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Quarterly Letter to Clients

April, 2012

Indices at quarter-end (March 31, 2012):

Dow Jones Industrials: 13,212.04 1Q'12 +8.14% YTD +8.14%

Standard & Poor's 500: 1,408.47 1Q'12 +12.00% YTD +12.00%

It appears that the situation in Greece has reached a conclusion, albeit probably a temporary one. So that is one overhanging problem that we can stop worrying about for now. But ever since dinosaurs roamed the earth one problem has followed another problem. For example, recently, more than one person has asked me what will happen (in the markets) should Iran be attacked. I confess that I do not know. Would it be a six-day war, or a 10-year war? If the former, you certainly would want to be long any market, while if the latter, perhaps gold is your best bet.

Oil prices have been strong of late, and that strength can be directly linked to fears of such conflict, which would doubtless disrupt supplies. The rise in oil over the last few months has not yet seemed to affect the economy, but the lingering question is, at what point will prices at the pump make consumers pull back in other areas?

The resolution of the Greek crisis and the strong possibility of an end in our involvement in the Mid-East have had a happy psychological effect on our markets. Indeed, we had a rousing first quarter, pushing the Dow up 8% and the S&P 12%, and bringing the advance of the last six months to over 20%. This leaves me to reflect on what might happen next. You will remember that in my last letter I mentioned how a rapidly rising market is a dangerous market, drawing people in at high valuations. This is true for stocks, bonds, houses, oil, gold, wheat, corn, stamps, even interest rates. It is true for any market in which people speculate or invest.

But stocks have been constrained for some time by the Euro zone problems, and perhaps what I see as over-ebullience is simply a catching-up move. Today, stocks feel like they are a little high, but probably not unreasonably valued, while bonds seem to be at valuations that can only be described as "stretched". Indeed, to my mind, the only cheap asset today seems to be real estate. But that asset class is also a difficult one to invest in. In the publicly-traded arena there are REITs, of course, but the area with the most upside potential seems to be in the private ownership of real estate properties, a path not suited to many investors.

In addition to the factors mentioned above, the move in stocks can further be attributed to the improving economy, and an upswing in corporate earnings. These are all systemic, fundamental reasons for higher stock prices.

The price level in bonds, however, can only be rationalized by the Fed's publicly announced stance on holding rates down. As you have surely discerned, this is a largely artificial construct.

There are other factors affecting the fixed-income markets. One is a "flight to safety", probably primarily out of the Euro. In addition, it would not be a wild assumption to say that the rise in bond prices, and the resultant decline in yields, is also at least partly a function of the graying of the populace. As the "boomer" generation enters retirement, they naturally seek income along with less volatility. The asset of choice to accomplish such ends has historically been bonds.

But picture a chart in which the bond yield starts at a relatively high level at your left, and consistently moves lower over time. On this same chart, plot dividend yields, which start at a low point and gradually rise, until the two lines cross. From that point on, an investor will generate more income from dividends than from stocks.

Thus, today every fixed-income investor must at least consider adding high-quality, high-dividend paying stocks to his holdings. Given the significant differences in stocks versus bonds, especially in terms of risk, this may seem like a radical shift in thinking, but it is something that must enter the equation.

There is no urgency to alter the course; I have arranged maturities to protect our accounts. But if you are among my fixed-income clients you may want to have a conversation with me on this subject.

Further, this whole exercise may be made moot by the fact that interest rates appear to have made a bottom near the end of the quarter.

It is an interesting and challenging time in the markets. Will our next problem be Portugal, or might it turn out to be Iran? Perhaps the market will decline simply because it has run so far so fast. One thing that we can project with certainty: there will be another problem to roil the markets. Perhaps we should simply be grateful for the robust quarters that we just had, and not project our fears too far out into the future.

Jim Pappas