EP | Wealth Advisors

Fourth Quarter 2011 Investment Letter

In a year characterized by unprecedented global events and record financial market volatility, it seems ironic for U.S. stocks, as measured by the S&P 500, to conclude 2011 with their smallest price change in over 60 years. Masked in the modest returns were dramatic market swings that nearly qualified for both “bull” and “bear” markets at different points in time.Investors found themselves caught between the uncertainty of social uprisings in the Middle East, natural disasters in Japan, fiscal discord in the European Union and the historic loss of the United States coveted triple-A credit rating. In the final tally, the S&P 500 index closed at 1,257.60, exactly 0.04 points below where it started the year.

There are many reasons why U.S. markets held up relatively well in spite of the largely negative headlines. GDP continued to grow, albeit at below historical rates. Unemployment, elevated by historical standards, improved throughout the year. U.S. corporate profits are likely to hit record levels for the year and balance sheets have improved dramatically since the financial crisis of 2008. In addition, housing continues to show signs of life aided by historic low interest rates, depressed prices, and rising rents that encourage renters to become homeowners.

The U.S. Treasury market rallied materially in 2011, as the benchmark 10-year yield dropped down to close the year at 1.88%. Few anticipated the dramatic move to the downside in interest rates and the “flight to quality” at the beginning of 2011. Consequently, many fixed income fund managers failed to match the return of the Barclays Capital Aggregate Bond Index. Corporate and high-yield bonds did not keep pace with Treasuries, although both asset classes posted solid positive returns for the year.

The BRIC markets (Brazil, Russia, India, and China) all fell more than 20%, while a composite of world markets excluding the U.S. dropped in excess of 15% for the year. The European debt crisis worsened throughout the year, marked by numerous governments being replaced, severe austerity programs, and protests/riots in several countries. A series of meetings by European leaders in the 3^rd and 4^th quarters led to a number of new programs intended to buy governments time to get their budgets in order. Investors have been unimpressed and continue to push interest rates higher in the most troubled nations, causing debt burdens to become even more onerous.

Unfortunately, a quick resolution in Europe seems unlikely. In exchange for monetary assistance the European Union has demanded that troubled countries meet specific guidelines in balancing their budgets in relatively short order. The problem with mandating balanced budgets is that it is likely to cause several years of subdued growth and deflationary wage pressure on labor markets. Unable to devalue their currency versus global competitors,peripheral countries will continue to struggle to recover from their debt-induced economic slowdown.

2011 will also be marked for extreme volatility in stock markets. The Dow Jones Industrial Average moved more than 4% during four consecutive trading sessions in August; the first time in history this index has experienced such a move. Although an increased frequency of near record-setting, short-term price swings in the stock market are emotionally challenging for investors,it does not necessarily imply that “long-term” investment risk has increased. Higher volatility does make the market more risky for traders who try to “predict the unpredictable.” However, as long-term investors we view volatility as creating opportunity more than uncertainty,and attempt to capitalize on short-term moves that have no basis in long-term fundamentals.

Although the European crisis as well as what is sure to be a contentious election season in the U.S. give us concern, we remain encouraged by the recovering U.S. economy and robust corporate profits. We expect that the first half of 2012 will play out similarly to the last six months of 2011, with the market looking for direction and trading on news out of Europe and from our own political leaders. By the second half, we expect that a clearer picture will have developed on the European crisis as well as our own elections, sending an encouraging message to investors and prompting a modest shift toward higher equity exposures.

As always, feel free to contact us at any time.

Best Regards,

EP Wealth Advisors

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