23rd, respectively. Technical analysts and trend following models interpret both

Figure 1 - Source: Bloomberg Initial jobless claims

the silver and golden cross patterns as bullish indicators. If nothing else, these patterns certainly provide some interesting challenges to our “decession” focused minds. Since last fall I have repeatedly emphasized that one of the core requirements for an economic turnaround would be effective functioning of the credit markets. Without functional credit markets, none of the central banks’ nor the governments’ efforts aimed at increasing liquidity and credit availability to corporations and consumers can succeed. For several quarters I have been presenting updates on the TED Spread which I believe is one of the best measures of credit market health.

The TED Spread The TED Spread represents the difference between the LIBOR (London Inter Bank Offered Rate) and the Three Month T-Bill rate. The TED Spread is a measure of liquidity and is frequently used as a measure of credit risk. The T-Bills traditionally represent a risk free rate. The LIBOR represents the perception of counterparty risk among financial lenders. Although the TED Spread fluctuates over time, it tends to be much wider during times of financial stress. The size of the TED Spread is measured in basis points and, over time, it is typically close to 50 basis points. In

times of stress in the financial system, banks and other financial institutions don’t want to lend to each other as they are not sure they will be repaid. When that happens, the TED Spread will grow from its usual range. When the markets calm down, the TED Spread typically returns to its historical range. I believe that the TED Spread chart provides a good idea of where we are in the financial crisis as it indicates the perceptions that the financial institutions have of each other. Figure 2 presents the TED Spread since right before the collapse of Lehman Brothers in September 2008. Within less than a month of the Lehman Brothers bankruptcy filing and Bank of America’s acquisition of Merrill Lynch, the TED Spread spiked to a never before seen level of 463.11 on October 8, 2008 and the global credit markets froze. After reaching its October peak, the TED Spread dropped below 100 for a short period of time in the middle of January 2009 and then bounced between 90.12 in early February and 112.42 in early March, before moving solidly below 100 on March 31st and then below 90 on April 30th. This trend continued in May and June with the TED Spread declining to 40.73 at the end of Q2. As of this writing (July 8th, 2009), the TED Spread has fallen even further to 34.45, below its 20 year median level. It certainly looks like the coordinated efforts of the central banks around the world have

Figure 2 - Source: Bloomberg TED Spread

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Second Quarter 2009 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

achieved their goal of calming the markets, improving liquidity and improving the perception of counterparty risk among financial institutions. I have been closely following the TED Spread since it jumped above 200 in August 2007, soon after BNP Paribas announced that it could not value assets in three funds containing US subprime mortgage related assets, Coventree Capital was denied credit lines and declared it was seeing liquidity funding and several of the German Landesbanks - IKB, Sachsen LB and West LB accepted government organized emergency rescue (for more details about the TED Spread’s historical volatility during the current and past financial crises, please see our Q4 2008 and Q1 2009 reviews available on our website at www.1empiream.com). Nearly two years later, after all the carnage among the financial services companies and the unprecedented efforts by central banks and governments to prevent the collapse of the global financial system, we can finally acknowledge that the financial system has been successfully stabilized. I hope that by my next quarterly update I will be thinking about inflation and interest rates and focusing on the Federal Funds Implied Probability and Fed Funds target rates and no longer on the TED Spread. In the Q1 2009 update, I presented a matrix of early economic indicators which I believe address the early stages of economic activity. The selection of indicators was the result of my research into the empirical evidence of potential improvement (or continued decline) in economic activity. This focus on empirical evidence was driven by my desire to limit the emotional and cognitive biases usually present after an extended period of consistent economic growth or decline. The interpretation of the results of these early indicators was a significant contributor to my decision on March 30th to move the accounts following the FEAM50 investment

strategy back into a fully-invested status (from 22.1% cash position at the end of February). While the six early economic indicators included in the matrix presented compelling evidence of a slowing rate of economic decline (suggesting that the economy was close to or even at the bottom of the recessionary cycle at the end of Q1 of 2009), the number of “positive” data points was quite limited and left a lot to be desired. Last quarter provided not only three more data points for all the monthly indicators, but also significantly stronger evidence suggesting a rapidly slowing rate of economic decline or even some beginnings of a turnaround:

Index remained within a tight range until a solid +6.71% move in May. This leveling off followed by an increase on the CCG Index presents compelling evidence that we may be in the beginning of an economic recovery.

The Baltic Dry Index The Baltic Dry Index (BDI), published daily by the London-based Baltic Exchange, provides an assessment of the price of moving raw materials by sea. It covers 26 shipping routes worldwide and is a composite of the Baltic Capesize, Panamax, Handysize and Supramax dry bulk carrier indices. After a steep decline that started in May 2008, the

The Core Crude Goods Producers Price Index I consider the Core Crude Goods Producer Price Index (CCG Index) to be one of the best leading economic indicators for insight into the early stages of capital goods production. Due to the core crude goods’ price sensitivity to shifts in economic activity, the Core Crude Goods PPI is especially sensitive to any turning points in economic activity, and is therefore a valuable indicator for those who want to stay ahead of the business cycle curve. After a steep decline that started in July 2008, the slope of the curve’s decline moderated in December 2008. As one can see in Figure 3, the CCG

Figure 3 - Source: Bloomberg The Core Crude Goods Producers Price Index

Figure 4 - Source: Bloomberg The Baltic Dry Index

BDI reached its trough on December 12, 2008, declining from 11,793 to 663. Since December, the BDI has recovered to 1,615 on March 31st and continued its recovery with a gain of 132% in the second quarter of 2009, before settling at 2856 on June 30th. BDIY’s daily calculation results in much higher volatility than monthly indices. Due to the BDIY’s higher volatility we should focus on its longer term patterns rather than on daily or weekly volatility. Despite its volatility however, the second quarter of 2009 was the first time since the third quarter of 2007 that the BDIY experienced a positive change in each of the three months of the quarter again suggesting recovery in raw materials shipping under way.

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Second Quarter 2009 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

The Architecture Billings Index

The Primary Metals Index

The Architecture Billings Index (ABI) is a leading economic indicator of commercial construction activity, capturing the approximately nine to twelve month lag between architecture billings and actual construction spending. The ABI is derived from a monthly “Work-on-the-Boards” survey sent to a panel of architectural firms owned by members of the American Institute of Architects. The ABI is published monthly and is produced by the American Institute of Architects’ Economic and Market Research Group. After the recent peak in August 2008, the ABI experienced a steep drop until November, and then declined further (albeit at a more moderate pace) until it reached its trough in January 2009 at 33.3. The ABI had risen to 43.7 by the end of the first quarter, and remained within a narrow range after a small decline in April and then a slight increase in May. Although the ABI is still below 50 (a score above 50 indicates an increase in billings), the pace of the decline in architectural billings has significantly moderated. The related Inquiry Index (measuring the capacity to take on additional work) staged an impressive turnaround, moving from 38.5 in December to 56.8 in April, experiencing a modest decline to 55.2 in May. The Inquiry Index’s score above 50 for the third month in a row is suggesting the possibility that the ABI might continue on the path to recovery.

The Primary Metals Index is one of the indicators included in the Advance Report on Durable Goods Manufacturers’ Shipments, Inventories, and Orders (M3). The M3 survey compiles data from 4,200 manufacturers with $500 million in annual shipments (plus a handful of smaller companies) representing 89 industry categories. The survey contains information on new orders (for immediate or future delivery), shipments, unfilled orders and inventories.

Figure 5 - Source: Bloomberg The Architecture Billings Index (ABI)

The Core Capital Goods Orders Index New Orders of Nondefense Capital Goods Excluding Aircraft (also known as Core Capital Goods Orders) is another indicator selected from the Advance Report on Durable Goods Manufacturers’ Shipments, Inventories, and Orders (M3). The Core Capital Goods Index is considered to be one of the best leading indicators of business investment spending. After reaching the recent peak of 66300 in July 2008, the Index declined for five of the six following months, with an average decline of 4.92% per month, ending the year at 48698, a 26.55% decline. Since that time, the Index declined during March and April and rose during February and May, providing little evidence of any directionality and ending May at 50524. It is reasonable to interpret the results as suggesting a bottoming out process, but there is little evidence so far to suggest possible beginning of a turnaround in business spending.

Figure 6 - Source: Bloomberg The Primary Metals Index

The Primary Metals Index captures information about raw materials being ordered by large manufacturers. The increase in orders for primary metals suggests that industrial production is likely to increase in the near future. After reaching its high of 24418 in July 2008, the Primary Metals Index dropped steeply to its trough of 11641 (52.33% decline) in March 2009. Since the end of the first quarter of 2009, the Primary Metals Index increased in both April and May, gaining 0.34% to 11680. These two positive (if only slightly) months after eight months of declines (with an average monthly decline of 8.75%) suggest that the raw materials demand might have reached the bottom that may precede a more pronounced recovery in the near future.

Figure 7 - Source: Bloomberg The Core Capital Goods Index

The Building Permits Index The economic crisis has continued to significantly affect the housing industry. I believe that housing is usually one of the most reliable indicators of future economic

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Second Quarter 2009 Review ASSET MANAGEMENT

An Economic and Market Commentary continued...

activity. Within housing, residential real estate is typically one of the first sectors to turn around with an improving economy. The April S&P Case-Shiller Home Price Index for 20 metropolitan markets declined 18.1% from April a year earlier. This large decline actually represented a slowing of the rate of decline on the year-to-year basis and the lowest year-to year rate of decline since October 2008. On a month-to-month basis, April’s 0.56% decline was the smallest decline since July 2007. While the ABI precedes commercial construction activity, one of the leading early indicators of housing activity is the Private

and the 4.02% increase in May are certainly promising and suggestive of a bottoming process. However, the pattern does not yet show much of a recovery in the works. Because it is closely watched as a long term economic indicator, and because of its huge multiplier effect, the Buildings Permits Index is an important index to watch. By some estimates, construction of 1,000 single family homes generates 2,500 full time jobs and nearly $100 million in wages. Despite the home construction business accounting for less than 5% of GDP, its effects are seen throughout the economy, as we have experienced during the recent economic decline. It is important to remember that the decline in building permits issuance did not just start in June 2008. The 5-year peak of 2263 was in September 2005, with a largely declining pattern until the recent April 2009 bottom of 498 - a staggering 77.99% decline (see Figure 9).

Figure 8 - Source: Bloomberg The Building Permits Index

Housing Authorized by Building Permits Index, provided on a monthly basis by the US Commerce Department’s Bureau of the Census. This index provides information about private residential real estate activity based on the issuance of building permits. While not every permit results in construction, nearly 95% of localities in the US require construction firms to obtain a building permit before any construction activity takes place. After a recent peak of 1174 in June 2008, building permit issuance experienced a drastic decline for nine of the next 10 months (the only positive change was in February). A slowing rate of decline from January 2009

Figure 9- Source: Bloomberg The Building Permits Index since 7/31/2003

The six early economic indicators presented above have added another layer to our critical thinking toolset. The interpretation of these indicators assisted us at the end of the first quarter of 2009 with the decision to move away from large cash positions back to a fully-invested status. During the first few months of this year, the early indicators we discussed presented information suggesting that the global efforts aimed at stabilizing the financial system were

beginning to work and that the ferocity of the economic crisis was beginning to wane. Three months later, there is strong evidence that the global financial system has been successfully stabilized. At the same time, some of the the economic indicators suggest the bottoming of the economic activity and even some signs of potential beginning of recovery. Current evidence supporting the beginning of recovery is still quite tepid, but it is important to remember that we are still in the very early stages of spending the $787 billion economic stimulus package enacted at the beginning of the year. As of the end of June, only the tax cut portion and $60.4 billion of the $499 billion has been spent. While the White House’s goal is to spend 70% of the funds by September 2010, political pressure has been building quickly for accelerating stimulus spending on both the federal and state levels. With the majority of the economic headlines illustrating the economy in the midst of a recession, it will take some more time for positive information to affect the minds of investors, economists and politicians. I still believe that it is very important to attempt to put our emotions aside and focus on the empirical evidence of economic activity and its early indicators. Based on those indicators I believe that we are at or that we have passed the bottom of the economic activity cycle. Since equity markets are frequently considered early indicators of the economic activity, the strong Q2 2009 returns should not have been a surprise. I still do not expect the lagging economic indicators to start turning around any time soon and I expect the unemployment rate to increase in the near future. I do expect the equity markets to lead the recovery that will result in the GDP turning positive. The timing of the GDP’s recovery depends on the ability of the stimulus package money to filter through the economy and provide additional multiplier-effect driven spending by both consumers and private industry.

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Second Quarter 2009 Review ASSET MANAGEMENT

One recent positive effect of the global effort to counter economic slowdown is the evidence suggesting that a $585 billion stimulus implemented in China is already having an effect of reviving the world’s third largest economy. The World Bank and many analysts have already started increasing their forecasts for China’s economic growth.

An Economic and Market Commentary

With aggressive stimulus measures and efforts targeting improved liquidity being implemented in the US, I believe that the US economy will return to positive growth rates by the end of this year, well before the euro zone’s middle 2010 GDP recovery expectations.

– Michael Obuchowski, Ph.D. First Empire Asset Management, Inc.

Firm Update On May 21, 2009, the Hauppauge Industrial Association (HIA), in partnership with the Long Island Forum for Technology and Suffolk County Community College (SCCC), hosted its 21st Annual Business Trade Show and Conference “Survive and Thrive in 2009”, at the SCCC campus in Brentwood, New York. First Empire Asset Management, Inc. (FEAM) was proud to be one of the 300+ exhibitors to participate. As a new member of HIA, FEAM found its first appearance at the trade show to be informative. According to FEAM’s Managing Director and Chief Investment Officer, Michael Obuchowski, Ph.D., “We welcome the opportunity to meet with fellow, local professionals and business owners. We look forward to the next event.” With over 3,500 in attendance, the event proved to be a worthwhile and enlightening experience. The Dr. Michael Obuchowski and Jennifer Vernier HIA is a thirty-year old business organization that focuses on the welfare of its more at the 2009 HIA Trade Show and Conference than 1000 members and the entire Long Island business community. By providing a variety of services and programs, the HIA’s goal is to ensure the economic wellbeing of its members. “It’s an interesting time to attend,” stated Dr. Obuchowski. “During these difficult economic times, business professionals are completely focused on maintaining their place in the business world and targeting new business opportunities as the economy begins the recovery process. They’re increasingly turning to investment professionals for advice with their retirement plans, corporate investment programs and personal investments. Our job as an investment advisor on Long Island is to assist these busy professionals with all their personal and corporate investment needs and to enable them to focus on the success of their own businesses.” On July 11th and 12th, First Empire Asset Management, Inc. team members participated in the Sewanhaka Corinthian Yacht Club’s Annual Club Rendezvous. Ian Gumprecht, Michael Obuchowski and Peter Sobel, racing Windsong, Ian Gumprecht’s Sea Sprite 34, finished first in class on both days and were the winners of the James A. Roosevelt Cup.

For more information, visit us at:

FEAM’s Ian Gumprecht and Peter Sobel onboard Windsong

www.1empiream.com

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Second Quarter 2009 Review ASSET MANAGEMENT

DISCLOSURES The foregoing letter is qualified by the following notes: 1. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Index is one of the most widely used benchmarks of U.S. equity performance. The Russell Top 200 Growth Index measures the performance of the especially large cap segment of the U.S. equity universe represented by stocks in the largest 200 by market cap that exhibit growth characteristics. It includes Russell Top 200 Index companies with higher price-to-book ratios and higher forecast growth values. The companies also are members of the Russell 1000 Growth Index. The Russell Top 200 Growth Index is constructed to provide a comprehensive and unbiased barometer of this larger cap growth market. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

An Economic and Market Commentary

and therefore do not have any transaction costs, advisory fees or similar expenses to which a client account would be subject. It is not possible to invest in these indices. The indices are for comparison purposes only. It should not be assumed that a composite will invest in any specific securities that comprise the indices. The composites managed by First Empire Asset Management, Inc. may not be as diversified as the indices and may experience differing degrees of volatility. Performance for all indices includes the reinvestment of dividends. 2. All net performance figures include the reinvestment of dividends and other income, and reflect the deduction of actual advisory fees paid quarterly in arrears and actual trading and other costs incurred by each account in the composite, which varied based upon the client’s directed broker or custodian. Differences in client trading costs will affect each client’s actual returns. Only clients invested in the FEAM50 composite

with balances above $100,000 are included in the performance figures. The amount below $100,000 was not significant and has no material impact on these numbers. 3. There is no guarantee that the matrix of economic indicators (or each indicator individually) can accurately predict profits or losses in the markets or the composite. The matrix of indicators discussed herein is not intended to determine investment decisions. Such indicators were chosen by First Empire Asset Management, Inc. among many potential economic indicators. Other indices or economic indicators may reflect differing or contrary results. There is always the potential for gains as well as the possibility of losses. 4. Past performance should not be construed as an indicator of future returns or results. 5. This letter is not an offer or solicitation.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Growth Index is constructed to provide a comprehensive and unbiased barometer for the large-cap growth segment. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics. The indices referred to herein are unmanaged 100 Motor Parkway, 2nd Floor • Hauppauge • New York • 11788 Tel: 631.630.2500 • Toll Free: 888.620.5736 • Fax: 631.622.0168 www.1empiream.com • info@1empiream.com

FEAM Q2 2009 Update  
FEAM Q2 2009 Update  

FEAM Q2 2009 Update

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