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March 2012 Investor Letter

Dear Investors,


The S&P 500 was up another 4% in February and is now up almost 9% for 2012.  This return would be wonderful if judged over an annual timeframe—for a two-month period it is a phenomenal one.  Considering that in an average year, the stock market has historically returned about 8%, 2012 is already outpacing history.  In other words, this stellar performance could continue, but it would be a little out of the ordinary.


As I mentioned last month, I wasn’t expecting the market to keep the pace it set in January, but it did.  Reflecting this expectation, our portfolios were modestly out of position last month, because I raised cash looking for a buying opportunity that never came.  Luckily we did have the luxury of a good January, so we didn’t give up too much ground even though we were underinvested.  For now our portfolios remain with large amounts of cash waiting for a more appropriate entry point.  Towards the end of the month there were some signals that the rally was starting to lose momentum and so I remain comfortable with our levels of cash.  As I write this letter the Dow is down nearly 200 points so maybe the opportunity is finally here.


Though unexpected, it’s not at all surprising that the market has climbed further than we planned for.  Rallies have a tendency to persist longer than most expect.  Still, markets will eventually correct as valuations become stretched, and I think this is beginning to occur today.  At the October lows, the S&P was selling with approximately a 10% earnings yield.  Today that same yield is about 7.5%.  While this level is still favorable compared to treasury yields, it is less favorable on an absolute basis especially given rising inflation (I filled my gas tank with $4.77 gas last week).  In my opinion investors need more than a 7.5% return to be adequately compensated for the risk of owning equities in such an environment.  At best, 7.5% is a fair price.


February’s market has complicated the picture slightly for March.  February is often a weak seasonal period for stocks, but March tends to be a strong one.  Because of this, my bias would typically be to invest heavily in March, but because we rallied in February, purchases in March would rely on the market going from overbought to even more overbought.  Such a scenario is not totally unthinkable, but stocks never go up in a straight line, and so a March rise would bring the market to even more dizzying heights.  This would likely put markets in a position for a double-digit drop in the months that follow.


On a longer time horizon, not much changed in February.  On a cyclical basis (1-3 yr ahead), the market seems to be signaling that 2012 (the fourth year of an economic expansion) will look a lot like 2006 (the fourth year of another economic expansion) when the market returned 13.6%.  On a secular (5-10 yr ahead) basis though there are still lots of obstacles to a healthy economic landscape.  The European Central Bank continues to add liquidity to the Eurozone, but European economies are noticeably slowing.  In Asia, there are drumbeats of a European style debt crisis for Japan beginning to sound in the distance.  Meanwhile, the US continues to run a deficit that is 8% of GDP with a congress that seems incapable and unwilling to help.  At some point the markets will have to grapple with these issues.  The question is when.


Scott Krisiloff, CFA
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