Commentary

2012 First Quarter

The 2012 first quarter price performance of the US stock market was the best we have seen in a number of years. The S&P 500 total return (price change plus dividends) advanced 12.6% for the first quarter, the Dow Jones Industrial Average rose 8.8% and the NASDAQ Composite increased an astonishing 18.8% for the quarter. The unweighted index of the S&P 500 advanced 11.7 % for the quarter. Mid and small-cap stock indexes rose about in line with the S&P 500 for the quarter. The S&P Small Cap 600 Index rose 12.0% (total return) and the S&P Midcap 400 Index advanced 13.4% (total return). International investing faired well during the quarter. The MSCI World Index increased 10.9%, the MSCI Emerging Markets Index accelerated 13.7% and the MSCI European Index advanced 10.0%.

The 2012 first quarter advance for the S&P 500 was impressive, rebounding from a dismal total return for the prior year of only 2.1%. The total return (price change plus dividends) of the S&P500 for the last 3 years has seen a positive annual return of 23.4%; 5 year total returns have compounded at just 2.0%; 10 year total returns have totaled 4.1% and fifteen year returns of only 6.1%. Five, ten and fifteen year total returns through March 30, 2012 have substantially lagged the long term arithmetic average total returns of the S&P 500 of approximately 12% since 1926. During the last 12 years, we have lived through two serious US economic recessions, concerns regarding economic stability in Europe, bailouts for the US banking system, the tech bubble, high levels of US unemployment and a substantial contraction in US home prices. This has resulted in a slowdown in the earnings/dividend growth of US corporations, a significant rise in equity risk premiums and a substantial contraction in market P/E ratios from 32 times earnings in early 2000 to 13 times earnings today. Despite all these events, we expect the S&P 500 earnings for 2012 to reach record earnings of $105 per share. The S&P 500 closed at 1408 on March 30, 2012. That is -8% below its cyclical high of 1527 in March 2000 and -10% below its all-time high of 1565 in October 2007.

The best performing US equity sectors during 2012 first quarter were essentially the opposite of what we experienced in 2011. The more aggressive, economically-sensitive sectors of the market did the best, while the defensive components of the market lagged the overall market averages. This was reflective of improving reports of domestic employment and economic growth. The financial sector (+22.1%), the technology sector (+21.5%) and the consumer discretionary sector (+16.0%) led the market for the first quarter. The utility sector (-1.6%), energy sector (+3.9%) and consumer staples (+5.5%) lagged after leading the markets over the past year. These sectors typically possess less economic sensitivity, lower exposure to foreign sales, higher dividend yields and lower market betas. These traits were not as attractive during a period of improving US economic growth.

The extreme volatility of daily stock price movement over the last several years has reflected several key concerns surrounding the future growth of the global economy. These were consistent themes throughout the last couple of years. The markets continue to focus on three major events: (1) The governmental budget deficits in Europe and its ripple effect on the Euro currency and future economic growth in Europe; (2) The stalemate in Washington DC and its impact upon business confidence and the growth of the US economy; and (3) the concern about the slowing economic growth in developing economies and particularly China. The common thread of all these macro events centered upon their impact on future global economic growth. Slower economic growth normally would mean reduced earnings and dividend growth projections. Both the world stock and commodity markets dramatically vacillated in direct response to these macro events. It appears that these concerns will be with us for some time.

The US economy has continued to show signs of improvement during the 2012 first quarter. US GDP growth was only 1.3% in the 2011 second quarter, 1.8% during the 2011 third quarter and 3.0% in the 2011 fourth quarter. Consensus GDP forecast expected for the 2012 first quarter is in the range of 2.3-2.5%. While the US GDP growth is subpar for prior economic recoveries (especially given the severity of the past recession), our economy is still showing signs of moderate growth. On the positive side, corporate earnings are doing well. Productivity is continuing to rise. The Federal Reserve policy is very accommodative. US employment is moderately rising, even though the unemployment rate is still high at 8.2%. Inflation is under control outside of energy and some food prices. On the negative side, US household disposable income remains under pressure. Employment growth is slow. Corporations are still hesitating to hire new employees given the uncertain macro, regulatory and economic environment. Wage growth is generally lagging inflation. US home prices remain a problem with 23% of homes with negative equity and interest rates are very low for savers.

European GDP essentially showed no growth for last year. We expect European 2012 first quarter GDP growth to be negative, reflecting a recession that should last for 2012. Unemployment in the European Union is over 10% and is expected to rise for most of 2012. Economic growth in China is still good, but less than was reported in the prior quarters. China recently reversed its restrictive monetary and fiscal policy in an attempt to overcome slowing export demand, especially from the European Union - China's largest trading partner.

The yields in the US fixed income markets continue to remain near historic lows. The 10 year Treasury yield fell from 3.2% at mid-year to finish the year at a yield of 1.9%. Current 10 year bond yields are 2.1%. Bond yields receded for three primary reasons - (1) Investors flocked to the safety of Treasuries and other high quality bonds during these precarious times; (2) The Federal Reserve was still keeping short-term rates low to stimulate the economy; and (3) economic growth remains sluggish with relatively low inflation.

On the positive side, we do expect another decent round of earnings reports to begin towards the middle of April. The growth rate in 2012 first quarter earnings will slow from last year due to a decline in some commodity prices, the prior recovery from depressed earnings for most industries and slower export demand. The focus on corporate guidance for 2012 will be very important. We expect the 2012 S&P 500 earnings to hover in the range of $105 per share, which would be record earnings. Bank earnings should report the best earnings growth for the quarter, showing moderate signs of recovery from very depressed earnings. The implied price/earnings ratio for the S&P 500 is 13 times (plus a current dividend yield of 2%). This is a reasonably attractive P/E compared to 10 year treasury yields of 2.1%.

The higher quality companies that dominate our portfolios continue to generate improving free cash flow with earnings/dividends generally advancing at a much faster pace than inflation. Balance sheets are the best that we have seen in years due to higher capital positions, lower cost of carrying debt, as well as lower debt levels. Productivity remains high and profit margins reflect managements focus on cost containment. We believe that with some clarification of the macro concerns, stock prices are positioned to improve further during 2012.

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