First Quarter 2011

Quarterly Review & Outlook

As we were writing this letter, we reviewed our 1st quarter letter from last year. We were struck by the similarity of equity returns for both periods. Bond returns were the exact opposite, however, up in the first quarter of last year but down in the first quarter of this year. You may recall the second quarter of 2010 was a particularly nasty quarter with the S&P500 declining by almost 11.5%. We are not necessarily saying history will repeat itself, but given our concerns about valuations and investor sentiment, we would not be surprised to hear it rhyme.

Since late 1998 we have been cautious toward most sectors of the stock market based on our assessment of equity valuations and expected returns. We do not consider ourselves “Perma-Bears” but we do prefer to dial down the level of risk in client portfolios when we observe equity valuations in the top quartile of their historical norms. Our valuation approach has worked very well over the past 25+ years and has helped to preserve our client’s portfolios during hostile market environments. As a practical matter, it is easier to predict long-term expected returns in the equity markets than it is to predict the short-term direction of the market. Intuitively, people understand that it is less risky to buy stocks when they are cheap but many have an emotional block toward buying when there is “blood in the streets”. It’s more comforting to buy when markets have been rewarding, when investors are in agreement, and when there is the perceived safety of the herd.

One attribute of our value based approach is that we tend to be early. We were early in late 1998 being “anti” tech stocks, but we were subsequently rewarded during the 2000 to 2003 bear market. Again, we were early in 2007 when we expressed our concerns about the housing markets and forecast the likelihood of a recession in the near future (little did we know the extent or magnitude of the recession to follow). Once again, we are early implementing our defensive approach as the markets have continued to climb since the lows of last summer.

We believe a key driver of market returns over the past nine months has been the Federal Reserve’s Quantitative Easing program (QE2) which has injected over $700 Billion into the financial system. The stated goal of the program was to lower long-term interest rates, but ironically, long-term rates actually increased instead of decreasing when QE2 began last August. The Fed’s actions have increased the “risk” trade, pushing investors into more and more risky assets in search of higher returns. Ben Bernanke, the Chairman of the Federal Reserve, has actually been quoted saying the Fed fueled gains in the equity markets were intentional and that he believes the “wealth effect” from the markets will carry over into the real economy.

The stimulus activities of the Federal Reserve have been accompanied by massive deficit spending and borrowing by the Federal government. We find it hard to believe you can solve a debt problem like the sub-prime mortgage fiasco by taking on still more debt. Ultimately, there will have to be some sort of meaningful debt restructuring before we can resume a more sustainable growth trajectory. QE2 has had a modestly positive impact on the economy, but it is scheduled to expire within the next two months. Given the current political environment, it is unlikely there will be a QE3 anytime soon. There is legitimate question whether the economy can continue to grow without further government stimulus.

We expect the economy will continue to grow for the balance of this year at sub-par but positive rates, but this will do little to help the unemployment situation or boost consumer confidence. There are several issues lurking in the bushes that could rear up at any time to upset the apple cart. Some of the concerns we continue to monitor include:

1) Inflation. Inflation is clearly beginning to heat up, and if it persists, it will ultimately become a drag on the economy.

2) Interest rates. Long-term interest rates have been in a sustained down-trend since the early 1980s. Current rates are artificially low due to government actions, and there is little room for rates to fall further. We are already seeing some upward pressure on rates and this will become stronger should inflation persist. The Eurozone has already begun to raise rates as has China and India.

3) Political instability. The uprisings in the Arab states are far from over and it is far too early to predict the ultimate outcome. Oil prices are already reflecting these uncertainties. In the event that the Arab states end up ceding control to more radical regimes, we would expect a further hike in oil prices which would be a large impediment toward further economic growth.

There are always known and unknown risks with respect to the markets. However, when there appears to be a great number of risks in a richly valued market, we prefer to err on the side of caution.

Our investment philosophy and approach is based on fundamental and relative valuations between the various asset classes (i.e. stock, bonds, alternatives and cash) as well as the current and prospective monetary and economic environment. Our analysis is tempered greatly by a long historical perspective. Ideally, we would maximize client exposure during periods of low valuations and favorable monetary and economic environments. In the current environment, however, valuations are not particularly attractive, we have grave concerns about the prospective monetary and economic environment and the historical guidelines are not particularly encouraging.

Notwithstanding our somewhat negative longer-term outlook, the world’s economy is very likely to grow. There are often pockets of opportunities in various sectors, styles and asset classes. We intend to manage client portfolios with one eye on capital preservation and the other eye on potential opportunities. Our current outlook is one of caution that calls for a moderate level of risk, but we remain optimistic that attractive investment opportunities will emerge.

As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.

Sincerely,

James A. Martin, III

Michael W. Masters