The following are some significant events that occurred in the 1^st quarter:

• The Dow Jones Industrial Average closed above 13,000 for the first time since May 2008.
• The S&P 500 also had its highest close since 2008; in fact, it had its best first quarter since 1998.
• Parliaments in Germany and Finland approved the second bailout package for Greece.
• The ECB’s (European Central Bank) 3 year Long-Term Refinancing Operation (LTRO) was initiated and served its intended purpose of stabilizing the Eurozone.
• The third estimate for 4Q GDP was revised up to 3.0% from the original 2.8%, driven by positive revisions to personal consumption expenditures, nonresidential investment and government spending.

The effect of these events was the return of real confidence to the world’s stock markets which precipitated a rally that started off 2012 with a bang. Equity markets this year have shown a resilience that we have not seen in quite a long time. Just when the world was expecting more financial calamity, the future surprised us all by being better than expected.

Economy

Last quarter we noted that we thought the economy could “surprise us to the upside” this year and so far that has been the case. Economic data this year has been quite encouraging, though still a far cry from the robust recovery everyone would prefer. Employment continues to improve, retail sales are rising sharply and manufacturing continues its relentless move upward.

Jobless claims are a good surrogate for the degree to which the economy has had to make necessary yet painful adjustments. Since 2008, our economy has experienced an enormous shift of resources away from the construction industry and the financial industry into other areas like manufacturing. With jobless claims approaching “normal” levels, it’s tempting to think that the majority of this adjustment has been completed. For the four month period ending in February, private businesses have added 930,000 jobs, the most since 2006. The unemployment rate has fallen as a result. However, large numbers of job seekers have fallen out of the workforce entirely which has played a role in lowering the unemployment rate as well. Retraining for new jobs takes time. With time we believe that the economy is going to do more of what it has always done – grow.

With that said, there are still economic headwinds to face. High gasoline prices, one of the more publicized issues, serve as an unwelcome ‘tax’ on our economy and have the effect of slowing growth. As we examine the current political environment, we are hard pressed to believe a cogent energy policy that leads to lower gasoline prices will be forthcoming any time soon. There are glimmers of hope though. The natural gas boom coupled with new production of oil in the U.S. will continue to create jobs and has the added benefit of increasing domestic manufacturing activity. Over the last few months, a number of manufacturing companies that use natural gas as a primary input in their products have relocated plants to be in close proximity to large natural gas deposits. Additionally, with this input priced at historic lows, a number of manufacturers are finding it less expensive to operate facilities in the U.S. than in China. Thus our manufacturing base is continuing to grow which is a welcome consequence of cheap energy here at home.

Given these developments, it appears that economic risks are easing. We’re even starting to see firmness in new housing construction which bodes well for GDP. We will need all the help we can get as Europe is falling into recession and China’s economic growth slows, both of which have negative effects on U.S. exporting activity. Thankfully, our economic recovery isn’t dependent on the health of every business sector. Rather, the recovery only needs to advance far enough for the virtuous cycle of growing employment, income and spending to take hold.

Stocks

After the stunning rally of the first quarter, overall valuations are not quite as attractive as they were at the beginning of the year. On a sector basis, Financial stocks led the way this quarter with Technology stocks a close second. After that, every sector had a positive return except for Utilities. One of the main characteristics of the first quarter was the positive reversal in the stocks that underperformed in 2011. In other words, 2011’s losers have so far this year become 2012’s winners. This reversal is directly tied to the “risk trade” whereby investors have moved into equities as the fears around a European collapse dissipated. The equities they have chosen were the stocks most beaten down last year. In our third quarter letter last year we noted that investors had re-priced shares based on a perceived negative future. This quarter shows what happens to stock prices when the negative future does not come to fruition.

While we do not expect this rally to continue unabated for the rest of the year, we do think that the rally has legs and the underpinning of it is based on a fundamentally improving economy. This economy is nowhere near its potential and given the continued amount of pessimism that exists, we have a hard time believing that the market is pricing in an overly optimistic future. As we review the various sectors we see pockets of overvaluation but we also see areas of deep value. We see value in Energy as well as Financial stocks. Even though Financials have led the way this year, a number of banks and insurance companies continue to sell for well below tangible book value and while some discount may be appropriate given the new regulatory environment, the current discount is greater than we think is justified.

There have always been, and will always be, fits and starts as the market marches forward from a difficult period. If past economic and stock market cycles are any indication, stocks are likely to rise to overvaluation well before economic growth stagnates. Given that we are, in our view, still on the ground floor of an economic expansion, we think it is more likely the current perception underestimates what stocks can do over the next 5 years, especially as the economy picks up steam.

Bonds

In a reversal from last year, the fixed income market took a back seat to equities in the first quarter of 2012. The broad taxable bond market as measured by the Barclays U.S. Aggregate Index advanced 0.30% for the period. Corporate bonds were the clear leader as this sector returned 2.08%. Corporate bonds issued by financial companies, one of the worst performers last year, returned over 5.0% when concerns regarding the solvency of financial institutions abated once the results of the Federal Reserve stress tests were released. Government Agency bonds with higher coupons and call features also did well as prices did not move much and we collected the coupons.

The Treasury market, on the other hand, did not fare as well. The 30-year Treasury bond fell nearly 8.0% and the 10-year fell 2.25%. We view this as an unwinding of the “flight to safety” affect witnessed last year as opposed to any credit concerns for the Federal Government. If the economy continues to improve we would expect Treasury yields to drift higher (meaning their prices would fall further).

Financial corporate bonds in the five to seven year maturity range still offer compelling value. The excess yield investors earn over the risk free Treasury comparable is still above of 2.75% for issuers we feel are sound. Bonds from Government Agencies that have step-up coupons and call features continue to offer better yield opportunities versus Treasuries as well.

The tax free municipal bond market was up approximately 1.5% for the quarter on a national basis. Tax receipts in most states are trending above expectations and will continue to ease budget concerns. The Federal Government has been and will continue to lower assistance to states for various programs, most notably Medicaid. While there is uncertainty in this area due to the current political environment, our view is that the municipal market as well as the state and local governments have the ability to adjust to whatever policies come out of Washington. The overall amount of debt outstanding in this sector actually decreased last year as municipalities tightened their belts as opposed to raising debt. We expect a degree of pent up demand for new issuance this year as rates are still very low historically speaking. We believe that investors will absorb this new supply without any problem since demand for tax free income remains robust. We like bonds with 10-15 year final maturities with an intermediate 3-6 year call structure where we can lock in yields that are almost double that of the taxable Treasury equivalent.

Conclusion

As we reviewed our letters from last year it was nice to see that being patient, understanding the adaptive nature of our economy and remembering that emotion does not drive long term value, paid off handsomely. As uncertainties declined, stock prices rose. While we celebrate the rise in equity prices, we also understand that our work is by no means complete. We will continue to watch the global economic and political indicators and invest accordingly.

There is no question that there are dangerous waters ahead for stocks and bonds – both geopolitically and economically. Iran’s desire for nuclear power has not subsided. The U.S. budget deficit and national debt concerns remain on the forefront. Couple those factors with a Presidential election and a massive health care law before the Supreme Court and we see how stocks could fall quite easily – at least in the short term. In the same breath, we acknowledge that predicting the future is a losing game. We strive only to prudently manage potential outcomes.

2011 was a wildly volatile and emotionally taxing year for investors worldwide. After an attractive first quarter, the Japanese tsunami devastated a portion of our manufacturing supply chain which damaged production, sales and ultimately, GDP. Following that natural disaster, we experienced a man-made one when politicians seemed intent on creating a financial crisis over America’s very large debt. Their indecisiveness contributed to a decision by the ratings agencies to lower our nation’s pristine triple-A credit rating. Then, as we began to overcome the effects of the tsunami and the hangover from the budget debacle, Europe’s debt problems reappeared on the world stage and its leaders seemed so ineffectual that they made our politicians look stately by comparison. Yet for all the noise, intrigue and fear, the U.S. stock market ended virtually flat for the year. International equities fared far worse, losing 12% on average and much worse for some individual countries.

Economy

After smoothing out bumpy GDP results, we think the economy will have grown about 2% for 2011. Not much to write home about, but much better than the alternative. While the 4^th quarter numbers have yet to be released, we believe we experienced some of the strongest growth of the year during this quarter; possibly as much as 2.5% to 3.0%. We noted last quarter that we did not believe we were in for a “double dip” recession and so far that belief has been vindicated.

Economic fundamentals continue to strengthen and it is easy to see ways in which the economy could surprise us to the upside during 2012. With that said, uncertainty surrounding Europe’s debt crisis persists and the fear of economic catastrophe emanating from Europe hangs over our heads like the sword of Damocles. Setting those fears aside we see that here at home employment is improving, leading to a strengthened consumer that is in the best financial shape in years. Businesses continue to be conservative by keeping very lean inventories and limiting new hires. If the economy continues to accelerate business may be caught unprepared for the increase in demand. On that note, with over $2 trillion on the collective balance sheet of corporate America, we are confident that businesses would be able to move quickly to satisfy any unexpected demand.

Given that consumer spending makes up 70% of our GDP, it bears mentioning that the financial situation of the household sector has improved markedly from two years ago. According to the Federal Reserve Bank of New York, delinquencies on consumer loans have fallen 30% in the last two years while U.S. consumers have reduced debt by more than $1 trillion in the 10 quarters ended in March. When measuring household obligations (mortgage, car, lease, and credit card payments) as a percentage of disposable income, the ratio got up to 19% at the peak in 2008. Today household debt obligations are down to about 16% of disposable income, on its way to 15%, a multi-decade low. Lower debt payments as a percentage of income means families have extra money that can be saved, spent elsewhere or used to further reduce debt. In our view, if the American consumer can continue to spend right through all of the bad news of 2011 (including the U.S. deficit and downgrade) we think it bodes well that they will keep spending despite worrisome headlines from Europe or Washington.

As for Europe, we should remember that U.S. exports to Europe represent about 3% of our GDP, much of which is for necessities. Therefore, a large amount of that spending will persist even if Europe experiences a deep recession. Our primary concern regarding Europe is not government austerity and recessions. Our primary interest (which we think is shared by Wall Street) surrounds the European financial system and the fear of systemic failure and the contagion which would ensue. Leverage is a powerful force; our country experienced this lesson first hand in the 2008 crisis. While we are concerned with the amount of leverage in the European banking system and the cross lending dependency that it breeds, we believe that systemic failure has been averted. While Europe will most likely continue to struggle, we believe the financial framework will not collapse.

Potential sources for an economic surprise to the upside include a strengthening housing market, increased U.S. oil/gas production and a strong rebound in auto manufacturing. The housing market seems to be stabilizing after years of decline. Recent reports on housing starts, housing permits and builder sentiment have all been improving. Thankfully, banks are moving foreclosed homes out of inventory while new housing starts have stayed low enough to allow the excess inventory to be absorbed. As this process continues, inventories should return to normal levels. Home ownership affordability is at a record high due to increasing rental rates in most markets and record low interest rates.

Amazingly, U.S. oil production is now growing again after years of decline, led by new shale discoveries in Montana, North Dakota, Ohio and increased production in Texas facilitated by new drilling technologies. During the 1990s, the United States imported over two-thirds of its oil. As of this year, less than half of U.S. oil consumption is imported and we are now a net exporter of refined petroleum products. We have the potential to significantly reduce our need for foreign imports over the coming years through both new production and the increasing use of cheap and clean natural gas. We have long been proponents of domestic natural gas which has the added benefit of generating thousands of well paying jobs in the energy industry. The stockpile of cheap natural gas in the U.S. is having a very positive economic impact on those industries that use it as a key input such as manufacturing, chemicals and fertilizer.

As for automobiles, it is clear that production is on the mend as consumers have ceased putting off the purchase of a new automobile indefinitely. After the bankruptcy and reorganization of automobile companies we are witnessing signs of a manufacturing renaissance where the U.S. is becoming more competitive on a global basis. As confirmation of this fact, Honda (a Japanese company) recently claimed that they plan on producing substantially more cars in their U.S. plants for global export.

Stocks

Surprisingly little has changed since we wrote our last quarterly letter with uncertainty around Europe’s future continuing to depress stock prices. The risks associated with the fiscal and financial difficulties in Europe remained the focus of attention and contributed to the pronounced volatility in a wide range of capital markets. American companies have seen their stock prices whipsawed without regard to improvements in their underlying business fundamentals. Many strong earnings reports over the last three months have been met with muted responses from the market. The stock and bond markets continue to take their sentimental cues from European headlines. Eventually this focus will shift, but for now it is the investment environment in which we operate.

To summarize, many of the themes and trends we were seeing at the end of the third quarter still hold true today: the market’s laser-like focus on Europe, continued undervaluation in economically sensitive sectors (such as Industrials, Basic Materials, Energy, and Financial Services), and reasonably strong reports coming from U.S. corporations. The silver lining is that the U.S. is beginning to look more and more like the strongest of all the developed economies.

Bonds

The bond market outpaced the stock market by a wide margin for the whole of 2011. Similar to the third quarter, the European sovereign debt concerns created an insatiable appetite for long dated U.S. Treasuries. The U.S. Aggregate Index experienced a total return of nearly 8% for the year. The majority of this performance was driven by the 10 and 30-year segments of the U.S. Treasury Market. It appears that international investors are parking dollars in our bond market to escape the headline risks in the Euro Zone. The Federal Reserve is also a buyer of long dated Treasuries in the ongoing “Operation Twist” that we highlighted in previous letters.

Callable agencies, mortgage backed securities and corporate bonds lagged. Notably, corporate bonds of Financial Service companies were negative for the year. We are seeing many short dated credits in this sector yielding north of 5%, which we view as attractive. Many of the Financial Service companies are in much improved financial position which makes their bonds especially attractive at these yields.

We expect interest rates to fluctuate as the uncertainties surrounding the economy persist. Overall, we still do not find value in buying 10-year bonds yielding sub 2% nor 30-year bonds under 3%. If the employment numbers improve along with modest growth in the economy, which we expect to see, then the longer end of the yield curve could move substantially higher (meaning current prices would fall), notwithstanding another round of “easing” from the Fed. In this environment we are currently investing in longer dated “step-up callable agency” securities that have above market short term coupons. We are offsetting this duration risk with corporate bonds maturing in five years or less. The yield on this “credit barbell” approach allows us to generate yields well in excess of benchmark rates. This strategy also hedges the potential increases in long term rates as the coupons on the callable agencies “step up” to higher rates over time.

Municipal bonds turned in stellar returns even with the stumble out of the gate at the beginning of the year. The concern that there would be hundreds of billions of municipal defaults did not materialize; in fact we did not even broach the $5 billion mark. While it was frustrating to see markets react to this sort of outlandish forecast, it was a net benefit to our clients as we were provided an opportunity to buy high quality municipal bonds at cheap prices. Now that the fear has subsided and prices have rallied, it is getting harder to find attractive yields at current levels. However, on a taxable equivalent basis municipals are still cheap to their taxable counterparts. We are finding value in longer dated municipal bonds that have a short to intermediate call structure where yields are in excess of 200% of the Treasury equivalent. We expect municipal solvency concerns to abate as budget shortages are closed on a nationwide basis. While we do expect limited defaults of local municipalities, this should be limited in scope and focused primarily in states such as Michigan, California and Illinois, to name a few of the more fiscally constrained. Overall, the credit profile in municipal bonds remains strong on a nationwide basis.

Conclusion

For 2012, the markets will likely show similar patterns that we witnessed in 2011; mainly volatility and uncertainty driven by debt discussions on a global basis. In the U.S., the Presidential election will likely add to these concerns with each side of the aisle proposing very different policies to put our country on the right track. We are hopeful that the political impasse experienced last year will not be repeated, but we are also not naïve enough to expect much progress given how divided our government has become during these uncertain times.

As we discussed last quarter, we continue to hold the view that the dire European scenarios the markets have imagined will not fully come to fruition. We believe that as we maintain our investment strategy of investing in undervalued businesses, we will see higher market values in the coming 12-18 months. We do not underestimate the irrational moves that equity markets can experience in the short run, but we view stock prices as currently too low given our perspective on the economy. Conversely, prices for safe haven fixed income securities appear too high which is another way of saying the yields are too low. The risk appetite of investors will likely turn back in favor of stocks as we overcome the challenges we have discussed. By way of example, in October of last year the market thought we had gotten through the worst of the European situation and stocks rose substantially – the S&P 500 alone rose almost 11%. We look forward to a similar situation as uncertainties subside.

Instability, uncertainty, and overall headline risk drove stock prices for the last three months. While many of the concerns we have written about earlier this year persist, the drama in Europe supersedes everything right now. On the whispers of agreements or dissensions between the deal makers/politicians in France and Germany, equity markets have moved hundreds of points upward or downward. Sentiment is quite negative these days and sentiment is driving the fluctuations we’ve witnessed this quarter. At the end of the day we still believe the fundamentals of the U.S. and world economy should drive stock and bond valuations. In the following pages, we will discuss the themes that are developing in the capital markets and their impact on investors.

Economy

While macroeconomic concerns continue to pervade the media, we observe that employment in the private sector is rising (while government employment is falling), home sales are stabilizing, auto sales have improved (albeit adjusted for a short-term interruption in supply due to the tsunami in Japan), retail sales are rising, exports are rising, individual balance sheets are strengthening, and most importantly we believe the U.S. Real GDP is expanding. Despite these positive factors, there has been continued weakness in various “sentiment” indicators and although the economy is not shrinking, it is not as robust as we need to materially reduce unemployment. Consumer and business confidence is quite low, unemployment remains stubbornly high and the housing market continues to slowly grind its way through the worst real estate market in decades.

We believe the economy continues to only muddle along because of the continued hangover of excessive debt, uncertainty related to world and political events and a swath of new regulations on large portions of our economy (namely Energy and Finance). Political risk is front and center at the moment. Stories about the National Labor Relations Board suing Boeing for opening a Dreamliner plant in South Carolina can be chilling to new business investment and erodes business confidence. The flow of capital has been constrained by new capital requirements and trading rules that are being implemented by financial institutions. Future healthcare expenses for corporations continue to be a moving target as the Court system currently holds the fate of the healthcare bill. All the while, changes to the tax policy are recommended weekly in an effort to spur our economy. In short, this has created a sense of “wait and see” until agreements are finalized.

Last year at this time we noted that an improvement in GDP would need to come from the export and private investment components of the GDP formula[1] (while consumption keeps pace) since the government could not continue to fill the gap. We’ve seen the consumer hang in quite nicely and we’ve seen exports doing their part (more on both below), but business investment has lagged for reasons we’ve noted above – hence a year later we are not in recession, but growth remains tepid. With large amounts of business capital on the sidelines, we see the “I” component of GDP (business investment) as the bullet yet to be fired.

Through all the uncertainty we’ve experienced, the consumer continues to spend money and keep the wheels of the economy turning. Same-store retail sales, as reported by the International Council of Shopping Centers, have continued to increase at a 3%-5% level for the last year. One helpful ‘stimulus’ during the past quarter was the price of gasoline which fell approximately 13% over the past three months.

Besides consumer and government spending, exports have been the biggest driver of GDP growth. According to Morningstar, through the first eight quarters of the current recovery, exports have been responsible for 50% of the growth in GDP. A weak dollar, a revival of the manufacturing sector and strong capital goods sales in emerging markets have all contributed to this growth. Exports now account for almost 14% of GDP, one of the highest levels on record. We need exports to continue their growth and if some or all of the trade agreements waiting to be finalized by Washington are implemented, then export growth should get an added boost.

As we write this letter, European officials are crafting a plan aimed at shoring up the stability of European banks. The plan would involve money from the European Financial Stability Facility (EFSF) which was created in 2010 in response to the sovereign debt crisis in Europe. The EFSF would then fund a special purpose investment “vehicle” that would be created by the European Investment Bank, a bank owned by the member states of the European Union. The hope is that this would alleviate the pressure on distressed countries and on the European banks that hold a majority of the distressed sovereign debt. To put it more simply, European banks that carry a lot of distressed sovereign debt (Greek, Irish and, Portuguese debt, etc.) would be able to sell the debt to the special purpose vehicle. In some ways, this resembles the original plan for our own Troubled Asset Relief Program (TARP). As originally conceived, the TARP’s goal was to purchase “toxic securities” from banks. In this case, the securities would be sovereign debt rather than mortgage bonds.

We thought a brief summary of the Greece situation would be helpful. The majority (75%) of Greece’s €350 sovereign debt is held outside of Greece; mainly by Portugal, Ireland, Italy, and Spain and the banks within. Assuredly, these countries are experiencing economic woes in their own right (Italy’s national debt is 120% of GDP to Greece’s 180%). Germany and France, relative bright spots in the EU, are themselves heavily exposed to Spain and Italy. Furthermore, the financial institutions that hold the Greek debt are much more important economically speaking than banks are in the U.S. For instance, in Europe, banks supply about 70% of consumer and corporate funding whereas the figure in the U.S. is closer to 40%. So the basic argument is that if the Greek situation is not handled satisfactorily, it could cause Spanish & Italian bank failures which would in turn be stressful to the financial systems of France and Germany, two globally important economies. Among other repercussions in our globalized world, such fallout would directly affect U.S. money market funds. Of the ten largest U.S. money market funds, approximately 40% of their assets are invested in European bank short term debt. (As an aside, Fidelity’s money market funds have no direct exposure to banks in Greece, Ireland, Portugal or Spain.)

At the end of the day European officials will keep their noses to the grindstone until they are successful, primarily because the risks of inaction are too great. Ultimately, we trust that the Europeans will be able to solve their difficult problems using methods that will not be self-destructive. Consequently, we do not believe a world economic depression is in the offing, even though news about such a scenario is quite popular right now.

Stocks

Stock prices declined during the third quarter as measured by the S&P 500. This quarter’s descent has included some of the most volatile trading days since 2008. This quarter’s decline brings most indices into negative returns for the year to date.

We see a disconnect between current equity valuations and what we observe in the end demand for product across a wide cross-section of the U.S. economy. We understand why this disconnect exists because markets trade on tomorrow’s data, not yesterday’s. Thus the fears of a European meltdown and a subsequent worldwide credit crash are driving markets lower as investors re-price shares based on a perceived negative future. The question on the minds of many investors is whether this is a ‘growth scare’ or are we headed into another recession?

Sentiment about the economic future has very real consequences on the stock market. It is estimated that just the companies that make up the S&P 500 have almost a trillion dollars currently in cash on their collective balance sheets (estimates for all of corporate America approach the two trillion dollar level). In aggregate, cash now accounts for 7.1% of all corporate assets; this is the highest level since 1963. Clearly, managers are hesitant to spend down their emergency reserves when economic prospects on the whole seem so uncertain. Already we have witnessed some companies purchasing their own stock (ConocoPhillips, Microsoft, Harris, etc.). With depressed equity prices, this is one way to return value to shareholders. For this trend to continue or for substantial investment in business growth to occur, sentiment will need to shift dramatically.

History has recorded only two double dip recessions in the modern era, one in 1937 and the other in 1982. Each occurred after Government action to raise interest rates, raise taxes, or some combination of both. If our leaders in Washington had caused a U.S. default in July or had raised taxes as part of the debt ceiling agreement, we believe the potential for a recession was quite real. Even now, credit is constrained because of new regulations on banks and the natural reaction by lenders to overcompensate for loose lending practices prior to 2008. In spite of this, the economy has continued to expand. If we enter a recession, it will be the first time the U.S. has ever done so with both increasing rail traffic and increased auto sales. Just this week, rail traffic hit a three year high which is clearly not recessionary. Thus, fears of a significant recession are overblown in our view. As we’ve heard one commentator mention, it is very difficult to fall from what is still the ground floor of an economic expansion.

All of the economically sensitive sectors of the S&P 500 fell during the quarter, with Materials, Financials and Industrials leading to the downside. The historical safe havens of Consumer Staples, Health Care and Utilities managed to post gains.

Bonds

The factors that drove down appeal for riskier assets had the opposite effect on the bond market as we just witnessed one of the best quarters in recent memory. It seemed the more interest rate risk the better, as the long end of the U.S. Treasury market returned an eye popping 29% during the quarter. This left the yield on the 30-year Treasury a paltry 2.92%. The 10-year Treasury has had a stellar run as well, leaving its yield at 1.92%. This was a result of the economic uncertainties we outlined above, but it was also driven by the latest monetary policy initiative from the Federal Reserve, dubbed “Operation Twist.” The Fed has accumulated over two trillion in U.S. Treasury bonds and Agency securities over the past few years, mainly through the “QE” and “QE2” programs, where bonds were purchased in the open market in order to increase liquidity and hopefully stimulate the economy. The Fed is now in essence selling shorter maturity bonds out of their portfolio and reinvesting proceeds into longer maturity bonds in an effort to more directly target consumer rates. Another goal is to make yields unattractive and therefore encourage risk taking in the economy as a whole, which in a capitalist system is essential. We expect that the Fed’s goal of lowering long term rates will be achieved, at least until the program expires mid 2012, and it may even have a modest stimulative effect on the economy. We do not view a sub 2% 10-year yield or a sub 3% 30-year yield as attractive at this point and are avoiding the Treasury sector.

Credit spreads, on the other hand, have widened relative to Treasuries as investors are demanding more compensation to hold corporate bonds in light of the perceived economic headwinds. We believe corporate bonds are inexpensive in general relative to Treasuries although the nominal yield is still low. For taxable bond accounts we are being patient as value is hard to find at current levels.

Municipal bonds continued their ascent as fears of massive defaults appear to have evaporated. According to Bloomberg, State tax collections jumped 10% in the three months ended June 30 from a year earlier which is the fastest quarterly growth since 2006. Municipal bond portfolios were positive for the quarter and we expect to end the year with attractive profits. We are still able to find value in this sector as it tends to be a little less efficient and specialized in nature. We are investing in yields near 3% to a short to intermediate call date that increases to 4% on a longer final maturity. These rates equate to 4.5% to 6% on a taxable equivalent basis, far outpacing the net to client yield available in the Treasury market.

Conclusion

Last quarter we espoused the hope that many of the uncertainties outlined would be resolved by our next quarterly letter. No such luck! Instead we suffered through a difficult quarter with falling stock prices plagued by widespread pessimism. However, we continue to believe this too shall pass. It bears repeating that our economy is extremely adaptive, as millions of individuals make decisions to better their lives, and we believe our current set of problems is not insurmountable. We have overcome greater difficulties in our history.

We continue to hold the view that the worst case scenarios the markets have imagined will not materialize and that as we maintain our investment strategy of investing in undervalued businesses we will see higher market values in the coming 12-18 months. We do not underestimate the irrational moves that equity markets can make in the short run, but we view stock prices as too low given our views of the economy. Conversely, prices for safe haven fixed income securities appear too high which is another way of saying the yields are too low. The risk appetite of investors will likely turn back into the favor of stocks as we overcome the challenges we have discussed. We are prepared for this eventuality.

The second quarter of 2011 had an all too familiar feel. After a strong start to the year, investors “sold in May and went away.” However, this time rather than an oil spill and the ensuing disaster, it was global supply chain issues caused by the Japanese tsunami, massive flooding in the US, a slowing growth rate in China and continued European debt concerns that caused investors to pull back. Added to that backdrop was heated debate and grandstanding by both political parties over the need to raise the debt ceiling. It should come as no wonder that consumer confidence was rattled. As Dan Pickering, one of our favorite analysts says, “in a world where the news cycle is 24/7 and people are swamped with information, anecdotes are king.” Anecdotes give a quick glimpse but often fail to adequately describe the complex machine that is our economy.

As always we will try to drill down to a few items that are pertinent to investors. We will try to avoid anecdotes and stick to the facts as we see them. Those points are outlined below.

Economy

Economic reports have been less than inspiring for the last few months. Industrial production, jobless figures and measures of consumer confidence have all weakened by various degrees since March, when the earthquake/tsunami disaster took place in Japan. As we examine the implications of this tragedy on our economy the most obvious area that experienced disruptions was the global supply chain. The most profound instance concerned both domestic and foreign car manufacturers. A great number of auto parts are sourced from Japan and as inventories dwindled, many domestic plants were forced to stop production altogether or at a minimum curtail output. The lack of new automobile supply then hurt sales for car dealers. Japan is the world’s third largest economy, so this scene was replayed across various industries all across the globe.

The flooding in the Midwest also played a major role in disrupting our economy this quarter. The Mississippi is the one of the largest water based distribution networks in the world. Beyond the devastating destruction the flooding and tornadoes caused themselves, the damage from closing this major economic artery was felt all over the country. Although the ability to measure its impact at this time is difficult, it is known that 6.8 million acres of farmland, billions of dollars in livestock and farm equipment, and tens of thousands of homes and commercial buildings were lost. It is estimated that the Joplin Missouri tornado alone will cost insurers close to $8 billion. Economics aside, it will always be impossible to measure the grief and suffering these disasters have caused our fellow Americans and our hearts go out to them.

Turning to Europe, Greece once again pushed out the Middle East from the headlines with rioting, austerity packages and bailouts. The one important message for investors is the exposure that European banks have to Greek debt and derivative instruments based on those obligations. Ultimately, we believe that the EU will not turn its back on the banks of England, Germany and France. So while there is pain ahead for the EU, we remain confident that they will avoid disaster.

The ongoing political debate regarding the debt ceiling in the U.S is still prominently in the background. Currently the capital markets have expounded a collective “yawn” as Treasury bond prices are not indicative of an eminent default. A short term deal appears to be the likely scenario which only means this uncertainty will reappear before long. The $14.294 trillion limit is estimated to be reached on August 2^nd of this year. If history is on our side (since 1962 the limit has been raised 74 times, according to the Congressional Research Service), we expect the ceiling to be raised once again.

When considering these uncertain headwinds it’s easy to see why businesses and consumers aren’t feeling as confident as they were three months ago. Worry is only amplified by the ending of the QE II program (Quantitative Easing) and many question whether the economy is ready to stand on its own. While we believe it can, all is not “pumpkins and mice.” We do see inflation moderating from the first quarter, as evidenced by falling gasoline, oil, and other commodity prices. Relief at the gas pump, although minor, will free up a portion of consumers’ budgets for other goods and services which drive economic growth.

Stocks

Stock prices declined during the second quarter as measured by the S&P 500, but if you include dividends the index finished slightly positive. The quarter was not shaping up very well until a strong rally during the final week which erased much of the decline. The descent has been moderate, especially when compared to the slump during the second quarter of 2010 when we saw a correction of over 10%. This year’s decline still leaves most indices in the black for the year.

A look back at where the returns came from shows that Financials and Energy were the worst performing sectors by a wide margin. Financials have European contagion fears, new regulation from Washington with Basel III and SIFI (Strategically Important Financial Institutions, as defined by the Dodd-Frank financial reform bill) as well as the general response to the fear that housing will continue to cost the banks money in lawsuits, foreclosures and write downs. On the other hand the Energy sector, which was on a tremendous run, corrected as oil prices declined on concerns that the economy is slowing. The strengthening dollar relative to the Euro is an additional reason that oil has fallen (the price of oil, which is usually traded in dollars, will decline with an appreciating dollar with all else held equal).

Oil prices were already falling due to concerns of diminished demand from a slowing economy when the EIA orchestrated the release of 60 million barrels of oil over a thirty day period. All 28 members agreed to the release with the United States releasing roughly half of the total. The action came as a surprise to the market and resulted in short term downward pressure. The move demonstrates that the EIA wants oil prices lower and that they are willing and able to make moves to adjust prices. However, the release should have little long term effect on oil markets since the 2 million barrels a day are only a small portion of the roughly 90 million barrels a day that the world consumes.

The other side of the ledger shows that investors sought a safer play in equities pushing Health Care, Utilities and Consumer Staples into positive territory. These sectors are generally considered safe havens. With traditionally higher dividend yields, they tend to benefit more during times of uncertainty.

Ultimately we seek to position your portfolios for what is coming, not for what has already occurred. Of course this is a delicate process because no one knows for certain what tomorrow brings. We do know that Corporate America looks quite healthy as demonstrated in the sharp rise in earnings over the last two years. We also foresee an increased pace of merger and acquisition activity that signals businesses are still looking for ways to grow and become more competitive.

Bonds

The renewed uncertainties that we have outlined were generally positive for the investment grade fixed income markets. The yield on the benchmark 10-year U.S. Treasury bond fell from 3.47% at the start the quarter to 3.16%, and briefly fell below 3% intra quarter (uncertainty drives investors to safe Government bonds and causes them to accept lower yields). GDP growth projections being revised down coupled with lower inflation expectations due to the correction in commodity prices drove the bid for safe haven assets. The Federal Reserve ended the Quantitative Easing process on June 29^th, and somewhat counter-intuitively bonds rallied into this. With the largest buyer of Treasuries substantially reducing purchases, conventional wisdom is that yields should rise over the coming quarters. This may or may not materialize in the short term due to the sovereign debt issues in Europe. Regardless, we do not view a taxable 10- year bond near 3% as attractive for long term investors. We continue to prefer step-up coupon callable Agency bonds in the 5-7 year effective maturity range. This structure allows for a higher current income in the short term due to the optionality while providing some protection for rising yields over the longer term.

The municipal market continues to mend from the sell-off that started at the end of 2010. While some prognosticators have loudly proclaimed impending catastrophe for municipal bonds in 2011, so far the results have been exactly the opposite. In fact, according to Bloomberg, the tax-exempt bond market had the best second quarter since 1992 driven by limited supply and renewed interest from investors. State governments appear to be getting their fiscal houses in order, and most have passed balanced budgets for 2011 which is bullish for municipal bonds. The yield on 10-year AAA rated municipals dropped from 3.32% at the beginning of the quarter to 2.67% at end of the quarter, or 85% of the taxable Treasury equivalent. The string of monthly outflows from municipal bond mutual funds appears to have ended, with investors adding over $400 million during the last week of the quarter. We expect this trend to continue and are generally more optimistic about municipal yields versus the taxable market. Supply will likely continue to be anemic as municipalities are generally adverse to stretch their balance sheets any further. We favor longer dated maturity structures with an intermediate call date in which we can find yields higher than general market rates. While it is getting more difficult to find value, we are able to buy tax free yields in the 3.5% to 4% range, which translates into over 6% taxable equivalent yield for investors in the top tax bracket which we view as attractive.

Conclusion

We are hopeful that many of the uncertainties outlined above will be resolved by our next quarterly letter. While we do expect volatility to remain ingrained in capital markets for quite some time, we also expect many of the pressing issues to subside and disappear from the headlines. We are confident that our Federal Government will solve the debt ceiling issue and avoid a U.S. default, and in doing so we expect the values of riskier asset classes to improve. Europe, specifically Greece, is making strides and should be less of a concern to market participants in the intermediate term. With election season heating up, it is inevitable that many of the troubling economic circumstances will be politicized and will contribute to the ups and downs of the market. Our economy is extremely adaptive and we believe our current set of problems is not insurmountable. Most importantly, we are maintaining our process for discovering and investing in undervalued securities and creating a mix of assets that adheres to each client’s investment policy statement.

Overview

The first quarter of 2011 closed with an upward trend in stock prices. A rally that began in December continued through March with the final day of trading in the quarter testing the highs set on February 5^th. This type of behavior shows the extreme resilience of investors; that despite the prevalence of intense “noise,” the fundamentals that drive investing currently rule the Street.

The following paragraphs detail our observations on the overall economy and financial markets.

Economy

Three months ago, it would have seemed crazy to predict almost $4 gasoline, government coup d’états in the Middle East, and one of the largest earthquakes in history resulting in a nuclear scare. Considering these events, who would predict that consumer spending would rise in this sort of environment? A year ago at the front end of the European debt crisis, consumer spending slowed dramatically and the market fell right along with it. So why has this time been different?

One of the reasons for the difference in outcomes may be that the US economy is growing stronger every month and consumers simply feel more confident than they did a year ago. In light of the economic reports we analyze, we think real GDP between 2.5% and 3.5% is possible this year. As usual, continued consumer spending will be paramount to achieving this level of growth. Evidence of the continuing strength of the economy can be seen in the recent retail sales numbers. Retail sales reported this February were at an all time high and exceeded the previous high set in November 2007.

The employment numbers have been a positive surprise this quarter as unemployment claims have consistently fallen below the 400,000 mark. Additionally, the overall unemployment rate has fallen materially from almost 10% last year to 8.9% last month. Many pundits see the high unemployment rate as a negative for the economy and rightfully so. However, as employment begins to increase (as it has over the last year) it can create a virtuous cycle for businesses. As the economy continues to grow, having ten million people who are out of work but are willing and able to do so has created a ready pool of labor. This potentially allows business to add to payrolls without increasing pressures on wages.

We have all felt the impact of increasing food and energy prices over the last year. While wage inflation has not become a reality, due to the unemployment situation, there has certainly been inflation across the spectrum of consumables that use commodities. Cotton prices have increased at an above average rate over the last nine months and are on trend to continue higher this year.  This potentially raises clothing costs significantly. While unhindered inflation is certainly a threat, limited inflation is one sign of a strengthening economy.

The banking sector is undeniably the cornerstone of our economy. While the industry continues to struggle under the weight of bad loans spawned by the housing debacle, we see light at the end of the tunnel. This month the Federal Reserve completed another round of stress tests. After those tests the Fed permitted many banks to raise dividends for the first time since they were cut due to the crisis (Fed regulators would not permit banks who received TARP funds to pay out dividends to shareholders). This is a vote of confidence from the Fed that our banking system is financially sound.  It also shows the that regulators are more closely monitoring bank activity and funding levels in an attempt to prevent banks from becoming overly leveraged.

Stocks

The markets continued their upward trend in the first quarter of 2011 locking in the best first quarter return since 1998. Multi-year highs in oil prices due to Middle East unrest, the Japanese tsunami, and continued European debt issues would normally put a damper on the bull market trend. While any one of these risks may come back to haunt investors, most have discounted the effects and are looking forward.  We give some credit to the Federal Reserve’s Quantitative Easing program (QE) for encouraging investors to look for better return potential in stocks to the detriment of the bond market.  With the prospect of the Fed holding down rates for an extended time to spur growth, it appears investors are reallocating funds from safe, low yielding assets into “risk” assets such as stocks and commodities.  We view this shift as healthy and will further assist economic growth.   The Fed’s QE program is scheduled to end in June. We believe the earnings power and fundamental valuations will allow the market to withstand this transition as the economy begins to stand on its own two feet again.

Additionally, Corporate America deserves credit for improving balance sheets and for positioning themselves to profit by the consumer’s strengthened position. Earning reports during the quarter were strong and dividends are increasing. As confidence grows, companies are using idle cash (which is earning next to nothing) to buy back stock and make acquisitions. These trends are very positive for equity prices.

The huge spike in oil prices drove the Energy sector to be the quarter’s best performer, up almost 17%. The Industrial sector was a distant second at +9%. It is interesting to note that these two sectors are the only two that outperformed the overall S&P 500 this quarter which returned 6%. The other 8 industry sectors underperformed. Consumer staples was the laggard in the group, as margin pressure is rising due to companies’ inability to pass through all of the higher input costs (commodities) to consumers.

We continue to see value in every economic sector of the market as well as in every market cap range. One significant change we’ve witnessed is on the Energy front as communities re-assess the use of nuclear power versus other forms of energy (like natural gas, coal and oil). We have long believed that natural gas has been under utilized in our national energy policy.  Recently there has been favorable momentum building towards this abundant, domestic source for fuel. We have positioned your portfolios accordingly.

We noted in our last letter that we expected a pickup in merger and acquisition activity and so far that has proved true. We continue to believe that with a record amount of retained earnings on balance sheets, US companies will look for ways to reinvest capital in operations or return it to shareholders. As shareholders, we like both options.

Bonds

The taxable bond market, as represented by the Barclays’ U.S. Aggregate Index, returned 0.42% for the first quarter. Longer dated maturities lagged shorter maturities as inflation expectations have increased over the past few quarters. Inflation erodes the value of a fixed coupon and as such longer bonds will normally underperform as expectations for inflation rise.

Lower rated bonds outperformed higher rated bonds. For instance, the Baa rated sector (low investment grade) returned 1.43%, a full percentage point over the index itself. Spreads, or the additional compensation one requires to hold a riskier bond, have contracted due to the strengthening of the economy and the resulting improvement in companies’ balance sheets. While this is good for corporate America, spreads have tightened to the point where we have to look a little harder to find value. We do like certain corporate credits, but many bonds appear to be rich relative to safer alternatives. As always, we want to be paid an ample premium to take risk.

Overall the yield curve remains very steep, as evidenced by the 2-year U.S. Treasury yield of 0.83% compared to the 10-year yield of 3.5%. With this in mind we find the 5-7 year part of the taxable curve the most attractive in light of the recent concerns over inflation. We will not become overly concerned about the spectre of higher prices until we see wage pressure begin to build. While the prospects for hiring are improving, wage pressures continue to be muted.

The municipal market started the year with a resounding thud, as the fear mongering over “imminent massive defaults” drove retail investors from the tax free market. As of the date of this letter we have witnessed 20 consecutive weeks of withdrawals from municipal bond mutual funds. We are pleased the market has been able to weather these redemptions and it appears that withdrawals are abating. To date, the municipal market in which we invest has eked out a positive return, essentially in line with the taxable market. When one compares the debt levels of state governments relative to the U.S. Government (and other sovereign issuers), states’ debt levels are much better managed and less daunting (again, in the select states/credits in which we invest).

Issuance of new bonds in the municipal sector has dropped precipitously as governors across the nation are tightening their fiscal belts. We do not expect a large “wave of defaults” in the investment grade market and view the taxable equivalent yields as very attractive. The tax free curve is even steeper than the Treasury curve. As such, we are seeing value in intermediate to long dated credits.

Conclusion

From an investing standpoint, little has changed from our last letter. Economic cycles shift slowly and certainly do not reset on a quarterly basis regardless of what the financial section of your newspaper claims. This is why a sound investment discipline is critical to investment success. It is also why following short term trends can be very dangerous to your long term financial health. Amidst the uncertainty, we have seen enough economic momentum to support our conviction that investing in the right mix of stocks and bonds will yield ample fruit in the months and years to come.

Last quarter we discussed our take on the future of the economy, noting that economics is a dismal science and thus we are required to take a less apocalyptic and more measured approach to our forecasts than the soothsayers in the media. We noted that economic forecasts over the last 12 months have been anything but consistent or accurate and that caution is therefore warranted.

While 2011 looks to be different and somewhat more constructive than 2010, there is no question that uncertainty remains. We begin by noting that while no one is clairvoyant, there are certainly trends and patterns that we watch carefully. Even as late as December, the economic ground was shifting under our feet due to the uncertainty surrounding tax policy and the sustainability of the Bush era tax cuts.

Economy

As with any economic recovery, positive factors compete with negative ones, with the positive forces usually prevailing. Along the way, movements are uneven across time and economic sectors. As we saw in 2010, markets can be volatile as investors debate the strength of the recovery.

We start with a few problem areas to pay attention to heading into 2011:

• State, Local and Federal Government Budgets
• The Housing Sector
• The European Debt Crisis
• China’s Economic Growth

State and local government budgets remain strained. Budgetary cuts have resulted in significant job losses over the last year. Public payrolls fell by 250,000 in the 12 months ending in November (while private-sector payrolls advanced by about 1.1 million)[1]. Many states are struggling against the backdrop of increasing liabilities (pensions, social programs, healthcare, etc.). While these problems aren’t new, they represent a drag on the economy. On a brighter note, the Census Bureau recently reported that state and local tax revenues actually increased by 5.2% in the third quarter compared to a year ago.[2] This is the largest quarterly increase since the fourth quarter of 2007 and will help as local governments work to close deficit gaps.

As we noted in the last quarter’s letter, an improvement in GDP will need to come from the export, private investment and consumption components of the GDP formula since Federal government spending cannot continue to fill the gap. With a new congress in Washington, it appears they are ready to move quickly to cut spending, but new lawmakers must walk the tight rope of appropriate versus inappropriate government cuts in light of the fragile economy. Our economy is driven by psychology and business needs to have confidence in our leaders. Rational and thoughtful approaches to this issue will have the dual benefit of lowering our fiscal deficits while inspiring business confidence. This would be the best of all possible outcomes. We will continue to monitor this situation closely.

The housing sector is expected to remain a drag on the economy in 2011, though most of the economic damage is already done. The consumer is the most powerful force in the economy, and the value of his home used to dictate much of his spending habits. In an America where savings rates were negative, many families were subsidizing their paychecks by spending the equity in their ever-appreciating homes. Everyone who reads a paper or listens to a news program can tell you that mortgage delinquencies and foreclosures are expected to remain elevated for some time. Of course, many investors are concerned that home prices could fall further (as much as 20% by some estimates), which prognosticators fear could quell the growth in consumer spending. A further moderate decline in housing prices will not significantly affect consumer spending because we believe the consumer has already accepted the idea that it could take years to see home prices re-appreciate. While the housing market problems will continue to be severe for many households and could last for quite a while longer, its impact on the economy should not derail the recovery. In short, we think the majority of the pain has already been felt.

The European debt crisis seems like a slow-motion train wreck –not unlike the housing situation in the U.S. As we wrote previously, the EU and IMF set up a €750 billion backstop in the spring. We’re now seeing the implementation of that backstop. Europe needs to come to grips with its long-term debt issues with long-term solutions, not short-term fixes. Greece and Ireland are in the midst of their debt intervention, with Portugal and Spain potentially not too far behind. In an intricately connected world economy, bankrupt sovereigns are bad for everyone.

China continues to grapple with inflation that is considerably higher than the government’s stated goal. As a result, it has been slowly raising interest rates and taking other actions to slow its torrid growth. These actions continue to flame fears that China will take even more drastic steps to slow growth in 2011. China’s economy has been a major engine for the worldwide recovery from the Great Recession of 2008. No one wants to see that engine significantly slowed, including the Chinese central planners.

What about the positive economic forces? For all the negative press around “QE2”, the second round of quantitative easing by the Fed, Federal Reserve policy remains accommodative. For all the bad press, any talk of a “double dip” in the economy has been taken off the table, which we think is very good.

It appears to us that the economy is about to move into a stronger, more balanced and more sustainable recovery. Until the third quarter of 2010, consumer spending had been increasing at a steady but weak 2% pace, which was not enough to really get a significant lift in hiring or overall economic activity. However, things began to change in the third quarter of 2010 as consumer spending accelerated to almost 3%, and some economists suggest it could accelerate to as much 4% in the fourth quarter on the back of the strongest holiday season we’ve had since 2005.

A lot of companies could hobble along at 2% consumption growth without having to hire a lot of new people. Manufacturing from overseas can handle 1% of that growth coupled with the contribution of 1% productivity increases. However, with 3% to 4% growth, that story changes and jobs have to be added to the domestic economy. Consequently, better hiring rates seem more likely if this consumption growth continues. It also helps the psychology of business owners when they see increased end demand for their goods and services.

The extension of the Bush tax cuts is good for psychology as well. We have learned not to underestimate the beneficial impact of the “wealth effect” on economic growth. The wealth effect is a psychological construct that shows how important the idea of confidence is in our economy. When we are fearful, we seek safety (we sell stocks and buy bonds or settle for cash). When we feel confident, we are willing to take risks and commit ourselves to future payoffs (we sell bonds or use cash to buy stocks, or invest in our own businesses). When end demand for goods and services is growing and the equity market is reflecting that growth, business owners feel more optimistic and begin to invest in both new equipment and in labor. This drives employment higher which allows consumers to buy homes, cars, and begin to spend and invest again.

We think large companies are using every trick they can to avoid hiring new, permanent employees, but in spite of this, indicators show that business is beginning to invest in permanent positions to keep up with expected demand growth in 2011.[3] Consequently, with renewed confidence, an improving job market, a reduction in payroll taxes and a more attractive balance sheet (lower consumer debt coupled with higher asset prices), we see a light at the end of the tunnel for the American consumer.

Stocks

This year marked the second year of positive returns for the stock market indices following the declines we saw in 2008. The indices were led by small and mid size companies in what is often referred to as the “risk trade.” In other words, the stocks that saw the greatest upside move were for the most part those that were more speculative in nature and will benefit from a robust economic recovery. Not coincidentally these small/mid caps are the same that were most affected during the downdraft out of fear of persistent economic decline. The valuation between small and middle capitalization stocks and that of larger more established stocks has widened to a level not seen in many years – some would argue as far back as 1995. We find this encouraging as the best “value” we find today is in names we view as not only cheap, but also safe, relative to their peers. At the end of the day the price of a stock reflects its underlying valuation. On a 3 day or 3 month period this doesn’t always play out, but we focus on the long term and know that if history plays out as it has, valuation will drive returns and the “cheap stocks” we are buying today will be the beneficiaries.

What does this mean to you? Valuation spreads should narrow, either at the expense of the risk trade or to the benefit of the blue chips. Considering we purchase small, mid and large cap stocks in our portfolios our equity accounts are positioned in a way that should allow 2011 to be another year of solid risk adjusted returns. Another way to look at it is this: if the economy grows in 2011 as we think it will, then current earnings estimates for many companies may in fact be too low. While we see a number of companies selling for what we think are unreasonably low multiples to their forward earnings, if estimates rise from here, those multiples shrink even more. This should lead to material price appreciation and would have a very favorable impact for our equity positions.

Beyond the valuation gap, we are also seeing a pickup in mergers and acquisition (M&A) activity in the market. As companies sit on large mounds of cash while earning paltry rates of return, they begin to look for opportunities to improve their situation by buying back their own stock or buying other companies. While mergers can often times be value destroying propositions on a company by company basis, overall M&A activity demonstrates increased confidence in the future and is generally good for stock prices.

Bonds

Bonds began the year out of favor as the prospects for economic recovery brightened. The 30 year U.S. Treasury bond started 2010 with a yield of 4.64%. As the previously mentioned troubles in Europe cropped up, bonds rallied and investors sought the safety of dollar denominated bonds. Bonds rallied (yields fell) from April until August, bottoming out at 3.51%, equating to over a 20% total return. The Federal Reserve began discussing further monetary stimulus measures, commonly referred to as “Quantitative Easing” or in lay terms, the Fed purchasing of U.S. Treasury debt in the open market. Traders anticipated these purchases and helped push yields to the low for the year. As the year wound down, an announcement was made from the White House confirming that the Bush era tax cuts would be extended for all Americans as well as new Estate Tax laws that were more conservative than expected. This compromise did two things: positively, it brightened the prospects for future economic growth, but negatively it added to the growing U.S. deficit for 2011 and 2012. This resulted in a bond sell-off that concluded with the 30 year settling at a 4.34% yield, a solid 15% drop from the August high. That market was volatile!

As we enter the New Year, there appears to be a rotation from bonds to stocks in asset allocation decisions across the spectrum. In a reversal of recent trends, last month equity mutual funds saw a net inflow of capital while bond funds saw net redemptions. This simply signals that risk appetite is clearly returning to the retail investor. With this in mind we expect bond yields to trend upward until the next event occurs that increases risk aversion, either domestically or internationally. While inflationary pressures are still muted and real yields remain attractive, it can take time to rebalance the market into equilibrium when money is being reallocated. We believe taxable yields will likely end the year higher than they are today.

Municipal bonds also enjoyed nice returns for the first 11 months of the year, until news that the Build America Bond (BAB) program extension was not included in the tax package. Remember the BAB program was part of the stimulus effort by the Federal government that subsidizes 35% of the interest payments on new taxable municipal bonds.  Consequently municipalities rushed to market immediately and issued bonds while the U.S. Treasury subsidy was still available. This brought an unexpected supply of bonds to market at the same time that several analysts published scathing comments on the health of municipal finances. We concede there are several states/municipalities that we would not want to invest (anything in Illinois or California for example) in. In the lower rated states (typically those hardest hit by the real estate bubble) the issues of underfunded pensions and years of overspending have now come home to roost. In fact, as little as 5 states make up nearly half of the estimated $148 billion in budget shortfalls nationwide.

As always, security selection will play a key role in staying out of harm’s way, and to date we believe the credits in which we invest remain quality investments. North Carolina remains a AAA credit (1 of 9 countrywide), Virginia, South Carolina, Tennessee and others also offer credits we find attractive. We do not buy into the story of widespread municipal defaults in the face of an improving economy. There will be outliers with lower rated credits that struggle and end up in a restructuring. However we do not expect the issue to be of the size and the scale that the naysayers predict. More importantly, we do not expect it to affect the investment grade credits we are buying.

We see green shoots sprouting. As previously mentioned, The Census Bureau released 3rd quarter state tax revenues which showed revenues grew by over 5% on a quarterly basis versus the prior year. It also showed annualized growth for the first time since the 4^th quarter of 2008. Also, the Philadelphia Fed index showed 45 of 50 states with growing economic situations in November, up from zero reporting expansion last year at this time. The point here is that state finances are not immune to recessions, and there is a lag effect before budget pressures appear, especially with large stimulus checks from Uncle Sam delaying the pressure. However, the economy is improving, revenues are increasing in most states at the same time that cuts to spending are being made. We believe this will lead to balanced budgets for the majority and in the meantime is giving us an opportunity to invest in quality municipal bonds at attractive prices. The market has temporarily painted all municipal bonds with the same brush of fiscal irresponsibility. We believe that the more fiscally sound states will trade at a notable premium to the have nots as this all plays out.

Conclusion

We continue to observe this economy with a watchful eye knowing that while we have passed through quite a storm these last two years, risks remain. While we have reason to be encouraged and hopeful, vigilance remains the order of the day.

We do not think the volatility in the bond and equity markets is going away any time soon, so it is easy to conceive that market valuations will continue to fluctuate, at times dramatically, and going forward, as always,  investing will require good judgment, a firm grasp of the facts and prudence. We continue to pay close attention to the price we pay for the assets we invest in, whether bonds or stocks. If we remain disciplined in our approach and require a margin of safety on our purchases, we believe that the long term results will be rewarding.

[2] http://www2.census.gov/govs/qtax/2010/q3t1.pdf

[3] Staffing employment in December was 16% higher than in the same month last year, according to the ASA Staffing Index.

A recent story we read captures the idea of how many people think in linear ways that can lead us to underestimate the future – be careful how you think:

“In 1898, the first international urban-planning conference convened in New York. It was abandoned after three days because none of the delegates could see any solution to the growing crisis caused by urban horses and their output. In the Times of London, one reporter estimated that in 50 years, every street in London would be buried under nine feet of manure.”

The delegates underestimated how markets adapt, economies adapt, people adapt and, eventually, problems are resolved. In contrast, we (humanity) are often unable to see how problems will be resolved in the future. Tuning in the financial news before work most mornings, you can likely hear an analyst predicting hyperinflation. Tune in the next day and you may hear another analyst predicting depression and deflation. We don’t believe everything we hear (or read) and understand that most of these analyses are fundamentally flawed. Of these two analysts, we believe one – or both –will be proven wrong and that neither of these scenarios is most likely to occur. Instead we try to take a less apocalyptic, and more measured approach to the dismal science of economics.

Over the last 5 months investor sentiment has been volatile. Negativity and fear of a double dip recession, as measured by many metrics, reached a high in late June corresponding with a decline in stock prices (“risk assets”) and a corresponding rise in bond prices (“safe assets”). This negativity has abated somewhat since then and stocks have risen as a result. The market is sending mixed signals when stocks and bonds rise at the same time, while gold is at decade high levels. Strange times indeed!

Economy

The economy continues to grow – after 6 consecutive quarters of negative or flat GDP from 3/08 to 6/09 we managed to string together 4 quarters of positive GDP growth. In a service based economy, where more than 70% of GDP is personal consumption, with unemployment at 10%, it is encouraging to see growth. The American consumer has retrenched and “de-levered” but still manages to find a way to spend. An improvement in GDP will need to come from the export and private investment components of the GDP formula since the government cannot continue to fill the gap. Exports have improved and with some clarity out of Washington on new legislation we believe that private investment will improve with time. If this plays out as planned, the government will be able to step back from its attempts to stimulate, but we hope they don’t try it too early.

The NBER (National Bureau of Economic Research) says the recession ended in June of 2009 (by definition), but with jobless claims only stabilizing and unemployment very stubbornly staying above 9%, this is truly a jobless recovery. Much of this can be tied to structural employment issues, where the workforce is trained to handle jobs that are no longer available. Education and job training can address the needed changes but many are unwilling to take less pay and/or learn a new skill. We hope the growing demand for skilled labor will provide the needed incentives for unemployed or underemployed workers to retrain and get good paying jobs.

Uncertainty has abounded the last two years as we’ve experienced a significant political shift with many new approaches to the economy and health care being implemented. Uncertainty leads to hesitation in business, both in hiring and future investment. While the hesitation has been more pronounced this summer, as time passes the uncertainty will subside and business will again take center stage. We believe business hiring is picking up and we are hopeful it will continue do so at a rising rate over the coming quarters.

Europe is still fragile – although we have seen some easing of concerns, day to day headlines from the European Union continue to affect how our markets are trading. Recent bond issues by European PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) calm the fears of further EU bailouts, and each of those nations has a deficit-reduction plan in place.

On a longer term basis we acknowledge numerous economic headwinds, many of which we have detailed in previous commentaries. We continue to believe in this recovery, though it is certainly a mixed bag based on current numbers. Over the coming quarters and years we believe our economic ship will right itself and we will move forward with renewed GDP growth and an eventual decline in joblessness. For now “muddling through” seems the clearest description of our recovery.

Stocks

From the recent lows of June 24^th to the end of the quarter all component sectors of the S&P 500 were positive. Telecom, Materials, Consumer Discretionary and Industrials had the highest return and Financials, Healthcare and Consumer Staples brought up the rear. This is the typical sector performance one would see in a market that is pricing in a recovery in economic conditions with the one exception – the financials are the worst performing category. Financials usually lead as we come out of a recession. We believe that uncertainty surrounding both domestic and international regulations on banks, plus the continued purging of troubled assets on their balance sheet most likely account for this anomaly.

In today’s environment we believe the accumulation of a diversified portfolio of attractively valued equities where their dividend yield exceeds their bond yield will prove to be very successful over the medium to long-term. We also believe that active management of that portfolio is necessitated by the strong price movements (both up and down) we have recently seen.

Our equity approach has always focused on companies, fundamentals, and bottom-up stock selection with an eye to the larger economic landscape. Our approach is to invest in a good company at an attractive price and hold until we believe the full value is realized. When prices are fluctuating as much as they have for the last two years, we adapt and take advantage (as much as we can) of those price movements. With stocks declining significantly in the 2^nd quarter of this year and then rising significantly in the 3^rd quarter, our portfolio activity has increased accordingly. If we are able to sell a security after a short-term move upward in price that nets us 75% of our target price, we will take it. We are active managers and we believe this environment requires it.

Bonds

Bond prices continue to be supported by the combination of the ongoing “flight to safety” transactions, such as the reallocation away from stocks into bonds (as witnessed by mutual fund flow data), and the widely held belief that the U.S. Federal Reserve will embark on another round of quantitative easing. Long U.S. Treasury bonds led the way with a robust 20% return for the year to date period versus 7.9% for the bond market as a whole.

We have taken the stance that buying 30 year bonds at sub 4% yields is not a good risk/reward trade off as history has shown that this trend of ever lower yields can reverse very quickly. The duration of a 30 year Treasury is roughly 18, which in layman’s terms means that if the yield curve was to move from the current 3.68% at quarter end to 4.68% (or a one percentage point increase) the price of that bond should drop by 18%. This would represent over four years of income, and we are not willing to take this risk. We are buying callable agency bonds and select intermediate corporate bonds that offer competitive yields as investors are able to capture over 80% of the yield curve with substantially less interest rate risk. Many of the callable agency bonds being offered have step up coupon features, which simply means that the initial coupon increases on a pre-specified schedule.

The bond market is signaling the onset of a deflationary environment, and should this perception change rates will correct accordingly. As we noted at the beginning of this commentary, we do not see severe deflation or inflation being a legitimate risk in the short run, but we will not turn a blind eye to what the Federal Reserve is doing with its monetization policies and the impact it will have on prices of goods and how that will affect the prices of bonds. The bond market is substantially larger than the stock market so we give a lot of weight to what trillions of dollars of investment capital is saying about inflation.

Municipal bonds have also performed well ahead of expectations this year. Several municipal credits are deteriorating in credit quality, but most of the deterioration is concentrated in the areas most impacted by the housing collapse (CA, FL, NV, etc.). With the appropriate credit research we are able to find attractive yields with minimal credit risk and view the municipal market as mispriced relative to the U.S. Treasury market. We can still find yields that are well over 100% of the taxable equivalent, which for those in even a modest tax bracket makes a great deal of sense. The issuance of Build America Bonds continues to be prevalent, and as such it is becoming increasingly more difficult to find tax exempt bonds that meet our investment criteria. Couple the supply curtailment with the risk that tax rates could rise in the short-term and the yield on the tax exempt bonds could be even more attractive.

Conclusion

While the economic picture is not particularly rosy right now, there is no question we are in much better position than we were even a year ago. Private job growth has begun and income growth has begun as well. We believe the Fed is committed to supporting asset prices and actively working to avoid deflation which means we see upside in equities. Bonds have run and run hard this year. As an asset class, many of them seem unattractive. The job of finding new bonds to purchase is much harder than it was a year ago.

We work hard to think about our investments strategically with an eye toward the long-term. In economies like this, where so much attention is paid to short-term measurements, we believe we have an advantage by thinking in terms of years, not days, weeks or months. We understand that markets adapt and change and we plan to change with them while still staying focused on the horizon.

The second quarter marked a pause in the 18 month rally in the equity markets. International markets performed substantially worse than domestic ones, particularly when translated into U.S. Dollar terms. Much of this correction stemmed from the uncertainties in Europe and lackluster domestic indicators of economic activity.

The last three months have brought market participants to a point where many feel we are evenly balanced between economic decline and growth. That viewpoint is reflected in asset prices in both the stock and bond markets. We hold to our belief that growth will occur, albeit slowly, due to a very stubborn labor market in which unemployment remains high. Economic data aside, in the last three months financial markets have had to contend with the “flash crash,” a massive oil spill in the Gulf of Mexico and numerous austerity packages passed in Europe.

Economy

Economic activity as measured by the GDP grew at an annualized 2.7% rate in the first quarter of 2010. Although positive, this is a lower reading from the fourth quarter 2009 level. This figure has discouraged many since GDP growth following a recession is typically significantly higher; particularly with the massive stimulus efforts we have implemented in an attempt to spur growth. We note that history has shown it is common to have a temporary slowdown in growth after the beginning of a strong recovery and this may be exactly what we are experiencing.

Looking over the last year we see three good quarters of real growth in the GDP. According to Robert Schiller, in past recessions when GDP has reversed course and posted three or four quarters of gains (as it just has), it has never immediately begun to fall again. That record goes all the way back to 1947. When GDP starts moving upward after a decline, it usually doesn’t stop in its tracks.

Following the Greece fiasco, the EU passed a trillion dollar liquidity package intended to serve as a backstop to member nations that are having problems with their level of sovereign debt. Although heralded as a vital response to calm fears in the European markets, the fanfare was short lived and both sides of the Atlantic still view sovereign debt levels as monumental risks. The issue is simple: member countries of the EU have spent more than their tax base can support. Since the individual member countries do not have their own central banks, they do not have the ability to “print money” which debases the value of their currency and in turn reduces the true cost of debt. Quantitative easing (what economists call printing money) is only possible at the EU level and with so many governments involved, that is obviously a complex decision.

Adding fuel to the fire is the fact that austerity measures are being passed across the EU creating fear that the fragile recovery in the world economy could suffer due to the pullback of government spending. Again, if executed correctly we fall on the good side of the tipping point, but the risk does remain that execution is poor and a contraction follows. We are hopeful a healthy balance can be achieved, one in which investor confidence is supported.

BP’s massive oil spill adds immeasurable risk to our economy. First and foremost the direct economic losses from thousands of fishing and hospitality jobs are at risk as oil is causing tourists to cancel trips and the Government to close fishing areas. Secondly, the “drilling moratorium” as ordered by the executive branch, now deemed illegal by a Federal judge, risks thousands of jobs along the Gulf. Potential for further economic losses in areas such as real estate values, energy security, environmental restoration etc. are unknowns right now but will assuredly be large. For the environment and for the economy, let’s all hope that the relief wells currently being drilled by BP will succeed.

Although improving, job growth continues to be slow as companies stretch their workforce as much as possible. Manufacturing has picked up and companies are restocking inventories. However, they are achieving this via increased productivity as opposed to hiring new workers. Uncertainty regarding the new health care bill and future tax policy is preventing managers from knowing the true cost of employment and is thus contributing to the lack of large scale hiring. A strong consumer is paramount for a strong economy and consumers are made strong by employment.

Congressional leaders are in the midst of creating a new bill that if it passes, will be the biggest overhaul of financial institution regulation since the 1930s. Derivatives, bank proprietary trading, securitization and hedge fund registration are all issues that will be addressed. At present nothing has been passed but we expect a push to make it law before the next election. Regardless of the form, this bill will most likely mean more oversight, more regulation, and more government involvement in our financial system.

Finally, we mentioned in the last letter the need for the Chinese Yuan to appreciate relative to the Dollar. It appears this idea has finally gained some support from Chinese leadership. In a recent meeting the communist nation approved relaxing the ratio at which they have held their currency pegged to the Dollar. If this plays out it will make products that the U.S. exports more affordable in China and assist in balancing the current trade deficit. Our expectation is that the revaluation of the Yuan will be a multi-year process which will depend on the strength of the global recovery.

Stocks

May 6, 2010 will go down in history as the day of the Flash Crash. The exact series of events which led to the short lived drop may never be known in full. We have long held the view that a share of stock represents a minority ownership position in a real operating business and should be bought and sold as such. We would cheer regulatory change that would “slow” trading down to benefit the long term investor. Debate on appropriate regulatory response is in full swing and no resolution has been reached at this point.

As one might expect, the energy sector was hard hit following the Gulf oil spill in late April. Almost every energy stock from service companies to oil producers have suffered as investors sold the energy index in one fell swoop, throwing the good out with the bad. We believe there is a real risk that the government moratorium which bans drilling for 6 months could convince all 33 deep water rigs currently in the Gulf to leave for other countries. This would do damage to a vast number of other companies that support the Gulf drillers. There are 3,600 structures in the Gulf that produce oil and gas which provide 31% of domestic oil and 11% of natural gas production. If the moratorium lasts too long we may force the industry into a steep decline and our dependence on foreign oil will grow even larger.

Economic and political uncertainty has certainly led markets lower this quarter. The psychology of many investors and certainly of the major media outlets is depressed and fearful. As we’ve shown in this letter, there are a number of legitimate factors, both political and economic, that support a gloomy outlook. Losing money is on everyone’s mind right now, but simply because the media is fearful and economic numbers have slowed it does not mean a double dip recession is a certainty as some have concluded.

What’s not in the headlines is that analysts are raising earnings estimates for U.S. companies at the fastest rate since 2004 and valuations after this correction are even more attractive than they were 6 months ago. According to Bloomberg, during the first quarter “the proportion of S&P 500 companies that raised their profit outlooks reached 8.6% … compared with 3.4% that lowered forecasts, according to data compiled by Bespoke Investment Group LLC. That’s the second-highest level of companies increasing their projections since 2001…” Not only that, but 28% of S&P 500 companies either increased or initiated a dividend in the first 6 months of this year and amazingly only 1 company has lowered its dividend in 2010! When dividends are rising like this it is a strong signal that companies are strong and confident about their future.

Bonds

U.S. Government and high quality bonds are again en vogue, as one would expect in turbulent times. The uncertainties mentioned above have driven investors to the safe haven of Dollar denominated government debt. The yield on the 30 year Treasury dropped to 3.89% at quarter end from 4.63% at the beginning of the year. While this may sound trivial from a yield perspective, this move equates to nearly a 13% increase in price and signals that bond investors believe there is a greater risk of deflation as opposed to inflation. Agency bonds (Freddie Mac, Fannie Mae, etc.), now backed by lines of credit at the Treasury, have held their ground and performed well. We have been participating in the new Agency issues coming to market with step-up coupon structures that are designed to protect investors from an increasing interest rate environment. While there is little room for these structures to appreciate in price due to their callable nature, at this point we are content to earn an above market yield and to have short effective durations.

The investment grade portion of the corporate bond market has performed well in this correction, which is a healthy sign. We can remember when the credit crisis was in full bloom in late 2008 that prices on investment grade bonds fell precipitously and created tremendous buying opportunities. In the current market, prices of corporate bonds have increased, but not as much as the Government market. The difference between Government and corporate yields (called the spread) has thus widened, which means the market is pricing in additional risk on corporate bonds. This is a welcome reaction since it leads us to believe the correction is temporary and based on emotion as opposed to a real liquidity event or default risk.

The municipal market has also held firm, but the unending media reports of default risk in this sector have kept a lid on prices. Tax free yields relative to taxable equivalents have crept back to well over 100%, which we view as attractive. It is important to understand the credits you buy since there is a wide disparity in the health of various state and local budgets. We are comfortable with the credits we buy and continue to believe there are structural issues that will support municipal prices going forward. Although we have outlined our rationale before, it is worth noting that the issuance of the “Build America Bond” program is gaining traction.  This is essentially a stimulus program where municipalities issue taxable bonds and the U.S. Government subsidizes their interest payments. In many cases the issuers are choosing to issue taxable bonds to the exclusion of tax free bonds. This has, and we believe will continue to, decrease the supply of tax free bonds. At the same time, we believe income tax rates will inevitably rise. The health care bill alone will levy a 3.8% tax on investment income over a certain threshold. However, municipal bond income is exempt from this tax. We believe the demand for tax free bonds will increase when tax rates rise, thus creating a supply/demand imbalance that will support municipal prices. We have been buying longer dated maturities in this space for several months now, and doing so by selling bonds with very high premiums, low yields, and short maturities. In some cases we have been able to reinvest the proceeds into bonds with longer maturities and double the yield.

Conclusion

This quarterly letter is not intended to be a farmer’s almanac whereby we predict the specific occurrence of distant future events. It is meant to summarize the current situation in which we now find ourselves and to funnel the ocean of financial and economic data into an easily consumed glass.

The stock market is always trying to predict the short-term economic future and right now it’s saying that future is bleak. We understand its pessimism, but find that valuations are quite attractive and if your time horizon is measured in years rather than months, there are opportunities available. We plan to invest accordingly.

Last week we experienced a selloff reminiscent of the days of Lehman Brothers’ failure in 2008. While some claim a trading error may have been responsible for a portion of the massive decline on Thursday, we know that fears of a European collapse and Greek contagion gave speculators and traders a reason to sell.

It’s clear the markets have risen substantially from the March 2009 lows, but we continue to live by the belief that it is valuations that drive markets in the long term and emotions and current news that drives markets in the short term. As much as we believe that there are real problems in Greece, and as much as we know that we have problems aplenty at home as well, still we don’t see the rationale behind the kind of market action we saw Thursday.

At the end of the day we don’t like this selloff any more than you do, but we are not doing our job as advisors if we simply try to beat the crowd by anticipating each maniacal move it makes. There is no question that stocks had risen pretty steadily for a long time and a pullback would be healthy for the market. Thursday’s action can’t simply be described as a “pullback” though, it was more like a “throwback” – to the ugly days. It is days like this when having a good advisor at the helm can protect your assets from permanent impairment.

The trading in the market late Thursday afternoon was like nothing we have ever seen. In a span of 15 minutes, the Dow Jones index went from being down about 300 points on the day, which was bad enough, to down 998 points at its worst moment – on essentially no news!

The market then quickly bounced back. There was no doubt in our mind that electronic trading by computers was behind the rout that caused some truly unbelievable prices. For instance, Accenture (NYSE:ACN) traded below a penny at the height of the craziness.

In response, the Nasdaq exchange said that certain trades that were made in excess of a 60% daily move would be canceled, but that still leaves a huge number of trades that will stand at incredible prices.

Yesterday, with all the troubles in Europe, and with the EU stepping up with a significant relief package for the Eurozone countries in need, world markets rallied. Once the situation in Europe is stabilized, US investors will begin to focus on our own economy again and we think, be met with some good news. For one, the economic recovery here in the United States continues to gain steam. The employment numbers from last week with those filing for initial unemployment benefits continuing to fall and companies starting to add jobs again, are a very good sign.

We don’t want to dismiss the real fears that are present in this market, but we think that Armageddon is not at hand.

To support this view we note that the current quarter will be the first time in years that no S&P 500 companies will cut or suspend their dividends.  If true, it would mark the first such quarter since the second quarter of 2004, and it is certainly a bullish statement by US corporations.  Earnings have steadily improved over the last year, and according to our data, trailing twelve month reported earnings on the S&P 500 have increased 89% over the past year.  Having heavily cut costs companies are flush with cash, and very few S&P 500 stocks are distressed or in need of a dividend cut to conserve capital.  As a comparison, S&P 500 companies decreased dividend payouts by a record $52 billion in 2009.

We don’t believe our economy is on the edge of collapse or setup for failure as it was two years ago. Many of the weaker financial institutions have already failed, and those that survived the first credit crisis have had nearly two years to raise capital and allow earnings to bolster their balance sheets. Bad loans have been cut back significantly. In other words, we have a very different situation today than we had in early 2008.

Morningstar’s Paul Larson used this apt analogy: “The first credit crisis came through and burned the underbrush and lower branches, sparing the tallest trees. And now if a second fire comes through, there is not nearly as much fuel to let it burn.”

We tend to agree.

Today, only a bit more than a year later, the S&P trades over 1,140, nearly a 70% increase from that infamous low. What a difference a year makes! Even with that gain it should be remembered that the S&P still stands 20%+ below its 2007 high, so it’s important to “zoom out” when looking at the recent rally to put it in context.

The last year and a half has been full of economic upheaval accompanied by stock and bond market volatility. We believe the worst has passed and that while these waters are navigable, significant risks remain. Acknowledging these risks, we see many reasons to be cautiously optimistic. Let us explain why.

Economy

Many economic variables have either improved or stabilized over the previous 12 months. As we wrote last quarter, prognosticators, even those who are experts, often get it wrong. Currently, the conventional wisdom is that consumers are retrenching and are unwilling to make discretionary purchases. The data we examine confers just the opposite message: the recent report for individual store sales showed overall sales were up 0.3% in February from the previous month. If you back out motor vehicle sales the number was even larger at 0.8%. This data does not seem to portray a weak consumer. Additionally, the average ticket price at Home Depot and Target (two retail bellwethers) has risen. We would venture to say that reports of the death of the American Consumer have been greatly exaggerated.

According to Morningstar, Industrial production fell almost 15% this recession, which is one of the largest reductions in history. With consumer spending picking up pace, we believe manufacturing and production will begin to ramp up. Production cannot lag forever and keep up with growing consumer demand. According to the Census Bureau, inventories are down almost 9% year over year. What this tells us is that instead of making new goods to satisfy consumer demand, manufacturers simply shipped goods they already had in inventory. So the question now becomes how long producers will wait before rebuilding inventories, at which point the virtuous cycle of hiring begins. Presently manufacturers are pushing workers (as measured by hours per worker and productivity figures) versus adding to payrolls. Soon we will reach the point where the band snaps and hiring begins.

Unemployment has persisted during this recovery longer than we had hoped, as many employers are uncertain about the sustainability of the stimulus spending and its effects on demand. Employers are also greatly concerned by policies coming from Washington that will affect variable costs, health care and taxes. The debate concerning the recently passed Health Care Bill is beyond the scope of this letter. However, one of the main takeaways for investors is that as these new bills and spending programs become law, the uncertainties surrounding the issues will diminish.

We do not see a robust employment picture developing any time soon.  Encouragingly, the mass layoffs that companies used to balance cash flow have all but ended. This sets the stage for hiring back full time workers and eventually lowering the unemployment rate. Full employment (most view this as 4% unemployment vs. the current ~10%) will not happen for the foreseeable future. We find it likely that 8% will be the range over the next two years.

Where does the “cautious” come in for our “cautiously optimistic” view? There are a number of risk factors we are monitoring closely. They include:

• European Sovereign debt crisis
• Chinese attempts to slow growth
• U.S. Tax Policy/Government Spending/The end to Quantitative Easing by the Fed
• Inflation

The fiscal problems in Portugal, Italy, Ireland, Greece and Spain (shortened to “PIIGS” by creative Wall Street traders) have been well publicized. These countries are all members of the European Union and have adopted the Euro as the common currency. EU members agree to keep debt levels below a certain percentage of GDP in order to ensure sound fiscal policy and prevent the need for a financial bailout caused by irresponsible borrowing by any one country. The PIIGS (Greece in particular) violated these agreements and used financial derivatives to hide high debt levels. The normal tactic taken by a country in this situation is to debase the currency and print money to offset the financial obligations, more commonly known as “monetizing debt” (this is what Ben Bernanke and the Federal Reserve have been doing for months in the U.S.). This strategy is not an option for countries that have a common currency and no central bank; thus insolvency issues arise. This is playing out now in Europe and investors are nervous. We believe the EU will work this out, led by the stronger countries (Germany and France) and potentially the IMF, but it further undermines confidence in the financial markets. This has led to a strengthening of the U.S. Dollar relative to the Euro.

China and the U.S. are in the midst of a love/hate relationship. Both parties would be economically challenged, to put it nicely, if they divorced. China is heavily dependent on U.S. imports and the U.S. is heavily dependent on China reinvesting its trade surplus into our Treasury market to fund deficits. As one of our portfolio managers likes to say “we send China paper and they send us plastic.” If any one side gets disgruntled with the other the global economy would be destabilized. One upcoming date of interest (other than it being the tax deadline) is April 15. This date is the when the U.S. Treasury department must decide who, on the sovereign level, should be classified as a currency manipulator. Most currency traders will acknowledge the Renminbi (the formal name for the Chinese Yuan) is perhaps 25-40% undervalued versus the dollar based on economic fundamentals. This perhaps should be considered manipulation but it is unclear if we have the political will to state this publicly and create a stand-off with China when they are funding our Government at the moment. Time will tell.

U.S. tax policy, government spending, quantitative easing on behalf of the Federal Reserve and inflation are all closely linked, and all present risks to our economy. We have just embarked on the largest Keynesian Economic spending experiment since the New Deal. Government spending is widely considered to be unsustainable and will be curtailed as our stimulus efforts wind down. The Federal Reserve is ending their program to purchase government and mortgage backed-bonds and we are unsure what the economic effect will be. Rising inflation (if gold prices are an indicator) is widely viewed by many as a foregone conclusion. We simply cannot see a scenario where we have high unemployment, low industrial capacity utilization, weakness in the housing market and high inflation. We see the likely scenario as low to no inflation in the short run and hopefully low to moderate inflation in the long run. This assumes a modest economic recovery that will include increased employment.

This is a longwinded way of saying that we acknowledge there are headwinds facing this recovery. We hope that the naysayers will acknowledge that there are fewer headwinds today than 12-18 months ago. When we view all of these data points collectively, we tend to lean towards optimism.

Stocks

What we’ve seen from the markets more recently is that the specter of 2008 remains very fresh in the minds of investors. As we observed during the September, December and March earnings seasons (when companies give quarterly reports) there has been a clear trend. Earnings have consistently beat the expectations of analysts, but stocks initially fell after earnings were announced, only to rise again in the succeeding months. In other words, investors don’t seem comfortable waiting; they are quick to move on to another investment for fear they will be hurt by staying with their current portfolio.

We continue to see attractive opportunities lying in plain sight. Large, diversified companies with high barriers to entry in their respective markets are selling for very attractive prices. When looking just at price/book ratios, various analysts believe stocks have been this cheap only three times in the last 120 years. Even more importantly, when these investments are weighed against the alternative of cash or short-term bonds, it is clearly the rational choice to invest in these types of equities with one caveat – one must have an adequate time horizon to benefit from this strategy.

It is a well known maxim that when it comes to investing in the equity of a business, the price paid and the time horizon are two of the most important factors to consider. Today we think many prices are right. As we mentioned earlier though, many investors are looking for instant gratification; their time horizons are not properly calibrated. So even with the right price, if a boring company announces earnings that aren’t spectacular, investors are prone to sell the stock. We believe that one quarter’s performance, positive or negative, should have very little impact on the price of a business that operates for the long term. We believe in the concept of “time arbitrage,” which means a 3 to 5 year investment horizon is much more successful than a 3 to 5 (day/week/month/quarter) one. This may appear to be an unpopular approach, but it has served our clients quite well over time.

The consensus estimate for the earnings of the S&P 500 in 2010 is $75, a figure that is based on a very weak recovery in GDP of around 2.5%. We think this figure is too conservative. Reviewing 2009, analyst profit estimates were consistently low right through the fourth quarter. In fact, over 53% of S&P 500 companies beat analyst expectations for the fourth quarter of 2009. For 2010, we expect GDP growth between 3.5% and 4.5%, which implies profits north of $80 for the S&P 500, possibly as high as $85. Profits in 2011 could approach $100. Using a price earnings multiple of 16 implies an index level of 1,360, almost 15% higher than current prices. Using a price earnings multiple of 15 on 2011 earnings implies another gain of more than 10% next year. Neither of these earnings multiples is aggressive, particularly if interest rates remain fairly low.

Bonds

The bond market was mostly positive during the first quarter, as investment inflows are still more heavily weighted toward fixed income securities. The overall taxable fixed income market was up 1.78% for the first three months of 2010. This performance, similar to recent quarters, can be attributed to a strong showing in corporate credits and asset-backed securities. Investors continue to unwind the “flight to quality” trade and turn to asset classes that were most affected by the recession. The laggard in the taxable space was the long U.S. Treasury bond, which turned in a negative .07% return. This may not sound that bad but for the month of March the long Treasury was down 2.57% and the weakness has continued into April.

Overall our strategy has not changed for taxable bond accounts. We have been buyers of “step up” Agency debt, where the coupon adjusts higher over time, as we feel that rates are headed higher for U.S. debt. We have been pleased with the way the market has absorbed the massive supply of US bonds. As we work through the economic issues we outlined above, we believe investors will demand higher yields to continue funding US deficits. Value remains difficult to find in corporate bonds. Spreads (or the premium you receive for owning riskier debt) are as tight as, or tighter, than before the credit crises began.

The securitization market, or the practice of pooling loans, credit card receivables, private mortgages, etc., is showing signs of life, which will be an engine of growth for our economy. We do not see a full securitization market recovery in the short term. The market is realizing though, that underwriting standards have improved greatly and the yield levels have begun attracting buyers. If this market ignites again it could be the fuel for our economy that has been lacking, putting pressure on inflation expectations and thus rates.

The municipal market has performed well, despite the headlines of budget shortfalls for virtually every state. In fact, the market has been so healthy that we are finding little value in the new deals that are coming to market. North Carolina just issued a $487 million General Obligation bond at rates that were very good for state finances. An investor would have to tie up their money until 2027 in order to achieve a 4% rate! Our strategy in the municipal market has also changed very little although it is different than our taxable strategy. We are taking gains in the short end of the curve and reinvesting at more attractive rates in later dated maturities. We are firm believers that the prospect of higher taxes coupled with constrained tax-free issuance (due to the Build America Bond stimulus plan) will create an attractive supply/demand dynamic and keep longer rates low relative to the taxable market.

Conclusion

At the risk of repeating our letters from the last 6 months, we continue to believe the “risk rally” of the last twelve months will lose steam as higher quality stocks pick up the baton in 2010 and 2011. In our portfolios, we have moved from defense to offense as the economy has continued to right itself. We recently had the opportunity to have a one-on-one visit with the management teams of two of our holdings. We came away impressed with the amount of cash on their balance sheets and the pending backlog of new orders. Both management teams stated that one big problem is the uncertainty over legislation coming from Washington concerning the cost of health care and environmental regulations (Cap and Trade), etc. We keep getting the message that the business world is primed for growth, but are cautious and awaiting clarity from Washington so they can plan for the future.

In 2009 the markets surprised us all by going up. It paid to be a long-term investor and to stay patient in the midst of the storm. In 2010 the market may very well upstage conventional wisdom again by staying up. We look forward to it.