Client Communications

Fourth Quarter, 2011

Presented below is our fourth quarter, 2011 report for your portfolio. The overall tone for the report is set by the bullet points below.

The euro crisis remains the predominant investment risk in 2012.
European sovereign leaders and the managers of the European Central Bank are now showing that they finally “get it”. Both groups have begun to tackle deep rooted monetary and fiscal problems of both a short- and intermediate-term nature.
Greece is getting ready to “throw in the towel”.
The U.S. stock market offers an extremely attractive risk-reward profile for 2012 versus other global stock markets and versus domestic bonds.

Euro Crisis (cont’d) Year 3

As the new year begins, the world remains at the mercy of the euro crisis and we’re guessing you are as tired of reading about it as we are of writing about it. The fact remains however that the potential still exists for Europe to derail the global economy.

Since our last quarterly report there have been a number of Euro zone summit meetings with a central theme of achieving increased political integration to go hand in hand with fiscal integration and discipline. It’s been a tough sell for Merkel to herd these cats into agreeing to behave more like Germany. It’s been an even tougher sell to have the Euro zone countries agree on enforcement mechanisms on new budget rules to avoid in the future the kind of spending problems being faced today. Success has not been achieved in these efforts through the political process and so the goal of greater political and economic unification remains “out there”.

There have been other noteable achievements, however, of a more favorable nature. Italy, Spain, Greece, Ireland, etc. have brought in new, more conservative governments and many concrete steps have been initiated to attack today’s growing budget deficits, lack of competitiveness in the global market place, and the entitlement mindset of the people. Politicians don’t like taking away previously promised benefits and only agree to take such actions when riots in the bond markets force it upon them, as was the case last year.

Regardless of how change is coming about, the fact is that Europe’s fundamental problems of over-indebtedness and lack of competitiveness are now openly recognized for the problems that they are, and they are actually beginning to be addressed in meaningful ways.

Resolution and economic improvement are slow processes however, and today’s austerity moves in the various Euro zone countries are hurting all their economies in this new year. In fact many economists believe that attempting to reduce a country’s debt level through austerity measures while countries sink into recession is ludicrous. Noted economist John Maynard Keynes stated it this way: “The boom, not the slump, is the right time for austerity at the Treasury.” Unfortunately for the European politicians, bond markets are making it difficult for countries to further leverage up their balance sheets when they are already choking with debt. Interest rates simply rise to levels which make new debt issuance prohibitive. That’s when countries begin to entertain ideas about defaulting on their sovereign debt (so much for the notion under modern portfolio theory that government debt is a risk free asset!).

Ok, so here Europe is, beginning to seriously attempt to deal with its deep economic problems, its back to the wall with a debt crisis, and all of its banks teetering on the edge of bankruptcy after years of leveraging up with sovereign debt. This grim picture brings us to a couple of significantly positive monetary developments which occurred prior to year end.

First, during September, the world’s central banks came together with a coordinated program to make their currencies available to European banks. Those banks need dollars (primarily) as well as other currencies to fund their non-euro activities. This arrangement takes pressure off the European banks by reducing their need to conduct fire sales of assets in order to free up operating capital.

Second, the European Central Bank (ECB) is becoming kinder and gentler. Hard liners are leaving the bank’s Board of Directors. Decision making is becoming more pragmatic and conciliatory. The ECB has recently taken a great deal of pressure off the banking system by 1) agreeing to lend significant (perhaps unlimited) amounts of money to the banks at 1% interest for up to three years and 2) purchasing significant amounts of Spanish and Italian bonds in an attempt to stabilize those countries’ sovereign debt markets. These actions are designed to assuage the bond market’s fear of a credit crunch which could spiral down into a global debt crisis. For the first time in the three-year history of this banking crisis, the ECB has constructed a strategy to head off further contagion.

Don’t call us starry-eyed optimists however. We fully recognize that the road ahead in 2012 is littered with potential catastrophes waiting to be triggered. We’re simply saying that powerful economic medicine is being swallowed in Europe (in contrast to politically gridlocked USA) and that a slow process to recovery is underway.

Our economic consultants advise:

“Any credible plan that includes heavy involvement by the ECB’s printing press is likely to stoke a rally in risk assets, and we continue to inch closer to that scenario.”¹

¹13D Research, 12/1/11 Page 8

Longer term, over the next 15-25 years, the demographics of ageing populations and their attendant rising healthcare and retirement costs across all of Europe, China, Japan and a smattering of other countries is the most significant financial risk these countries will be facing. This means that today’s fiscal problems at home and abroad are just a hint of our future fiscal problems, a mere taste of bigger problems to come. Today represents a window of opportunity to address these challenges but we fear these longer-term challenges are simply too daunting for politicians to consider at present.

Boiling the euro situation down to its most fundamental essences, we have the following:

  1. An immediate liquidity crisis in which lending to the banks dries up; banks become starved for cash and the panic spreads from one institution to another as their cost of borrowing money for operating needs soars. We believe recent actions by the world’s central banks, and the ECB in particular, are successfully dealing with this issue, possibly for an extended period of time.
  2. An intermediate term solvency crisis in which all of the European nations need to 1) reduce their levels of sovereign debt and 2) institute policies to increase their ability to compete in a global marketplace thereby enabling their tax revenues to increase. Every European country has its own set of unique problems in dealing with a multitude of difficult issues in this regard.
  3. Changing the peoples’ mindset after years of receiving increasing entitlements is extraordinarily difficult and painful. But, steps are being taken. Government leaders have been replaced across Europe. Austerity plans are being enacted. Intransigent unions are witnessing erosion of their power. We are looking at a multi-year process with a 3-to-5 year window from today, with many crises likely to occur along the way.
  4. A longer-term demographic time bomb crisis building towards a peak over the next 15-25 years. Ageing populations as a percentage of total populations across all of Europe, (and the U.S., China and Japan) are increasing rapidly. Rising healthcare costs and retirement benefit costs are growing exponentially for this cohort of the population as they continue to live longer. We are not aware of governments anywhere in the world that are adequately preparing themselves for the growing “old age crisis”.

Greece Out?

The country is insolvent. It is highly likely that they will never be able to pay down their debts fast enough to actually reach an improving long term fiscal situation. It’s time to give up the ghost and the politicians are now beginning to acknowledge this reality. The only way for Greece to deal with its insolvency is through default.

Greek officials are now, for the first time, openly discussing leaving the euro zone within the next few months if current negotiations for ECB and IMF money don’t work out favorably for them. Such an action will be extremely painful to banks all across Europe as it is virtually assured that Greece will default on its debt immediately thereafter and the banks will be forced to recognize significant losses on Greek debt which they now pretend isn’t going to happen.

Using history as a guide, Greece will likely sink into chaos for a while after which an explosion in growth of their economy could be expected to occur as the country and its many attractions will be on the market at “fire sale” prices. The Euro zone countries will eventually be better off without Greece as well, allowing the rest of the member countries to stop pouring money into that financial sink hole.

Will a Greek exit from the Euro zone trigger a global financial panic? We simply do not know. It is clear, however, that European Union bureaucrats are in for a tough year in 2012.

The chart below, courtesy of BCA Research, presents a picture of sovereign debt load stress across many developed-market countries. The higher interest payments are as a % of GDP, the greater the risk of eventual country default. Risk also increases as the % of debt held externally rises. Please note from the chart that the U.S. sovereign debt situation presents little cause for concern based upon this 2014 projection. Those who are predicting an imminent U.S. debt crisis are still way too early, in our opinion.


The U.S. Recovery

A quarter or two ago there was much talk of the “double-dip” recession. We don’t hear about that anymore as a growing number of economic and business indicators continue to advance into expansionary territory, political gridlock notwithstanding. Granted, the recovery is anemic by historic recovery standards but cyclical trends are moving in the right direction. We are encouraged to learn, for example, that domestic banks are beginning to provide some growth assistance: lending standards are being relaxed, deposit growth is strong and bank capitalization continues to improve. One of the most unexpected recent findings is that consumers are once again increasing their rates of borrowing after two years of declining credit balances. Rising holiday retail sales have surprised investors as well, coming in well ahead of economists’ projections.

Asset Allocation

As the year progressed we became increasingly concerned about the possible impact on client portfolios of the world’s proliferating investment risks. Consequently we began reducing client exposure to the stock market early in the second quarter. It wasn’t until near the end of the fourth quarter that we began to sense some stabilizing influences both at home and abroad as a result of the items discussed above in this letter.

As the first quarter of 2012 gets underway, we are faced with the prospect of an improving economy at home offset by a spreading recession in Europe and a rising potential for a disorderly default by Greece. Because it simply is not possible to foresee the degree of damage to the global banking system (and hence global stock markets) of a Greek default we are maintaining client equity exposure at or below benchmark weighting while we watch these events unfold.

Performance Analysis

4th Qtr. 12 months ending December 31, 2020

U.S. Treasury Bill return 0.0% 0.2%

MSCI All World Stock Index 7.3% -6.9%

Investment Grade Bonds Index 1.9% 8.1%

Broad based commodity Index 2.4% -8.3%

Gold -3.7% 10.0%

CPI (12 months through Nov. 30) 3.4%

Cash

Cash (money market funds, treasury bills) maintained yields at or close to zero for the year. The Fed has indicated that it intends to hold short term interest rates at current levels into 2013 in an attempt to encourage longer term investment in riskier assets. It is our intention to keep cash at a minimum in client accounts.

Stocks

The MSCI All World Index is one the broadest measures of global stock market performance. As evidenced by its -6.9% return for the year, it was a losing year for stock market investing. Relative to the rest of the world, the U.S. stock market was a global leader with a 12-month total return of +1% for the Russell 3000 Index. Emerging markets performed very poorly, declining by 18.4% for the year and a broad index of major European companies lost 13% for the year.

The U.S. stock market is now considered to be cheap by a variety of valuation metrics. Dividend yields of many companies are quite attractive. European stock prices are generally more attractive than in the U.S. but concern about the survivability of the euro and the deepening recession are contributing to an investor reluctance to jump in to that market at present.

Fixed Income

The conventional wisdom in the U.S. last year was that interest rates were certain to rise because of the Fed’s quantitative easing activity and a sharp increase in the CPI by midyear. Naturally, the opposite occurred, reminding us once again to never fall for the conventional thinking of the moment.

We typically seek to reduce interest rate risk in client portfolios by holding the majority of fixed income investments in relatively short maturities – in the 1-5 year range. The broad investment grade corporate index against which we measure bond portfolio performance contains bonds with maturity dates as far out as 30 years. It just so happened that interest rates declined over the course of 2011 and the most significant rate declines occurred in bonds which mature in 10 years or longer. In this situation, longer term bonds outperformed shorter-term bonds on a total return basis: 1-3 year maturity bonds +1.9%; 7-10 year maturity bonds +9.3%; 10+ year maturity +15.9%.

Commodities

China’s slowing growth rate during 2011 and the general slowdown in global trade negatively impacted virtually all commodities last year. We’ve lightened up in this area as the year progressed. We are waiting for the global economy to show some new signs of life before adding to client holdings.

Gold

Gold was a profitable investment for the entire year but the price correction which occurred in the fourth quarter has been puzzling. It seems that governments of various emerging market nations are purchasing significant amounts of bullion on a fairly regular basis. China is seeking to develop an international trading presence and is actually encouraging its citizens to buy gold. On the flip side, we read about a number of major hedge funds and other speculators who dumped massive quantities of gold during last year’s fourth quarter.

Our view is that government efforts around the world to reflate their economies in 2012 should be a source of upward pressure on the price of gold. Ongoing debasement of currencies calls for continued gold ownership by every investor. We are holding steady at 5-7% of client portfolios dedicated to gold.

Shale

There is very good news indeed coming from the on-shore oil and gas industry and its name is shale. Spurred on by advances in American drilling technology, vast areas of the U.S. now have the capacity to produce massive new quantities of oil and gas. The amazing thing is the ubiquity of all these reserves, as illustrated on the attached map.

In areas where drilling has been underway for some time, the financial impact on local and regional markets has been remarkable. New pipeline construction is underway, railroad terminals and line extensions are being built, and new manufacturing facilities are being planned near areas of assured long-term sources of energy. Such facilities will include natural gas power plants (in place of coal-fired plants), fertilizer plants, steel fabricators, petro-chemical plants – the list goes on. Steel? Tens of thousands of tons will be needed for pipeline and related infrastructure, along with vast quantities of other manufactured products.

The international oil giants are moving in by purchasing tens of thousands of acres of leases and preparing to spend billions of dollars for developmental drilling and associated infrastructures. Lots of new employment will follow – Price Waterhouse estimates up to 1 million new jobs across the country in the next five years, assuming enough skilled people can be found!

Natural gas liquids (ethane, propane, butane) are also flowing from shale formations. These liquids have the potential to revive the U.S. petrochemical industry. In turn, transporting increased quantities of natural gas liquids will require constructing as much as 12,000 miles of new pipeline over the next 20 years at an estimated cost of $14.5 billion, according to the Interstate Natural Gas Association of America. American ingenuity once again has the potential to transform America’s long-term energy picture by reducing our dependence upon hostile and/or unstable foreign sources of carbon based energy. Shale production is still in its infancy but already the U.S. has become a net exporter of refined petroleum products to other countries around the world. We believe many favorable investment opportunities will emerge from our shale oil and gas abundance.

New gas production has caused a surplus of natural gas in the country today, with one positive result being a decline in price from $15 per BTU six years ago to around $3.20 per BTU now. As natural gas use increases, coal usage as a source for electrical energy has declined. According to the Wall Street Journal, coal constituted 51% of the fuel for electrical generation in 2003 vs. 43% now. Current projections are calling for continuing declines in coal consumption at the rate of 2-4% per year, very pleasing news for our efforts to reduce air pollution.

As always we look forward to discussing with you any thoughts or questions you may have regarding the contents of this letter.

Sincerely,

Sheffield Investment Management, Inc