Market Commentary 
January 1, 2012

                                                           

Unintended Consequences

“Although the stated intention of political leaders and economic policy makers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite.”

Nassim Taleb

When it was all said and done, the S&P traversed a course that left it relatively unchanged for the year, though the path it followed was reminiscent of a drunken sailor. It was as if a number of conflicting forces conspired to buffet the capital markets back and forth confounding the prognosticators and policy makers alike only to end where it began which was a place few had forecasted.

Signs of economic strength domestically provided a basis of periodic support for the equity markets while Europe’s inability to find a solution to their debt crisis offered a constant headwind to global markets. Municipal bonds were cast into doubt by a failed forecast while the government bond market enjoyed strong returns as investors sought the safety of U.S. debt in spite of a credit downgrade.

China and India reported slower growth and commodities fluctuated with each economic report. Gold was torn between a lack of inflationary pressures and a lack of confidence in world currencies. But in the end it was a continuation of the same fears and uncertainties that investors have faced for several years with no resolution in sight that guided the markets.

So, where do we go from here?

At the moment we are concerned with the next twelve months and the cyclical issues that will impact capital markets, but in doing so we have not lost sight of the structural issues that will continue to define the global economy and therefore the capital markets for the next several years.

Not since the 1930s has policy intervention played such a significant role in the capital markets. Unfortunately in an attempt to stabilize economic conditions, world leaders and policy makers have introduced a set of variables that are difficult to quantify and have the potential to produce unintended consequences or Black Swan events. In addition, as we stated in the past, it is our belief that current policy is extending the duration of the economic crisis by not allowing the markets to self-correct.

In an environment of increased uncertainty it is natural that investors would focus on the protection of capital rather than the growth of capital. However, one of the unintended consequences of current policy can be the short-term inflation of risk assets such as commodities, real estate, and equities. Even though policy is adding to the crisis, short-term it could be providing opportunities in the capital markets.

Consider 2009 when domestic policy increased liquidity. Long-term the economic benefits proved to be negligible at best, but short-term the markets rallied as money flowed into the markets. Recently the European Central Bank (ECB) instituted a “swap program” with the assistance of the Federal Reserve. In short, without violating the letter of the law, the ECB and the U.S. have found a conduit to inject massive amounts of liquidity into the European banking sector.

The primary objective of this policy intervention is to provide stability to European banks and consequently the time required to constructively address the debt issues facing the Eurozone. A secondary impact will be a short-term boost to the markets given the increased level of liquidity. While this could provide an opportunity to increase risk, it would be prudent to wait for a more opportune time. We would suggest that at some point in the first half of the year the markets will grow impatient and question the ability of European leaders to achieve a substantive solution and enter a corrective period. That correction would in our opinion offer a tactical trade to increase risk going into the second half of the year.

However, given the level of uncertainty our short-term forecast is subject to several variables. First and foremost is Europe and it’s ability to impact the global economy. Secondly, China will need to avoid a hard landing and successfully begin the transition to a more diversified economy that is not so dependent on exports, and finally U.S. economic growth needs to remain stable. Those are a lot of ifs during a year that will also include a contentious political race, which could define domestic policy for the next several years.

What about longer term?

We are not as sanguine regarding the next five years. We continue to believe that we are in the midst of an economic crisis that is reminiscent of other historical periods such as the 1930s though muted as to the degree of pain that will be felt here in the U.S. However, in order to successfully navigate this period, it will be important to understand the breadth and depth of the problem we are facing in the developed economies.

For several generations we have slowly evolved from a society of savers to a society of consumers. From a manufacturing based economy to a service based economy. As long as there existed the ability to provide ample liquidity at favorable interest rates, consumption could be maintained and with it a level of economic growth that continued the virtuous cycle and delayed the repayment of debt.

In an effort to maintain this economic growth, monetary policy for the past thirty- plus years has encouraged the creation of debt globally until it has reached a level that is untenable. Current monetary policy has focused on the avoidance of constructive solutions while softening the impact of financial disruptions. We believe this strategy will continue to be pursued until all other options have been exhausted. Then and only then will difficult decisions be made and progress achieved in confronting the crisis.

Unfortunately the ability to support unlimited spending by printing money or financial engineering is quickly coming to an end. Correcting the present imbalances will require a prolonged period of adjustment. It will take years to recalibrate both our economic foundation and behavior to a more balanced stance and in the process we will experience a degree of financial pain that is always present during economic transitions.

If you consider that the recent series of asset bubbles and corresponding level of debt accumulation was more than thirty years in the making, was global in scale, and is only now being addressed, it would be reasonable to assume that it will take more than a few speeches on austerity and a tax increase or two to solve the problem. Society will need to relearn behavior much as a previous generation did who lived through the Great Depression.

Given the significant but not insurmountable problem the developed world is facing we anticipate that economic growth will be curtailed for several years to come. Interest rates will remain contained due to overall economic weaknesses though commodity inflation could periodically erupt during attempts by policy makers to stimulate growth.

In this environment we would argue that fixed income should represent an income stream and a diversification tool not a vehicle for capital appreciation, U.S. equities given attractive dividend yields could provide both income and capital appreciation, and positions such as gold, oil, and agriculture hedges against currency weakness, geo-political risk, and inflation.

Are there other concerns that could impact your forecast?

As mentioned, China needs to make a successful transition from an export-based economy to one that is more self-sustaining with a growing middle class. In addition, the current real estate market in China is reminiscent of the real estate bubbles in the developed world and will need to be addressed to avoid a financial contraction. With Europe in or about to enter a recession this would be an unwelcome event.

We are anticipating corporate earnings to decline based on a recession in Europe, but a hard landing in China and\or India would necessitate a further reduction to our earnings forecast and therefore our determination of fair value for the equity markets. This would in all probability lower our entry point for new purchases from current levels and we would anticipate downside risk to have increased.

In addition, the Arab Spring could be a sign of things to come not an isolated event. Historically economic crises lead to political unrest. Given the level of influence policy has on the current financial environment; consider what impact it would have if the political leadership in parts of the world were in flux. As much of the present unrest resides in the Middle East we would recommend maintaining exposure to the energy sector specifically the integrated oil companies as a hedge against geo-political risk.

Anything else?

In all of the focus on the global macro issues we should not lose sight of the fact that fundamentals still play a role in the division of assets. Bonds have been enjoying a bull market for thirty years. With interest rates at historically low levels this cycle will eventually reverse course. Though it may not happen immediately, it would be hard not to categorize fixed income as being in a topping process. The process could take several years to complete due to the economic malaise, but at some point inflationary pressures will be reintroduced into the system, interest rates will rise, and bonds will be negatively impacted.

In addition, even though we expect corporate profits to weaken in the coming year as the European debt crisis continues to unfold, over the long-term equities could be considered fairly valued if not attractive. Corporate balance sheets are in better financial condition than many sovereign states, valuation metrics based on reduced earnings are reasonable, and many companies pay dividends in excess of the ten-year bond. The greatest risk to owning equities at present is the inherent volatility prevalent in the financial system which dictates entry points need to be considered carefully, and profits protected when achieved.

For a long-term investor equities could represent the most attractive class at present.

Last Words?

The world is hoping we can muddle through the current economic crisis, but we believe in the end it will require difficult decisions and coordinated action to solve the debt problems that we have accumulated over the last thirty plus years. Though the markets may continue to struggle for some time to come, the ability to produce total return through a well-constructed diversified portfolio still exists and we will continue to strive to navigate the markets in a conservative and balanced fashion. If we are successful, we believe it should be possible to continue to generate positive returns regardless of market conditions.

As always, we thank you for the confidence you have placed in our firm and wish you and your families all the best as we look forward to a safe and prosperous year.

Sincerely,

Brad L. J. Griswold

i S&P The S&P 500 is an unmanaged capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries

iⁱ European Central Bank The bank created to administer monetary policy for the countries that have converted to the euro

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