Dear Clients and Friends,

The second quarter of 2010 saw Boise’s longest and dampest Spring in memory, at least in ours.  Cool temperatures and intermittent rain seemed to abate only with the Independence Day weekend.  That 2Q10 weather seems quite a long time ago as I sit in my office hunkered down like a lizard from Boise’s foothills, watching the heat waves ripple off streets and rooftops in the distance, our office’s hurricane force air conditioner roaring above my head. 

Likewise the economy and markets, which seemed to have made liars out of the few (including Kevin and Kenn) who remained skeptical of the gargantuan run-up in stock prices amid talk of “V-shaped” recoveries and “green shoots,” shifted into a very different environment during 2Q10.

Rather than dive right into a discussion of the economy and markets, though, we’ll start this quarter’s letter with a few more mundane items.

“Around The Office”

As has become commonplace, Harmonic was featured in the local press over the past few months, with Kenn being interviewed on local television and Kevin was quoted regarding Micron Technologies in the Idaho Statesman.   And of course, we released research on a range of economic and investing topics including our market view, reviews of Boise and Idaho economic statistics and analysis of the never-ending stream of national economic data.  Feel free to contact us or visit HarmonicAdvisors.com to review our research.

Harmonic has expanded its internship program to three students this summer, for the first time including a promising recent high school graduate.  James Marria graduated from Boise’s Bishop Kelly high school (where Kevin’s kids have attended) and will be attending Claremont College this fall.  Our other two interns are seniors majoring in finance at Boise State University: Jody Hilliard and Shevket Selimshayev (a.k.a. Shev) are doing some top notch work for us on projects on which we needed an extra set or two of hands.

We’re pleased to note that Vu Ngo and Brad Weigle, who interned with us in the Spring, found full-time employment (the paying kind, unlike their internships with Harmonic!) in the Boise area.

Economic and Market Review and Outlook

We wrote in our 2Q09 client letter that we expected the stock market advance to be less explosive than after previous recessions because the economic recovery would be quite muted. It’s fair to say that we grossly underestimated the fervor for speculation when money’s cheap and the government has virtually assured a taxpayer-funded backstop for bankers and investors who get themselves in trouble. In our defense, though, we got the second half of that assertion correct. The consensus has joined Harmonic in questioning the strength of the economic recovery and consequently the reasonableness of stock prices that rose 80%+ from their March 2009 low.

As the economic problems in the Eurozone revealed themselves and domestic economic indicators showed slowing growth, the US equity markets began to tumble April 27^th 2010. They caught themselves in early July after paring about 17% from their value; for the quarter the S&P500 was down -11.86%. The “sharp sudden break downward” we forecast in our 1Q10 client letter, and many other writings and conversations, at long last arrived.

Since the most recent stock market high, volatility has been exceptional, with the S&P500 rising or falling over 1% an extraordinary 30 of 66 trading days during the second quarter. Many investors, including yours truly, are uncomfortable committing capital in such wobbly times, which explains the higher-than-normal cash balances that some of our clients currently see in their portfolios.

We think it’s likely that the market “trades sideways” with higher than normal volatility for the next several years, which suggests that investors should become more tactical in their approach rather than pursuing a buy-and-hold strategy.

On the economic front, for all of our scoffing at the idea of a “V-shaped” recovery, in the ongoing debate over whether US economic growth is simply slowing marginally or will experience a “double-dip” recession, we come down on the side of the former. It’s clear growth has slowed dramatically but our research suggests that the nation’s economy won’t relapse into negative growth.

We continue to repeat our steady refrain of the past 21 months, however: The developed economies’ malaise is a debt-reduction, balance sheet driven downturn that’s likely to linger for years, not the run-of-the-mill inventory / employment based correction typical of the post WW2 period.

An interesting albeit frustrating feature of this downturn, and one that fools casual observers into believing the economy’s closer to “all’s well” than “batten down the hatches”, is that the economy is now more than ever one of “haves” versus “have-nots.”  Large companies, which are predominantly those represented in the government economic data, are faring much better than their smaller brethren; lending statistics show that bank lending is substantially freer to large firms than small. Similarly, large banks seem to be doing much better than their community bank competitors. Another dichotomy is between businesses, which have as a group solidified their balance sheets by hoarding cash and reducing debt (and of course paring human capital) and consumers, a far larger segment of the economy that that has only just begun the balance sheet mending process.

In an environment of low economic growth and the ever-present specter of a deflationary spiral, low bond yields and uninspiring capital appreciation of stocks suggests that income will return to the fore as a driver of investor returns. Where appropriate we’ve begun to tip portfolios towards higher cash returns, believing, to paraphrase an old saying, “A dollar in the pocket’s worth two in the market.”

Investment Performance

The glow from our top-tier 2009 investment performance faded quickly: In a 24/7/365 market and economy there’s no resting on one’s laurels. We’re pleased to report that Harmonic’s Large-cap Core, Smid-cap Core and All-cap core stock strategies outperformed their respective benchmarks again in second quarter. That they did so while assuming less risk than their respective benchmarks is especially noteworthy.

We’re also pleased that most of our private client portfolios beat their benchmarks during 2Q10, in no small part because of the conservative positioning we’ve mentioned many times.

Since the portfolios were already positioned for what we believed was the inevitable reversion towards fundamental value, we made few adjustments to portfolio structures during the second quarter. However, as the market seemed to right itself in July we began to selectively take advantage of more realistic valuations.

We would not be surprised, though, if the markets temblors continue as the calendar moves into the mid-term election season.

“Speaking of Candidates…”

As we’ve noted in previous letters, referrals from clients and friends are the lifeblood of our business; your kind words are our only advertisement.  Referrals to Harmonic of your friends, acquaintances, coworkers and family members are the highest compliment and are greatly appreciated.  Thanks in no small part to those referrals, our ”Assets Under Management” total has continued to expand.   We’ve also been asked to present proposals to several leading Idaho nonprofit organizations, have had some very encouraging conversations with institutional consultants about our stock strategies and have enjoyed a steady stream of new private clients.  As always, we hope you’ll feel free to forward our commentaries, and this letter, to those whom we may be able to assist.

As a reminder, Harmonic focuses on the following private client types:

• Nonprofits
• Profit-sharing plans
• Investors whose retirement investments are in transition or in need of organization or optimization
• Investors who’d like to participate in Harmonic’s industry-leading stock strategies as a part of their existing brokerage account
• Those who understand that investing is not a speculative short-term game, but is a contest that is won by methodical behavior and disciplined thinking

Personal Notes

Kevin and Kenn are enjoying their summertime hobbies now that the season’s in full swing. Kevin and his family enjoyed a two week respite in Hawaii and he’s proud that as of last week all three of his sons have scored holes-in-one (although he’s a bit piqued that he hasn’t.) Kenn and his significant other Tina Funkhouser have enjoyed visits to and from their respective parents: They spent their Independence Day weekend in Challis with her family, while Kenn’s mom and dad stopped in Boise for a few days in the midst of their post-retirement circumnavigation of the US. 

While the weather’s a little hot for our taste we know it won’t be long before the temperatures, and the economy and markets, shift once again.  It occurs to us that the old saying about the weather in the Rockies – “If you don’t like it, just wait 5 minutes…” – applies to other subjects as well.

Our best to all for a healthy, enjoyable and profitable third quarter.

 Kevin A. Jones, CFA                                        Kenn Lamson, CFA