Despite the doom and gloom of 2011, the US economy showed some signs of revival in the later stages of Q4. The most pleasant surprise was the 200,000 increase in jobs revealed in the December employment report. In addition, the unemployment rate dropped to 8.5%. Other measures of economic activity also surprised to the upside. In some ways, however, US economic data has become almost irrelevant, as events in Europe have cast a long shadow over the global economy.

As we approach the two-year anniversary of the Greek debt crisis, the Euro situation appears to be deteriorating. We have been consistently skeptical of the various “solutions” offered by European leaders. This drama has followed a familiar pattern of celebrating the latest plan, enjoying a few months of bliss, and then experiencing panic again when the “plan” fails. Greece’s days in the Euro appear to be numbered as a default seems more and  more likely. The next Greek bailout installment is due in March ( €100 billion), and it is difficult to imagine Germany throwing more good money after bad.  We expect a very rocky road in Europe, and it is uncertain how tall the resulting tsunami wave will be once it reaches US shores.

We anticipate continued, world-wide central bank quantitative easing (money printing) in 2012. Last September, the Fed launched “Operation Twist,” a plan in which the Fed bought Treasuries in a bid to lower long term interest rates. Fed officials have recently leaked the outline of a new quantitative easing plan, QE3, involving purchases of mortgage backed securities. The Fed is apparently determined to manipulate interest rates, creating distortions in the US economy that policy leaders will be forced to address for years to come.

Given the historically low level of interest rates and world-wide central bank money printing, higher rates are inevitable at some point. However, the situation in Europe has added much uncertainty to the outlook. While we see little value in Treasuries at current yields, we are maintaining a market weight in Treasuries as a hedge against a poor outcome in Europe. We are also neutral from a duration (average  maturity) standpoint, overweight credit (US corporate bonds) and underweight mortgage-backed securities. As visibility improves, we plan to redeploy our Treasury position into high yielding sectors. Our duration position will be largely dictated by events in Europe. A positive outcome would most likely lead to higher interest rates, and we would shorten duration to protect our clients’ invested principal. If events in Europe spiral out of control, the demand for Treasuries, as well as their returns, would be great, much as they were in 2011. 

The end of 2011 adhered perfectly to the script, where a little early turbulence exiting Q3 ultimately gave way to calmness and nice gains in Q4.  However, it’s safe to say that most of us are glad to have 2011 in the rear view mirror. It was a tough and bloody battle that in the end left us right back where we started. Little was resolved and the markets know it.  Debt issues here and abroad, political stubbornness and a global economic slowdown hampered the equity markets for much of the year.  Fortunately, U.S. stocks ended the quarter on a positive note as most major indices posted double digit gains for the period.  For the quarter, the Rockwood Strategic Equity Fund gained 13.3% vs. 11.8% for the S&P 500 Index.  For the year we trailed the benchmark -5.4% vs. 2.1%, which for those familiar with our style, while we never like to do this, it is generally more likely to happen during market transitions like the one that occurred in Q3.  International stocks experienced a reprieve of sorts in Q4 as the Morgan Stanley EAFE Index increased 2.9%; however, they were much worse off for the year down 14.8%.  Bonds had a more historically normal quarter as the Barclay’s Aggregate Bond Index climbed 1.1% and was up over 7.8% for the year. The Balanced Composite Index gained 4.4%.

The year turned out to be a very challenging one for money managers, as most underperformed their benchmarks, and many by over 5%.  This was one of the worst performances in history (according to J.P. Morgan, it was THE worst since 1998).  Many believe this is due to the high correlations among stocks, bonds and currencies today, which are even higher than during the financial catastrophe that was 2008. Investors continue to be focused on the three-ring fiscal circus in Washington and the European Sovereign debt crisis. These uncertainties continue to weigh heavily on investors and until there is some resolution on both fronts, the markets are signaling a more defensive posture is in order.   This “market transition” or leadership change, began in the second-quarter, went full bore in the third and continued through year-end, as defensive sectors were the place to be for the year, with Utilities, Consumer Staples and Health-care leading the way.  Finance and cyclical sectors, such as Materials and Industrials, were the hardest hit.  Value stocks outperformed growth and it was better to be invested in large-cap stocks vs. mid-and small-cap.

Evidence of a leadership change continued to evolve during the fourth quarter for both market capitalizations and sector selection.  The shift away from more volatile asset classes such as small-cap and emerging market stocks into “safer” blue chip stocks (typically offering higher dividend yields) has become more prevalent.  Defense is the name of the game, as Utilities, Consumer Staples and Healthcare are positively trending sectors that have displayed leadership qualities over the last several months.  In a market with many uncertainties, investors are clearly enamored with the relative stability and attractive dividends of both sectors.  Utilities in particular have surged impressively the last couple months with several groups (electrics, gas, and multi-utilities) producing buys for the portfolio.  While these sectors may be boring, they continue to show promise in an uncertain environment.  Additionally, the positively rated Healthcare sector rallied in December, and while we want to like this sector, we will tread carefully because true to form, just when you think it’s safe to invest, it begins to get wobbly.  Lastly, the holiday season was especially merry for the Consumer Discretionary sector, particularly the upper-end companies.  Yet, despite the rally we remain neutral here as signal distribution remains 50/50.

On the negative side; though crude oil continues to rise, energy stocks continue to slide, thus the negative rating for the Energy sector. Particularly negative would be the energy service group, our group focus sell this month.  The Financial sector remains firmly entrenched in a long-term decline. While the decline is very late stage there is little evidence that a positive turn is close. In fact, many of the largest and most important institutions have barely halted their recent free-fall.  While there has been some improvement within the Industrial sector, it’s not enough to influence a change to our negative rating. Much like the Industrials sector, the highly-cyclical Materials sector got a short-term boost in December, yet the longer-term downtrend remains in place.  Also, the Information Technology sector continues to fade; we will use price rallies to reduce exposure to this negative sector.  Lastly, while it has been a frustrating market here domestically, things are certainly much worse overseas as our International 100 group continues to get battered – stay defensive! 

So, despite the negatives, we believe 2012 should be positive, though the early going could be rough.  Corporate earnings in the U.S. are healthy and equity valuations are considered depressed by historical standards.  With low expectations for stocks, modest improvement in the economic and political landscape could produce above average gains for the year.  As the markets transition, though, the list of “theme” opportunities within sectors such as Consumer Staples, Healthcare, and Utilities, becomes narrower.  More than usual, we expect industry and stock selection to be a key ingredient in obtaining above average results for the year.  We continue to identify emergent leadership and redeploy investor capital in those companies likely to produce superior returns. We thank you for your continued support, confidence, patience, and most of all, YOUR BUSINESS!

It does not take a rear-view mirror to recall many of the events that led to, and resulted from, the Lehman Brothers bankruptcy and subprime mortgage crisis three years ago.  Comparisons have been made of the just ended third quarter and the fourth quarter of ’08, as stocks experienced double-digit losses and Treasury securities, particularly long-maturity bonds posted double-digit gains.  Like then, pessimists seized control of the equity markets during the quarter, only this time it was on news of the ratings downgrade of U.S. debt, the financial problems in Europe and the possible contagion, and the prospect of a global economic slowdown.  Much like the fourth quarter of ’08, there was no place to hide in the stock market, while there was a “flight to quality” in bonds.  For the quarter, the S&P 500 Index declined 14.3%, while foreign investors fared worse as the Morgan Stanley EAFE Index fell some 19.6%.  Only the utility sector of the S&P 500 had a positive return for the quarter at 1.5%.  Bonds were the “place to hide” as the Barclay’s Aggregate Bond Index climbed 3.8%.  The Balanced Composite Index declined 7.5%.

While the current “mess” of uncertainty falls on the third anniversary of the events of 2008, many conditions are better today than they were then.  In fact, many of the monetary conditions are more favorable now, in this historically low-interest rate environment with mortgage-rates at generational lows.  And, not to be overlooked, corporate America remains strong financially, flush with cash and liquid assets.  However, as we have mentioned in the past, the stock market does not like “uncertainty” and there clearly has been plenty of that to go around.  Although this “uncertainty” and extreme volatility has put even the most resolute bulls back on their haunches, we are not one of them.  A lot of negativity is currently baked in to the equity markets.  In our opinion, investors who sell now are likely to be left stranded on the sidelines when the market begins to recover.  Bull markets are often sparked by a single rally so powerful and so fast that many investors fail to react in time.  This happened to many investors when the market rebounded sharply in 2009 after the “fall” of ’08. 

Even though we are bullish, our research is telling us that leadership is changing.  Recent performance has the makings of an inflection point.  Prior leadership within economically sensitive sectors such as Industrials, Information Technology and Energy have begun to deteriorate as defensive areas (i.e. Health Care, Consumer Staples, and Utilities) exhibit new early leadership.  This potential theme shift has led to our short-term underperformance, as our selections have lagged behind during this transition.  While it is unpleasant, this is normal within the framework of our trend-following discipline, usually lasting just a few months, as we transition the portfolio to the more dominant, positive themes of the cycle. 

We remain confident that as we continue to identify emergent leadership and redeploy investor capital in those companies, positive returns will follow.  We thank you for your continued support, confidence, patience, and most of all, YOUR BUSINESS!

At the risk of sounding a bit gloomy, many parts of the world are truly a mess right now:  Nuclear accident in Japan, unrest in the Middle East (Syria, Egypt, etc), the rolling sovereign debt crisis in Europe and our own debt ceiling battle in the U.S.

QE2 did indeed expire at the end of June, and so far, there are only whispers of renewed stimulus (QE3).  We posed the question last quarter: “Will the financial markets have the strength to go “cold turkey” when Dr. Bernanke removes the I.V. needle of monetary stimulus?  Or will the markets exhibit severe withdrawal symptoms?”  The initial prognosis is not good.  Most of the economic data releases over the past several weeks have been less than stellar.  The gut punch was the June employment report which revealed that only 18,000 jobs were created in the month, and the unemployment rate rose to 9.2%. 

In addition to the poor economic news, the raging debt ceiling battle continues unabated in mid-July.  We are confident that the debt ceiling will be raised.  However, if there is a delay in raising the debt ceiling, the government will be forced to prioritize its payments and reduce spending.  Any talk of the US defaulting on its debt service of US Treasury securities is ridiculous.  US government revenues FAR exceed the amount due for US Treasury debt service.  Some have argued that a debt ceiling impasse and the threat of “default” would lead to much higher interest rates.  On the contrary, we believe that economic weakness and lower rates are a more likely result should the government be forced to temporarily curtail spending.

Then there’s the seemingly never-ending sovereign debt crisis in Europe.  The Greek saga has drug on for over a year now.  Leaders in Europe seem unwilling to face the realization that there is no way out for Greece short of some type of default/restructuring.  The contagion is spreading to Ireland, Portugal, and now Italy.  Italy has the third largest debt market in the world, and Italian government bond yields are near a 9-year high.  Until the Europeans confront these issues head on, the problem will continue to fester, pushing down US Treasury yields as investors seek the relative safety of US debt.

We continue to lament the fact that the Fed’s “zero interest rate policy,” money-printing, and bailouts have created distortions in the US economy that policy leaders will be forced to address for years to come.  Risk-averse savers have been punished by the Fed’s low interest rates.  In search of higher returns, investors have been forced into higher risk assets like high yield bonds and equities.  This is fertile ground for the creation of investment bubbles.

Over the course of the last quarter, we gradually extended the duration of our portfolios as the economic data began to exhibit signs of stress.  The European debt crisis is also exerting downward pressure on US interest rates.  We continue to look for opportunities to add yield to our clients’ portfolios through the purchase of high quality corporate bonds.

In many respects, the obstacles the equity markets encountered in the second quarter of 2011 were eerily similar to Q2 2010, minus the resulting negative returns most experienced.  Whether it was the sovereign debt crisis that resurfaced in Europe, the Middle East tensions that have contributed to volatile commodity markets or our own domestic debt and recovery issues, we have certainly witnessed this act before.  A major difference this time, the equity markets held their own, not experiencing the sell-off we saw last year.  For the quarter, the Rockwood Strategic Equity Fund gained 0.3% vs. 0.1% for the S&P 500 Index (last year the S&P 500’s Q2: -11.86%).  The average U.S. Stock Fund, however, declined 0.4%.  Growth stocks outperformed value and it was better to be invested in mid and large-cap stocks vs. small.  For the twelve months ending June 30, 2011 the Rockwood Strategic Equity Fund is up 51.5% vs. 30.7% for the S&P 500.  Foreign investors also experienced a holding pattern as the Morgan Stanley EAFE Index increased 0.3%.  Bonds did relatively well as the Barclays Aggregate Bond Index rose 2.3%.  The Balanced Composite Index (60% S&P 500 / 40% Barclays Aggregate Bond) appreciated 1%. 

This “Repeat Performance” is largely a continuation of problems that surfaced years ago and just won’t go away.  Whether it’s the European sovereign debt concerns that continue to persist in the so called “PIIGS” (Portugal, Ireland, Italy, Greece, Spain), or the weakening U.S. economy, where debt ceiling concerns and the possible default of the U.S. Government hover over the markets just as the Fed’s second attempt at quantitative easing (QE2), comes to an end.  Not to mention the volatile commodities markets that resulted from the tensions in the Middle East and the “hangover” or financial impact of the Japanese tsunami disaster.  The equity market in our estimation has taken a much needed “breather” and while we have been anticipating this corrective phase to consolidate last year’s heady gains, it has taken quite a bit longer to develop despite this depressing backdrop.  That speaks to the resilience of this bull-market, which was pointed out last quarter.  It’s hard to imagine worse post-recession news and yet the market continues to anticipate better times ahead.   That should give investors the stomach to push stocks higher by year end. 

During the first half of 2011, your portfolio has benefited by concentrating our investment selections within those sectors (Technology and Energy) and industry groups (Luxury Goods, Cloud Computing, and select Oil & Gas holdings) which we have identified as displaying the greatest relative strength.  As we enter the current quarter there has been early signs of rotation into other sectors such as the long-down trending Healthcare Sector.  Additionally, in this month’s research we had only fifteen (15) upward trend reversals vs. fifty-one (51) downward trend reversals, a decisively negative signal.  Careful monitoring is in order as this is symptomatic of a possible theme change.  As always we will remain vigilant on your behalf watching for new opportunities to emerge.

The Fed’s current round of Treasury purchases (QE2) is scheduled to expire at the end of June.  Nothing is etched in stone, but barring any exogenous shocks to the economy, the Fed will complete its goal of $600 billion in purchases by the end of Q2.  The big question for the economy, stocks and interest rates is: what happens next?  Will the financial markets have the strength to go “cold turkey” when Dr. Bernanke removes the I.V. needle of monetary stimulus?  Or will the markets exhibit severe withdrawal symptoms?  Are a relapse and the introduction of QE3 on the horizon?  The next several months will be telling.

Bernanke is no doubt pleased with the results of QE2 with respect to equity markets.  The S&P 500 was up another 6% in Q1 2011 after a 10% gain in Q4 2010.  Now Bernanke can only hope that his stock market magic translates into a positive wealth effect and higher consumer confidence.  According to the Fed playbook, giddy consumers should dust off their wallets and spend, spend, spend, boosting the economy to escape velocity and leaving behind this era of economic malaise. 

However, it appears that the Fed’s grand scheme may have to maneuver past a few chunks of space debris on its path to success.  While Bernanke is quick to take credit for rising stock prices, he claims that QE2 is not responsible for the meteoric rise of virtually all commodities, most notably gold and oil.  Nor will he accept blame for the plummeting value of the US Dollar. The biggest threat to the US economy, in our view, is inflation.  Despite the dramatic increase in oil and food prices, the Fed refuses to admit this is a problem. Bernanke insists that food and energy prices are historically volatile and should be ignored.  Instead, investors should focus on “core” inflation (excluding food and energy prices).  However, core inflation is also rising; just not as quickly as overall inflation.

Unfortunately for Bernanke, the market is not complying with his plea to ignore rising food and energy prices. Since the introduction of QE2, long term interest rates have risen substantially, apparently due to investors demanding a greater yield premium to compensate for the increased likelihood of inflation. The TIPS breakeven inflation rate has risen 1% since August and is at its highest level since 2008. In other words, inflation expectations have risen substantially in recent months.

The European sovereign debt crisis continues to fester. Investors are finally coming to the realization that the European Central Bank’s strategy of issuing more debt to cure a debt crisis is pure folly. The only solution is some type of default (the less frightening term is “debt restructuring”). Despite the problems in Europe, our bet is that the US economy will gradually improve, and interest rates will move higher from their current artificially depressed levels. In our view, the Fed’s “zero interest rate policy” has created distortions in the economy that policy leaders will be forced to address for years to come. The inflation genie is emerging from the bottle, and long term rates will move higher as a result. We intend to maintain a defensive duration position, and look for opportunities to add yield to our clients’ portfolios through the purchase of high quality corporate bonds.

Resilient is the best way to describe this market. Despite the many “reasons” to pull back, the market has been impervious. It could be described as the Teflon market. The tectonic shifts off the coast of Japan and the tectonic shifts taking place in the Middle East have not been able to shake this market. Whether it’s the natural disaster and its aftermath in Japan, the heightened Middle-East violence, a related jump in the price of oil or the uneven economic news, investors seem to be looking beyond the short-term and like what they see.  For the quarter, the Rockwood Strategic Equity Fund gained 7.5% vs. 5.9% for the S&P 500 Index.  All major indices ended on a positive note.  Foreign investors were also rewarded albeit modestly as the Morgan Stanley EAFE Index climbed 2.7%.   In the bond world, the Barclays Aggregate Bond Index eked out a gain of 0.4%.  The Balanced Composite Index (60% S&P 500 / 40% Barclay’s Aggregate Bond) appreciated 3.7%.

The Equity Portfolio continues to benefit from a broad market theme as small and mid cap stocks persist in outperforming their larger cap brethren, while growth stocks outperformed value.  An increase in the weightings of cyclical sectors (Industrials, Materials, Energy and Technology) and continued underweighting in traditionally more defensive areas (Consumer Staples and Healthcare) has also contributed significantly toward above average results. 

During the quarter the equity market leadership began to shift away from the more interest rate sensitive areas of Consumer Discretionary and Financials to a more cyclical based theme to include Industrials, Materials, Energy and Technology.  With Consumer Discretionary stocks having shown signs of erosion for the past couple months, while not overly concerned, we are being a bit cautious as this sector has been a big performer for us over the last several quarters.   Financials continue to trend downward as we underweight the sector, including banks and diversified financials.  On the positive side, after consolidating gains in February, the Industrial sector resumed its impressive bull run in March.  Material stocks also seem to be enjoying the rising commodity price trend, as this leadership sector extends its gains and although underweight, we have added to this sector and will likely look to increase exposure in subsequent months.  The Energy sector, which we were underweighted significantly at the beginning of the year, is a sector that has witnessed improved performance with the unrest in the Middle East and the natural disaster in Japan and is an area of “growing” interest for the portfolio.  Technology also continues to demonstrate resilience, as the large cap behemoths can’t seem to get out of their own way so, the more nimble small/mid cap names can “March” on.  The International group remains neutral.

The current bull-market is over two-years old.  While there are those that profess its pending doom, we continue to evaluate and identify “leadership” changes for however long this “run” may last.  We continue to look for opportunities to enhance the value of the portfolio.  In this environment, sector and industry group selection (stock picking) continue to play an ever valuable role in adding value for our clients.  Any equity market weakness during the spring and summer months should provide a growing list of buy opportunities.  As always, we will continue to search for dominant themes in the market and make adjustments to your portfolio as needed.

The uncertain economic and political climate that dominated Q3 gave way to greater certainty in Q4. As a result, equity markets advanced nicely during the final stretch of 2010.  These certainties, fiscal stimulus in the way of new and renewed tax cuts, the announcement by the Fed of a $600 billion Treasury buyback (QE2) and the change in the political landscape, all led to higher equity prices.  Investors should be encouraged that many of the economic and political uncertainties have cleared, as this “bull” should have farther to run.  For the quarter, the Rockwood Strategic Equity Fund gained 15.9% vs. 10.8% for the S&P 500 Index.  International stocks did not fare as well, yet the Morgan Stanley EAFE Index turned in a solid return of 6.7%.   The Barclays Aggregate Bond Index was down 1.3%.

2010 was a joyous year for equity and bond investors alike as most market indices outperformed their respective historical averages.  During the year, the Rockwood Strategic Equity Fund appreciated 31.3% vs. 15.1% for the S&P 500 Index. The Barclays Aggregate Bond Index increased a more modest 6.5% in 2010.   The average U.S. stock fund catapulted 17.1%.  International stocks did not perform as well but still managed a gain as the Morgan Stanley EAFE Index climbed 4.9%.  The Balanced Composite Index (60% S&P 500 / 40% Barclay’s Aggregate Bond Index) jumped 11.7%.

Famed investor John Templeton once said that bull markets “are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”  Over the past two years, despite rising equity markets, 90% of all mutual fund inflows have gravitated toward bond funds.  As contrarians, this interesting paradigm suggests that we are still in the early stages of a relatively new bull market where investor pessimism (or perhaps skepticism) remains a byproduct of the 2008 debacle.  Just as time heals all wounds, we would expect this mindset to shift in the foreseeable future as the appetite for risk (stocks) increases and the appetite for safety (bonds) decreases.

The equity markets continue to be characterized by broad market leadership with small and midcap equities outperforming their larger brethren.  As such, the Equity Portfolio has gradually shifted toward this dominant leadership space and hence benefited from the exposure.  An overweighting in economically sensitive sectors (Consumer Discretionary, Industrials, and Technology) and underweighting in traditionally more defensive areas (Consumer Staples and Healthcare) has also contributed significantly toward above average results.  In the current environment, sector and industry group selection (stock picking) should play an increasingly important role in adding value for our clients.   We will continue our search for dominant themes in the market and make adjustments to your portfolio as needed.

As always, “Thank you” for your continued support, confidence, patience, and most of all, YOUR BUSINESS!

In early November 2010, the US Federal Reserve officially announced a specific plan to purchase $600 billion Treasuries to stimulate the economy.  This new policy became more popularly known as QE2 (as in quantitative easing, part 2).  The Fed’s Treasury purchase program is a rather desperate move; something pulled from the central banker playbook when all other monetary policy options have been exhausted.  History is littered with episodes of money-printing that ended badly; typically culminating in a nasty bout of hyper inflation.  Former Reagan administration Budget Director David Stockman had a colorful quote on this topic: “I think that the Fed is injecting high grade effective heroin into the monetary system of the country and one day it is going to kill the patient.”  Mr. Stockman’s views may be over-the-top, but we do agree that excessive inflation is far more likely than deflation, which the Fed has consistently referenced as the biggest threat to our economy. 

Bernanke has been criticized for failing to clearly articulate the goals of QE2.  Based on a number of interviews and speeches over the past couple of months, Bernanke has telegraphed that the purpose of QE2 is twofold: (1) make interest rates go down, and (2) make stock prices go up.  Lower interest rates can spur economic growth by encouraging companies to borrow and spend.  Unfortunately, the Fed has failed miserably in their first goal.  Since the introduction of QE2, long term interest rates have risen substantially, apparently due to investors demanding a greater yield premium to compensate for the increased likelihood of inflation. The TIPS breakeven inflation rate is approaching a 5 year high, an indicator of rising inflation expectations. 

On the stock market side, however, the Fed has been very successful.  The S&P 500 was up more than 10% in Q4.  Mr. Bernanke has said that higher stock prices are supposed to make people feel better so they go out and spend (the wealth effect).  But think about that line of reasoning for a moment.  Aren’t higher stock prices supposed to be the RESULT of higher earnings and improved economic activity and not the CAUSE?  Almost by definition, the Fed is attempting to inflate a stock market bubble.  We remain concerned that the Fed’s “zero interest rate policy” (ZIRP) is creating distortions in the economy that may have long term negative consequences. 

In our view, the direction of interest rates (and stocks) over the first half of 2011 will be largely determined by a battle between two opposing forces: The Fed (and QE2) vs. the European sovereign debt crisis. If QE2 works, the economy will gain traction. Inflation, interest rates and stocks will all move higher.  On the other hand, the European debt crisis continues to fester. The European Central Bank’s solution to the rolling Euro debt crises seems to be the issuance of even more debt! Unless real fiscal solutions are found, this Ponzi scheme will eventually collapse spurring a flight-to-quality rush into US Dollar assets, especially Treasuries, pushing interest rates lower.  Risk assets such as stocks would take a beating in this environment.  Despite the problems in Europe, our bet is that the Fed will eventually win out, the US economy will improve, and interest rates will move higher in 2011.  However, investors are likely to experience many twists and turns in this real-world financial market drama shaping up in the year ahead.