Winter 2011

A more detailed review of sector and sub-sector returns cor-roborates these themes. In general, investors cried “risk on!” in 2010’s final quarter. Equity markets extended a broad-based, nearly straight-line rally kicked off by signs of a sec-ond round of Treasury-bond purchases by the Fed—quantita-tive easing round 2, or “QE2” as it was quickly dubbed—that was then initiated by the central bank in early November. That action, along with the extension of Bush tax cuts by Congress at year end, lifted expectations for economic growth along with estimates of corporate earnings.

In equity markets, investors favored growth over value, pil-ing into sectors that benefit from economic strength such as technology. Smaller-capitalization stocks raced ahead of their steadier and more predictable large-cap counterparts. Lead-ing the pack was small-cap growth, up 16.6% for the quarter and an impressive 27% for 2010.

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First Quarter 2011 Investment Outlook

Fourth Quarter and Full Year 2010 Review: A Fed-Induced Sugar HighMarkets for equities and other “risk” assets charged higher in the fourth quarter, fueled by a torrent of Fed-induced liquidity and improved expectations for economic growth. Talk of a double-dip recession vanished. Despite the Fed’s massive and ongoing purchase program, yields on Treasury bonds surged and their prices plunged on fears of renewed inflation. Municipal bonds, normally one of the markets’ most staid sectors, were the worst performers by a wide margin amid headlines about ballooning state and local-government deficits. All in all, there was plenty of market excitement to be had.

Conversely, fixed-income markets struggled in the fourth quarter. Almost every segment posted negative returns for the period; the exception was corporate high-yield bonds, which tend to track equities. Treasury bonds fell sharply in value as their yields surged from a low point on a 10-year bond of 2.42% to a high of 3.53% less than three months later. This rapid spike, exceeded in speed and amplitude on only a handful of occasions in the past 25 years, came as a shock to heavily overbought fixed-income markets.

At the eye of the storm were municipal bonds, faced with a unique set of challenges. These included the relatively long maturities that typically characterize the sector, making mu-nis especially vulnerable to rising medium and long-term rates, and a renewed focus on credit risk. The average open-end muni mutual fund shed more than 5% of its value for the quarter; some of the more highly levered closed-end munici-pal funds lost astonishing amounts of value, in some cases exceeding 20%.

For the full year, however, all fixed-income categories recorded gains. High-yield bonds and several other taxable credit sectors produced solid double-digits returns, driven by improving economic conditions. Even the beleaguered municipal bond sector squeezed out a positive 1.7% return, thanks to a nice first-half rally augmented by coupon income.

The key question going forward is whether this Fed-induced sugar high will succeed in propelling real economic activity. If so, the expansion could shift into higher gear, gain traction, and become self-sustaining. If not, then just like a child who has overindulged in sweets over the holidays, there will be a letdown once the sugar high wears off.

Review of Last Year’s PredictionsWe find it helpful and sobering to reflect back on predictions made and strategies employed a year ago. Were we on target? Did we position assets appropriately and benefit our clients’ portfolios?

Prediction #1: We suggested the lowering of return expec-tations from a robust 2009, and put 50/50 odds on a swift and potentially harsh correction of 10%–20%. But we also said that a true bear market, one exceeding 20%, would not materialize.

So far, so good! As we had anticipated, the market did grind higher through the first quarter —higher, in fact, than we

thought likely. And a correction took place in the second quarter that was indeed swift and powerful. (To be honest, though, we did not anticipate May’s “flash crash” or any similar breakdown of market functioning). Many strate-gists shifted at that point—wrongly, as events would prove—to predicting another bear market and/or double-dip recession.

Much more importantly, our clients benefited from our views and actions at this turning point. We were well posi-tioned for the first-quarter rally, and reduced portfolio risk levels while market valuations were high. We also exploit-ed, to an appropriate degree, May’s turbulent conditions. Then the Fed’s radical change in policy, first signaled by Chairman Bernanke in August, fostered optimism about the economy’s near-term prospects. That in turn spurred a rally through year-end that lifted returns to very near the top of the range we had anticipated.

Prediction #2: The Search for Absolute ReturnsAnother part of our message in early 2010 was to empha-size absolute-return strategies as an essential part of a soundly constructed, well-diversified portfolio. In general, these strategies worked exceedingly well last year, generat-ing solid gains while greatly mitigating downside risk. With-out question their greatest benefit was to significantly low-er overall portfolio volatility. That proved invaluable during May’s “flash crash,” allowing us to be more comfortable about taking on more risk. Often the best offense for a portfolio begins by playing well-designed defense.

Prediction #3: It’s Time to Focus on Quality Whoops. Small-capitalization equities and other so-called “lower-quality” companies surprised by surging to the top of the pack—again— after the Fed shifted monetary policy in August. But all in all, our mis-timed prediction of leadership by higher-quality issues is a mistake we can live with, for several reasons. First, our higher-quality strategies produced handsome returns. Second, the steps we took as the Fed shifted policy proved generally successful. Notably, within fixed income we added exposure to certain credit-sensitive sectors, correctly anticipating that they would rally. Finally, in most cases our investment managers added significant value and bested their respective benchmarks.

Prediction #4: Don’t Forget the Big Themes — Physical Assets and Non-Dollar Assets, Particularly Emerging Markets

volatility, and create sustainable income. In this asset class we strongly favor holding some high-quality bonds as a core and then adding several highly flexible strategies that exploit unique pockets of value and opportunity: senior secured loans, corporate high yield instruments, and carefully vetted residential mortgage-backed securities.

We round out these core holdings in publicly traded equity and fixed-income securities with a range of alternative assets to complete the well-structured portfolio. Thus we design a “risk mitigation” basket to produce positive returns in any economic scenario with below-market volatility, and a “return enhancement” basket of private equity and real estate aimed at generating high compound-ed long-term returns, albeit with greater principal and liquidity risk. How these baskets are apportioned within a specific portfolio depends on the unique circumstances of each client.

Of course, it is not enough to construct a portfolio and then fall asleep. Markets are in a constant state of flux, and dislocations and volatility open windows for making profit-able tactical adjustments. These tactical changes are an important aspect of our process, and a source of substantial value-added.

Commercial Real Estate is Starting to Look Very AppealingFor some time we have been carefully scrutinizing the com-mercial real estate markets. For a variety of reasons, we believe that certain parts of these markets are becoming extremely attractive, and we are moving toward making changes in our portfolios to capture those opportunities.

This shift is based on many factors. To begin, we believe the odds for a more vigorous economic recovery—and greater inflation—have increased. Hence we are lifting allocations to inflation-friendly asset classes. To date, commodities have been the main beneficiary of greater inflationary expectations; indeed, our portfolios have been bolstered by exposure to thriving emerging countries that export raw materials. But later in the cycle of economic recovery and inflation, other hard assets such as commercial real estate move to the top of the charts.

Of course, it is important to be selective within the sector. High-visibility “trophy” properties are already well bid

In absolute terms, 2010 was a year of continued strength in these key long-term strategies. Physical assets (i.e. com-modities) continued to reward investors. Emerging mar-kets also garnered excellent results, although they did not crush the returns of U.S. markets as in the prior year.

2011 Outlook and Key StrategiesThe outlook for financial markets continues to be unusually uncertain, calling for an actively managed and broadly diversified portfolio.

Suffice it to say that we are in uncharted waters. Federal budget deficits are at record levels, with no viable plan to reduce or end them in sight. After two major packages of fiscal stimulus passed by Congress in the past couple of years, that source of fuel for the economy is played out, leaving the burden of future policy stimulus solely on the shoulders of the Fed. Though interest rates have nudged up in recent months, they remain at record lows, and the Fed has embarked on the unprecedented policy of explicitly attempting to raise the level of inflation. Fiscal deficits are an even more pressing issue for some European nations, and for certain U.S. states and localities, than for the U.S. at a federal level. Meanwhile, with inflation rising in China and parts of its economy looking frothy, that key engine of global growth may begin to sputter in 2011.

Such an unstable and uncertain set of economic conditions results in an equally uncertain and unusually wide range of potential market scenarios. That is not at all to say that each scenario is equally likely, or that we do not have strong opinions about which asset classes are most attractive. However, particularly in today’s environment, we think a rational and successful investor should hold a portfolio containing a broad array of assets. Our goal is to build port-folios that will perform well across a variety of economic conditions, from strong recovery to depression (even if we consider the latter to be unlikely). We regard such a port-folio as an “all-terrain vehicle.” While it may get bounced around, we want it to traverse any landscape.

To build this sturdy vehicle, we segment assets into buckets with a target for each bucket. A diverse set of equity assets should still be a core holding, with the primary objective of generating capital appreciation. Fixed-income assets should be added to protect against deflation, reduce portfolio

with rapidly falling capitalization rates. But great distress, and correspondingly great opportunity, reside in the tier just be-low. A wave of mortgage loans is now coming due and, as with housing, the debt on many commercial properties exceeds their current value. Meanwhile, employment remains soft, depressing rental rates.

These conditions create a strong incentive for current owners or debtholders to restructure and sell these assets. In many cases they can be purchased at a small fraction of replace-ment cost. Meanwhile, rents are stabilizing, and capitalization rates (the rough equivalent of a bond yield) are exceptionally attractive (see chart). Most importantly in terms of timing, we believe that employment growth, historically the most important factor in predicting future returns in this sector, is now finally turning the corner.

Commercial real estate has several qualities that make this asset group uniquely useful in building an all-terrain portfolio. For one thing, cash yields are very significant. Compared to the meager yields on high-grade bonds, in fact, cash flow from commercial properties can be substantially higher and quite stable. But completely unlike a bond, real estate can perform exceptionally well during times of high and rising inflation. Cash flow actually increases as rents begin to perk up, and property values climb as investors pay up for the increasing cashflow stream and appreciating replacement value of the hard asset.

Skilled execution is critical for success in this arena. Not all real-estate assets are equally attractive. In fact, we consider certain vehicles, such as publicly traded real-estate invest-ment trusts (REITs) to be substantially overvalued. Private partnerships are our preferred structure for investing in this asset category; the potential to compound returns is much greater, and we have some measure of control over the assets. Overall, we intend to follow a carefully scaled, disciplined, and selective process in adding commercial real estate to our clients’ all-terrain portfolios.

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Past performance is no guarantee of future results. Charts presented in this article are not indicative of the past or future performance of any Argent Wealth Management strategy. This article has been distributed for informational purposes only and is not a recommendation or offer of any particular security or investment strategy. Information contained herein has been obtained from sources believed to be reliable. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Argent Wealth Management.

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