On the surface, a favorable near-term outlook for the stock market may give the impression that things are fine, but a look beneath the surface reveals serious risks.

The interventionist Fed has created a distorted illusion of prosperity. As the Federal Reserve authorities rap on about QE1, QE2, et al., investors intuitively know something isn’t right about perpetual money printing. But it’s hard to believe, as rampant speculation in the stock market continues to expand. The bad stuff in the stock market is going up, and the good stuff is going down, or simply wallowing. To get any type of yield today, investors are being forced into longer-term, more price-sensitive bonds or into the foulest sectors of the stock market. It is an environment we have seen before and one that rarely ends well.

And although employment appears to be in a strong groove, unseasonably warm weather may have fueled much of the recent momentum. This winter was the fourth warmest since records began in 1895. Construction crews were out early and consumers hit the malls more frequently this winter.

During the employment deflation of 2008 and 2009, non-farm payrolls were shrinking by as much as 0.3%, 0.4%, 0.5%, and 0.6% per month. In just late 2008 and the first three quarters of 2009, over seven million jobs went down the tubes. Since the so-called economic rebound began, there has not been a single monthly employment uptick of 0.5% or 0.6%. Not one! In fact, there hasn’t been a 0.3% monthly uptick. The best monthly uptick in this pseudo economic rebound came back in May 2010 with one lonely 0.4% aberration, which was quickly neutralized with a downtick the very next month. The net-net here is a gain of 3.4 million jobs over the last two years versus a loss of 7.5 million jobs in the prior period outlined above. There have been only half as many job gains in today’s period of supposed economic strength as those lost at the end of the financial meltdown.

A bona fide sound economic recovery is underpinned by a non-interventionist Fed; a tax-cutting, budget-balancing administration; and associated strong gains in both the housing and employment sectors. Despite white-hot money creation, we have the most modest employment gains. And housing? Did you know that the gap between the median price for new homes and “old” homes is a whopping $76,000, and that difference is up a staggering 57% from 2010? The main culprit, of course, is a monster backlog of cheap, foreclosed old homes. Americans are simply packing up, putting the key in the door, and splitting, leaving banks around the country to choke on piles of upside-down mortgages. Check out the depressing downside momentum in our new home sales chart.

The end of the three-decade secular decline in interest rates also poses risk to investors. Our chart shows that, over the last five decades, there have been two secular swings in interest rates. Just two. Number three is likely on the way. Can you guess the direction? It’s a little hard to have a secular downswing off a zero base, is it not? The reality for interest rates may be a nasty stair-step run-up. A big increase in interest rates won’t have a positive impact on bond prices, home values, the economy, or the stock market. Investors not preparing for such an outcome could be making a costly mistake.

To navigate through the current environment successfully, we invest with a balanced approach. Our investment strategy is similar to the strategies used by two of our long-favored Vanguard Mutual Funds—Wellesley Income and Wellington. We don’t currently own the Wellington Fund; but it is the older of Vanguard’s two balanced funds, so it offers a greater perspective on the performance of a balanced strategy.

With a history that dates back to 1929, the Wellington Fund is one of the nation’s oldest and most successful mutual funds. Wellington has successfully navigated through eight decades of financial market turbulence, including the Great Depression, the stagflationary 1970s, and the more recent credit crisis. We attribute much of the fund’s investment success to its balanced portfolio. Wellington invests about 60% of its assets in mostly dividend-paying stocks and the remaining 40% in investment-grade bonds.

A balanced strategy reduces short-term volatility and tends to hold up better than a single asset-class portfolio in a wider variety of financial and economic climates. By example, since year-end 1999, the average annual return on the S&P 500 has been about 0.55% compared to 6.33% for Wellington. And from year-end 1972 through 1981, a tough period for bonds, Vanguard Wellington earned an average annual return of 4.61% compared to a 2.6% gain on Treasuries and a 5.2% gain on stocks.

Wellington will rarely be the best-performing fund in any given investment environment, but it will keep you in the game and allow the power of compound interest to work for you. From its 1929 inception, the Wellington fund has delivered a compound annual return of 8.18%—enough to turn a $5,000 initial investment into $3.4 million.

Though there are similarities between our investment strategy and the strategies pursued by the Vanguard Wellington and Wellesley funds, there are also important differences. Vanguard Wellesley and Wellington are both multi-billion-dollar mutual funds with strict investment mandates. On the stock side of the ledger, both funds are limited to large-capitalization U.S. stocks. And on the bond side of the portfolio, Wellesley and Wellington invest in intermediate-term investment-grade bonds.

We don’t limit our investment universe to U.S. stocks and medium-term investment-grade bonds. We invest where we see opportunities. We currently own both large-cap and small-cap stocks that are domiciled around the globe. We own shares in Brazilian utilities, Canadian oil companies, Swedish household products firms, and British tobacco companies. And if we find opportunities in other parts of the world, we are free to pursue them.

In bonds we place no restrictions on the maturity or credit ratings of the firms we can buy for you. We buy what we find most attractive for the current environment. Today we favor a mix of short-term corporate bonds, floating-rate loans, high-yield bonds, GNMA securities, and short-term Treasuries. But when the interest-rate cycle turns, and someday it will, we most likely will favor a different mix of fixed-income securities.

We also think it is crucial for investors to diversify beyond stocks and bonds. We invest in precious metals, foreign currencies, and natural resources. All three asset classes provide an additional layer of diversification to a portfolio of stocks and bonds. And in an inflationary environment, where both stocks and bonds tend to perform poorly, an allocation to hard assets and hard currencies helps offset the corrosive effect of inflation.  

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,

 Matthew A. Young
President and Chief Executive Officer

 P.S. We recently initiated a position in iShares Silver Trust. The iShares fund owns physical silver. Relative to gold, silver appears cheap. The higher the gold/silver ratio, the cheaper silver is. The historical gold/silver ratio has been about 15:1; today it is 53:1. Central banks do not own silver, which they could dump on the world market to depress prices. This is a big plus for silver. Silver trades at about $31/oz. We estimate that the structural low is about $10/oz. There conceivably is a significant downside risk. Our strategy is to slowly build a position in silver over the next few years, with the intention of buying at an average price well below $31/oz. We view silver and gold as insurance policies that we hope will never be needed.

P.P.S. “There’s now a healthy notion that people should be getting income from the stock market. Until the early 1980s, the U.S. stock market was an investment platform for which you were paid in cash. Over the past couple of decades it’s come off of that. But before that, older people remember buying stocks for their dividends. Now they’re doing that again, for the first time probably in three decades, and some ask if that’s a new paradigm. Well, it’s not a new paradigm. It’s actually a very old paradigm. It’s the original paradigm.” —Daniel Peris, Federated Investors.

P.P.P.S. Since 1989, Richard C. Young & Co., Ltd. has emphasized income-producing securities. In 2003, we developed our Retirement Compounders (RCs) program in response to an overall low-yield environment for both stocks and bonds. The RCs is a portfolio of 32 dividend- and income-paying equity securities. The globally diversified portfolio features familiar domestic names, including Kimberly Clark and Procter & Gamble, and lesser-known international companies, such as Canadian Oil Sands, Companhia Energetica de Minas Gerais (CEMIG), and Statoil. The yield on the RC portfolio is currently 4.8%.

P.P.P.P.S. Investors concerned with maximizing yield—or total return, for that matter—benefit by keeping an eye on expenses. Higher expenses eat into a portfolio’s cash flow.  We charge less than 1% annually to manage globally diversified custom portfolios. On the fund front, we do not invest in 12b-1 mutual funds, but we instead emphasize lower-expense Vanguard funds and exchange-traded funds.                 

   The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter

Monetary policy has been one of the most influential forces in financial markets over recent years. The Fed has shifted policy from the conventional (changing the fed funds rate) to the unconventional (money printing and communications). Unconventional policy maneuvers have proven to be a potent force in financial markets. This is especially true for the bond market, where Fed action has the most immediate and direct impact.

The Fed’s latest was announced earlier this year. In January, it pledged to hold short-term interest rates at 0% until late 2014—more than a year longer than the market had anticipated.

The surprise extension of the 0%-interest-rate policy pushed Treasury rates down across the maturity spectrum. Five-year T-note yields dipped as low as 0.75% in the days following the announcement—more than two percentage points below the rate of inflation. Yields on our favored high-quality short-term corporate bonds fell in sympathy with falling Treasury yields. The more upbeat tone of recent U.S. economic data has also helped push down high-quality corporate bond yields as investors demand less compensation for taking on credit risk. The yield on the Merrill Lynch 1-2 year AA-AAA index has dropped below 1%.

With yields of less than 1%, high-grade short corporates have become less appealing. To offset the lower yield, we are seeking areas of the lower-rated (BBB and below) corporate bond market. We have an especially favorable view of high-yield bonds. With a shortage of yield in the bond market and rising risk appetite, a 6-7% yield from high-yield debt looks attractive.

To gain exposure to high-yield bonds, we recently began purchasing SPDR Barclays High Yield Bond ETF (JNK). JNK offers exposure to a diversified basket of high-yield bonds in a liquid exchange-traded vehicle. The yield on the SPDR Barclays High Yield Bond ETF is currently 7%.

Most often we favor traditional bond mutual funds over bond exchange-traded funds (ETFs). Why? Bond ETFs have a tendency to trade at prices above or below net asset value (NAV). With the purchase of JNK, we are looking past the NAV issue because many of the traditional bond mutual funds we favor have stiff redemption fees that can remain in effect for up to a year. In today’s fast-moving and volatile markets, it is our view most bond ETFs provide a greater opportunity to maximize return in high-yield bonds than traditional bond funds.

In conjunction with the purchase of the SDPR High Yield ETF, we also added bond positions in Frontier Communications and Arcelor Mittal. Frontier Communications is the nation’s largest provider of communications services focused on rural America. The Frontier bonds we purchased are due in April of 2017 and they are rated Ba2/BB by Moody’s and S&P. The bonds were acquired at a yield to maturity of 7.74% in most portfolios.

Arcelor Mittal isn’t a household name, but it should be. Arcelor is the world’s leading steel production and mining outfit, with annual production capacity of 100 million tons. The company has 260,000 employees spread across 60 different countries. Arcelor is the leader in all major steel markets, including automotive, construction, household appliance, and packaging. In 2011, the company produced around 6% of the world’s steel. The Arcelor bonds we bought are due in February of 2017, and they are rated Baa3/BBB- by Moody’s and S&P. We purchased the bonds at a yield to maturity of about 4.5%.

Another recent addition to fixed-income portfolios is two-year U.S. Treasury zero-coupon bonds. We purchased two-year zeros partly to offset the additional credit risk we are taking with high-yield bonds.

Zeros are Treasury bonds that do not pay income. Instead they are issued at a discount to face value. By example, if an investor purchased a one-year zero with a 5% interest rate, he would pay $952.30. In one year, the bond would mature and the investor would receive $1,000—a 5% return (($1,000 – $952.30) / $952.30 = 5%).

Our zeros strategy is to maximize capital gains over an entire interest rate cycle. With rates currently flat, we favor short-maturity zeros. As the rate cycle evolves and yields rise, we anticipate moving out on the yield curve to longer, higher-yielding zeros that offer greater potential for capital gains.

For retired investors and those nearing retirement, we have long advocated a balanced approach to investing. Balanced portfolios tend to hold up better than single-asset-class portfolios in a variety of market climates. When writing about balanced portfolios, we usually discuss the benefits of adding bonds to an equity portfolio. But the current prolonged period of zero interest rates and the prospect of two and a half more years of the same provide the opportunity to focus on the benefits of owning equities. 

While an all-bond portfolio may experience lower volatility than a balanced portfolio, it suffers from greater inflation and income risk. In the current environment, with intermediate-term Treasuries yielding 1% and inflation running near 3%, an all-Treasury portfolio generates inadequate income and sacrifices purchasing power. Assuming a standard 4% withdrawal rate, the purchasing power of a Treasury-only portfolio yielding 1% would fall 6% per year (3% from taking more income than the portfolio generates and 3% from inflation). It wouldn’t take long to decimate the purchasing power of a portfolio at a 6% depletion rate.

Stocks, and more specifically dividend-paying stocks, can help offset the elevated income and longevity risks that a bond-only portfolio faces.

Dividend-paying stocks are the focus of our Retirement Compounders portfolios (RCs). With the RCs, our goal is to generate a sustainable and steady stream of income that keeps pace with inflation. We make no attempt to “beat the market.” Our objective is to build and protect capital and provide a stream of income during retirement.

After two vicious bear markets and a prolonged period of ultralow interest rates, many investors seem to be rediscovering the merits of dividends. Asset flows into dividend-focused funds have increased markedly in recent years. But many of the popular dividend funds buy only U.S. stocks, and often pay scant attention to maximizing portfolio yield. The Fidelity Strategic Dividend and Income Fund and the Vanguard Equity Income Fund come to mind as two relevant examples. Both funds claim to focus on generating dividend income, but the Fidelity fund yields only 2.68% and the Vanguard fund yields 2.16%—not much more than the 2% yield on the S&P 500. There are of course some dividend funds that seek to maximize yield, but here we find that too much emphasis is placed on yield and not enough on dividend growth.

With the RCs, we take a different approach. We craft globally diversified portfolios of  businesses we view as stable that sell essential goods and services in industries with high barriers to entry. We purchase exactly 32 positions to ensure discipline. And we favor companies with strong balance sheets or readily available access to capital. Most importantly, we buy only dividend-paying companies and strongly favor those with a history of consistent dividend increases. Today our RCs yield about 4.5%—more than double the current market yield—and the average five-year dividend growth rate of our portfolio companies is 4.5%. The combination of a high yield today and dividend growth tomorrow should be compelling for investors in or nearing retirement.

 Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,

Matthew A. Young
President and Chief Executive Officer

P.S. The Cato Institute’s Chris Edwards effectively argues that House Budget Committee Chairman Paul Ryan’s annual budget blueprint is hardly a slash, burn, and pillage of the government’s safety net. As a share of GDP, the Ryan budget would trim outlays from 23.4% this year to 19.8% by 2022. That reduction would simply bring spending back to around the normal historical level. And note that spending would still be higher than the 18.2% achieved in the last two years under President Clinton.

P.P.S. Last year, our favored consumer staples and utilities were the two best-performing sectors in the S&P 500. YTD, staples and utilities are out of favor as the more speculative sectors of the market head higher. Regardless of the shift, we continue to favor the defensive characteristics of consumer staples and utilities in the current environment.

P.P.P.S. The Fed has flooded world markets with excessive liquidity. In our view, interest rates are at manipulated and artificially low levels. Eventually, rates should revert back to more normal levels. They could even overshoot dramatically, causing disruption for long-bond holders, speculative equity investors, and the U.S. dollar.

 
We recently updated both Part 2A and Part 2B of our Form ADV as part of our annual filing with the SEC. This document provides information about the qualifications and business practices of Richard C. Young & Co., Ltd. If you would like a copy of the updated document, please contact us at (401) 849-2137 or cstack@younginvestments.com. No material changes have been  made since the document was last updated on March 31, 2011. A copy of that document was previously provided to you.

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.

Last year was an unpleasant year in global equity markets. Modest gains in the S&P 500 (+2%) masked steep declines in most equity markets throughout the world. Of the 23 developed equity markets, only two were up in 2011—the U.S. and New Zealand. Of the 21 markets that fell, 17 were down double digits, with a handful of those down more than 20%. Emerging equity markets fared even worse. Of the 25 emerging equity markets that Young Research tracks, only three finished the year in positive territory. Close to half of the world’s emerging stock markets fell more than 20% in 2011.

 But the dismal performance of the world’s equity markets in 2011 has been relieved by a powerful global stock market rally to start 2012. As of this writing, the S&P 500 is up 9% with many international markets rising even more. In U.S. dollar terms, the German stock market is up more than 20%, and Brazil’s equity market—one of last year’s worst-performing markets—is up an impressive 25%.

 The performance reversal in global equity markets is a testament to the virtues of taking a long-term approach to investing. Investors who abandoned losing positions during the worst of the market collapse last year most likely forfeited substantial gains this year. Of course, taking a long-term approach is easier said than done. This is especially true when volatility and uncertainty are elevated, as they have been over recent years. To remain confident and comfortable with a long-term approach, it is useful to know what you own and why you own it. This month’s letter takes a look at a few of our favorite investment themes and companies. Brazil has long been our favored emerging market economy. Our investment thesis on Brazil is focused on the country’s long-term potential. We believe Brazilian shares have strong secular tailwinds working in their favor. Brazil is a middle-income country moving rapidly toward developed market status. Economic growth in Brazil has outpaced growth in the developed world, and we see very little on the horizon that points to a change in this trend.After years of rapid inflation and economic instability, interest rates in Brazil are sky-high. But past mistakes have seemingly been taken to heart by Brazil’s policy makers.

Current leadership appears not to want a repeat of the hyper-inflation that plagued the country in decades past. As a result, we expect a long-term secular decline in Brazilian interest rates. Falling interest rates are often bullish for equities. During the 20-year secular decline in U.S. interest rates, the S&P 500 rose at a compound annual rate of 18%. Looking at the year ahead, we believe a more accommodative monetary policy, a recent credit-rating upgrade from Standard & Poor’s, and the suspension of a tax on foreign equity investments point toward further gains in Brazil’s stock market.

To gain Brazilian equity market exposure, we purchase both Brazilian ETFs and common stocks. We are currently buying two small-cap Brazilian ETFs. We buy Brazilian small-cap ETFs because they provide more direct exposure to Brazil’s domestic economy than large-caps. Our largest Brazilian common stock position is Cia Energética de Minas Gerais (CEMIG). CEMIG is Brazil’s third-largest energy generation and transmission group and the largest energy distribution group in Brazil. CEMIG controls 65 generation plants, 59 of which generate electricity from the most economically viable renewable energy source—hydroelectric power. CEMIG has total generating capacity of 6,925 gigawatts. In our view, CEMIG also has strong growth prospects for a utility. Over the last five years, electricity consumption in Brazil has risen at a 5% compound annual rate. CEMIG shares currently yield 5% and offer the prospect of moderate long-term growth.

Like CEMIG, Canadian-based Brookfield Renewable Power is a big hydroelectric power producer. In our view, hydroelectric power producers have appeal to long-term investors. Hydroelectric power plants are a low-cost renewable source of energy. Hydro plants have long lives, low maintenance requirements, strong reliability, and no high-heat combustion to wear down equipment. Brookfield Renewable Energy recently completed a merger with Brookfield Renewable Inc.—a related company. The combined companies offer investors strong long-term dividend growth prospects. The new Brookfield is one of the world’s largest publicly traded, pure-play renewable power platforms. Its primarily hydroelectric-generation portfolio includes 170 hydropower facilities and five wind farms, and totals approximately 4,800 MW of installed capacity, including projects under construction. Its portfolio is diversified across 67 river systems and 10 power markets in Canada, the United States, and Brazil, and generates enough electricity from renewable resources on average to power two million homes annually. With a fully contracted portfolio of high-quality assets and a significant pipeline of projects and growth opportunities, the business is positioned to generate stable, long-term cash flows, supporting regular and growing cash distributions to investors. Brookfield Renewable shares currently yield 5%.

We also favor Statoil (STO). Statoil was formed by Norway in 1972 to exploit the massive reserves of oil and gas on the Norwegian continental shelf. After going public in 2001, Statoil has grown to be one of the world’s largest energy companies, with a market capitalization of over $84 billion. Today, Statoil is the second-largest natural gas supplier in Europe and the world’s sixth-largest. Statoil is also a world leader in subsea technologies, with the largest number of subsea wells at ocean depths lower than 100 meters. Statoil shares yield 4.25%.

Statoil is one of a handful of European stocks that we own—none of which are based in the euro-area and all of which are multinational companies. While the European Central Bank has stabilized the euro-area debt crisis by dumping massive amounts of liquidity into the financial system, risks remain. As we have long maintained, liquidity is not the underlying problem in the euro area. The liquidity crisis last year in Europe was a symptom of solvency concerns, which were in turn caused by the currency union’s flawed design. Varying levels of competitiveness between countries that share the euro are the underlying cause of the region’s problems. Competiveness is not something that can be easily improved. Consequently, we continue to view the euro area cautiously and, for now, we are still avoiding euro-area stocks.

We are, however, investing in non-euro-area Europe. Switzerland remains one of our largest European positions. We recently made some adjustments to our client’s Swiss holdings including the sale of our remaining position in the Swiss franc. Several months ago the Swiss National Bank (Switzerland’s central bank) made a decision to peg the franc to the euro. While the peg may be removed at some point in the future, until it is, a position in the franc is effectively a position in the euro.

We also initiated a position in Swiss-based ABB. Tracing its roots back to 1883, ABB provides power and automation technologies to utility and industry customers worldwide. ABB invented and pioneered many power and automation technologies. In 1952, ABB built the world’s first high-voltage direct current (HVDC) power connection to increase the efficiency of electricity transmission. In the 1990s, the company introduced HVDC for underground transmission. ABB’s portfolio of products ranges from light switches to robots for painting cars to electrical transformers and control systems that manage entire power networks and factories.

ABB’s end markets offer attractive long-term growth prospects. Growing emerging market demand for electricity, widespread government support for energy efficiency, and an aging electricity infrastructure in developed markets point toward consistent long-term demand for ABB’s products and services.

Emerging markets, the source of almost 50% of ABB’s orders, are projected to double electricity demand by 2030 and triple it by 2050. As incomes grow in emerging markets, more people move to cities and towns, driving up the demand for electricity. According to Goldman Sachs, a 1% increase in the number of people living in cities leads to a 1.8% increase in demand for electricity. And a 1% rise in income per head leads to a 0.5% increase in demand. Urbanization rates and per capita income in many of the largest emerging markets are only a fraction of what they are in the U.S. The potential here is enormous. Our chart, titled Electricity Demand, shows the projected demand for electricity in OECD (developed) markets versus non-OECD (emerging) markets. ABB shares pay an estimated yield of almost 4%.

Another European market we favor is Sweden. In many portfolios we recently purchased a position in iShares Sweden. What do we like about Sweden? Among other factors, Sweden is the world’s third most competitive nation, a neutral country, and a true AAA credit with a government debt to GDP ratio of about 30% compared to over 100% in the U.S. Some of the top holdings in iShares Sweden are Hennes & Maurtiz, Ericsson, Volvo, and Svenska Cellulosa (SCA).

Two other companies domiciled in non-euro Europe that we have added to portfolios are Vodafone and British American Tobacco. Vodafone is one of the world’s leading diversified telecommunications operators. The company is one of the largest carriers of mobile voice traffic in the world, serving more than 370 million customers in 60 different countries. Vodafone has a significant presence in Europe, the Middle East, Africa, Asia Pacific, and the United States through its 45% ownership interest in Verizon Wireless. Vodafone is positioned comparatively well among telecommunication companies (especially U.S. telecoms) to thrive, as the transition from fixed line to mobile voice and data continues. Did you know that mobile calls now account for 82% of all calls made globally? Vodafone’s fixed line business accounts for only 8% of revenue. The remainder of the firm’s revenue comes from mobile voice (64%), messaging (12%), data (12%), and other sources (4%). Industry-wide, about 40% of revenue comes from fixed-line services.

There are opportunities for Vodafone to increase revenue in developed markets. In Europe only 22% of Vodafone’s subscribers have smart phones compared to 40% in the U.S. The proliferation of tablets, and mobile broadband sticks, along with expanding 4G networks that offer download speeds comparable to cable, present compelling opportunities for Vodafone’s data business.

Mobile data is the fastest-growing part of the wireless industry. Industry-wide, data now accounts for 13% of revenue, up from 3% in 2006. By 2014, data is expected to account for 21% of revenue. In 2010 Vodafone’s mobile data revenue rose 26.4%. Based on dividend estimates for 2012, Vodafone shares yield a compelling 7.7%. What’s more, the board of directors has a medium-term dividend growth target of 7%. With a 7.7% yield and the prospect of meaningful dividend hikes in the future, what’s not to like?

The high level of regulation and taxation in the tobacco industry, as well as stagnant demand and litigation risk create high barriers to entry. The high barriers to entry give existing firms pricing power and allow them to remain unusually profitable. British American Tobacco is no exception. British American Tobacco, founded in 1902, today is one of the world’s largest tobacco companies. The company generates billions in free cash flow, with much of that cash flow coming back to shareholders in the form of dividends. British American targets a dividend payout ratio of 65%. The dividend has been increased every year since 1998 and over the last five years dividend growth has averaged 19.5%. Today, the shares yield 3.8%.

The performance of last year’s global equity markets offers investors at least two important reminders. Number one, it can pay to be patient. Many of the global equity markets that were down last year have enjoyed a nice rebound in 2012. Regardless of share price, investors can take comfort knowing they are receiving a consistent dividend payment when investing in the Vodafone and British American Tobaccos of the world. Number two is the continued degree of volatility in the global markets. We do not view this year’s stock market rally as anything but a respite from the many risks that continue to exist. We see problems ahead in terms of inflation, dramatically higher interest rates, dollar debasement, and market declines.

Our strategy with the purchase of equities continues to focus on what we believe to be big, durable, and lasting businesses. We invest in businesses with the potential to ride out economic downturns, distribute dividends, and raise those dividends annually. Ideally, these companies have strong balance sheets, pricing power, and operate in industries with high barriers to entry.

To complement the equities portfolio, we also favor bonds, gold, and foreign currencies. We appreciate the lack of enthusiasm investors have toward today’s bond yields. We are also frustrated with the Fed’s continued policy for a low-yield environment. But, bonds offer important diversification away from the stock market, helping to reduce portfolio volatility. Our bond portfolio tends to focus on shorter-term corporate bonds, which should limit volatility during a rising rate environment. We initiated our gold position in 2005 due to concerns about a declining U.S. dollar. As long we have dollar concerns, I expect us to maintain our gold and foreign currency positions.

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,
Matthew A. Young
President and Chief Executive Officer

P.S. Kimberly-Clark (KMB) has been in business for 140 years. Today nearly one-quarter of the world’s population buys KMB products each day including Kleenex, Scott, and Huggies. On February 28, KMB raised its dividend by 5.7%–the 40th consecutive increase. With a 4.1% yield and a consistent record of dividend increases, KMB is an ideal stock for our dividend-paying equity portfolio. Not as well known to most Americans is Sweden’s Svenska Cellulosa (SCA). We view SCA as the Kimberly-Clark of Europe. The company develops, produces, and markets personal care products, tissue, packaging, and forest products. SCA is the worldwide leader in incontinence care, the Nordic region’s leading diaper supplier (with 60% market share), Europe’s second-largest producer of corrugated board and containerboard, and one of the largest producers of corrugated board in China. SCA is also Europe’s largest private forest landowner with 6.4 million acres of forest. SCA is a basic consumer products company with valuable timber assets, and a strong balance sheet, trading at 12.5X earnings and paying an almost 4% dividend yield. What’s more, SCA has increased its dividend in 14 of the last 16 years. Over the last 10 years, dividends have compounded at an annual rate of 4.5%.

P.P.S. Next month I’ll preview some strategy adjustments we are making to fixed-income portfolios. In a yield-starved environment with economic data currently improving, the high-yield bond sector may offer areas of opportunity.

P.P.P.S. With the Federal Reserve pumping trillions of dollars into a global monetary system already soaked with liquidity, inflation is and will continue to be the result. For retired and soon-to-be-retired investors, the future inflation outlook should be alarming. Inflation is a destroyer of wealth—it’s compound interest in reverse. Owning commodities and hard assets that increase in value along with inflation may help. Owning stuff that’s in the ground can protect investors from a loss of purchasing power. As mentioned in this letter, Brazil and Canada are two countries we favor due to their wealth of natural resources.

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.

During the last five months of 2011, wild gyrations became common in the equity markets. The S&P 500 plunged almost 13% in early August, and then rallied over 8% to close the month, only to fall another 10% in September. Then in October, stocks rose a remarkable 17% from trough to peak. The spectacular rallies and corrections continued in November with the S&P 500 falling 7.5% and then rising an equal amount in the span of four trading days.

While this period of heightened stock-market volatility has been particularly acute, elevated volatility has been with us since the financial crisis began. There are many ways to measure stock-market volatility. Some investors prefer to look at the VIX Index, which uses put options to measure the implied level of volatility in the market. A more intuitive measure is the percentage of trading days the S&P 500 moved by more than 2%. Since the financial crisis began in late 2007, the percentage of days when the S&P gained or lost more than 2% has been almost five times the post–World War II average. In 2011, approximately 14% of trading days resulted in a 2% or greater move in the index. And for the final three months of 2011, the figure was a Depression-era 32%.

Why have markets been so volatile? There are many possible explanations. But in our view, the primary driver is the ongoing tension between a global economy trying to cure structural imbalances and actions by policy makers intended to prevent or slow this corrective process.

In past letters, I have discussed the structural headwinds the world’s largest economies face over coming years. The sources of these headwinds are many and varied, but a common thread across the world’s largest economies is the misallocation of capital.

When capital is misallocated, either by force or by monetary persuasion, an unsustainable boom is created, which inevitably leads to a painful bust. The real-estate bubble is the most recent example of capital misallocation in the U.S. Years of easy money, low interest rates, and a central bank focused on levitating asset markets contributed to an atmosphere of excessive risk taking by lenders, borrowers, and investors. Lenders made no- and low-documentation loans to folk with no ability, or in some cases willingness, to repay those loans. Investors and borrowers essentially made leveraged bets on home prices, using leverage of as much as 33 to 1. The underlying assumption of all market participants was that the downside risk was limited. If home prices started to drop or the economy slowed, the Fed would flood the system with liquidity.

When the housing bubble finally burst, the Federal Reserve did indeed flood the system with liquidity, but the damage was too great for Fed Chairman Ben Bernanke to contain. Some of the nation’s largest lenders collapsed, speculators were crushed, and foreclosures surged. Home prices are down more than 30% from their peak. Home equity has evaporated for some and collapsed for many more. According to Core Logic, 22% of all properties with a mortgage are underwater, and an additional 5% have an equity cushion of less than 5%.

The market is still correcting the widespread misallocation of capital built up over a decade or more. Market participants are searching for a bottom in housing and consumption and the stock market, but policy makers are doing everything in their power to prevent or delay this inevitable result. Despite the failings and risks presented by the Federal Reserve’s unconventional monetary policy, Mr. Bernanke presses on.

In the 38 months that have passed since Lehman Brothers failed, the Fed has been on hold (not easing or threatening to ease) in only six of those months. The Fed’s liquidity injections haven’t helped the labor market or prevented housing prices from falling.                  

But they have distorted financial markets, increased volatility, decimated the income of many retired investors, and created a dangerous dependency on 0% interest rates.

In the aforementioned six months that the Fed has been on hold, the average stock-market return was -2.02%, with only two out of the six months resulting in gains. This is a policy-driven market. When the Fed stops supporting asset prices, risk falls out of favor. When the Fed injects liquidity, investors bid up the prices of risky assets. This risk-on, risk-off environment has created a great deal of volatility.

But the policy-driven market is not limited to the United States. Financial markets have reacted violently to every statement and rumor about a possible solution to the euro-area debt crisis. As in the U.S., economic forces in the euro area are trying to right years’ worth of capital misallocation, and policy makers are trying to prevent or slow the process.

The euro experiment created a common currency and monetary policy for a diverse group of countries, but left each country to run its own fiscal policy. Profligate spenders such as Greece and Italy were able to borrow at Germany’s much lower interest rates. The euro area’s peripheral countries temporarily “papered over” the deficit in their competitiveness with Germany by going on a borrowing binge. In Spain and Ireland, too much capital was invested in real estate, and bubbles resulted. In Greece and Italy, government largesse was the result. Historically, countries such as Italy and Greece could improve competitiveness via inflation and currency devaluation, but now they are tied to the euro, those channels are closed. In a fixed-currency regime, the only way to improve long-term competitiveness is through politically intolerable wage and price deflation. But with debt levels now at unsustainable levels, the jig is up for the euro area’s periphery. Debt defaults, fiscal union, and painful wage deflation are the remedy to create a sustainable currency union, but these solutions are easier said than done.

In financial markets, the euro-area policy makers’ attempts to prevent a collapse of the common currency have caused elevated volatility. When rumors that a lasting solution to the debt crisis emerge, risky assets rally, but when those rumors are squashed, risky assets tumble.

High-frequency trading has also heightened volatility in the stock market over recent years. U.S. equity markets have changed drastically over the last 5–10 years. Gone are the days when the NYSE and its specialists dominated stock-market trading. Today, as many as 50 different venues in the U.S. trade equities. Now, almost all stock trades are done electronically. The NYSE specialists who were once obligated to make an orderly market during periods of market stress have been effectively replaced by high-frequency trading firms (HFTs).

HFTs are opportunistic traders that operate with little capital, hold small inventory positions, and are under no obligation to make an orderly market during periods of stress. These firms use sophisticated ultrahigh-speed programs to predict stock prices milliseconds into the future. The most successful HFTs are not the firms with the best insights into a company but those with the fastest programs, located closest to the exchange’s servers. HFTs don’t use fundamental analysis to make trading decisions. Instead these firms use information in order books, past stock returns, cross-stock correlations, and cross-asset correlation to make decisions.

While some might believe HFTs are benign market participants, just the opposite is true. High-frequency trading now accounts for 70% of U.S. stock-market volume—an astonishing statistic, to be sure. The purpose of financial markets is to efficiently allocate capital to its highest and best use, yet a majority of the daily trading in stocks is conducted by investors with no interest in the value of the companies they buy and sell. HFTs are interested only in the price of a stock over the next second or two.

HFT proponents will tell you high-frequency trading poses no risk to the broader market, and in fact increases liquidity and keeps transaction costs low. The counterargument is that HFT liquidity is transitory and shallow (large orders are hard to fill), and while HFTs have helped drive down bid-ask spreads on stocks, they are extracting those profits from investors in other ways (some of the strategies are discussed later).

Because HFTs are not under the same obligation as NYSE specialists to provide liquidity, they often pull back from the market during periods of stress, creating a liquidity vacuum, which can result in cascading prices. The so-called “Flash Crash” in 2010 was partly caused by several major HFTs stepping away from the market in order to limit risk. Here is what a joint CFTC-SEC report on the Flash Crash said about the structure of today’s stock market.

The Committee believes that the September 30, 2010 Report of the CFTC and SEC Staffs to our              Committee provides an excellent picture into the new dynamics of the electronic markets that now characterize trading in equity and related exchange traded derivatives. While these changes have increased competition and reduced transaction costs, they have also created market structure fragility in highly volatile periods. In the present environment, where high frequency and algorithmic trading predominate and where exchange competition has essentially eliminated rule-based market maker obligations, liquidity problems are an inherent difficulty that must be addressed. Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders. Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment.

More troubling than the transitory liquidity HFTs provide are some of the dubious strategies employed by these firms. Below are some examples of the strategies used by various HFTs—most are illegal but difficult for regulators to detect.

Front-running – Using computer algorithms to detect and trade ahead of institutional orders.

Quote stuffing – Submitting and then immediately cancelling trades in order to gain a few-  millisecond speed advantage over the competition. The computers of the HFT who submits the erroneous orders don’t have to process that information, whereas the competitors’ computers do.

Layering – Using hidden orders on one side of a trade and visible orders on another side of the trade to manipulate prices. For example, if a trader wants to buy a stock at $5.01, but the current bid is $5.02 and the asking price is $5.03, the HFT may put in an order that is hidden to buy at $5.01. It will then flood the market with orders to sell at a price higher than the current asking price, let’s say $5.05. Others will see the selling pressure and adjust their bid and ask prices lower, likely hitting the HFTs intended bid price of $5.01.

Spoofing – A trader may initiate the rapid-fire submission and cancellation of many orders, along with the execution of some trades to “spoof” the algorithms of other traders into buying or selling more aggressively, which can exacerbate market moves.

 My goal is not to suggest all high-frequency traders are unscrupulous or the practice should be banned (though I suspect few would actually miss it). But it seems to me high-frequency trading has become so vital to the proper functioning of today’s stock market that, at the very least, more oversight and disclosure should be required of these firms.

Even with the structural imbalances in the global economy and the potential for elevated volatility from high-frequency trading, we believe stocks could have a positive year in 2012. First, in the current low-interest-rate environment, many investors feel there is greater upside potential from stocks versus bonds. A bias toward stocks could help elevate share prices. Additionally, stocks tend to favor U.S. presidential election years. The election-year argument didn’t work out so well last time around, but in 2008 markets were in a bubble due to excessive leverage.

Even with the potential for a decent year in stocks, we do not favor abandoning our strategy for a globally diversified portfolio that includes corporate bonds. Short-term corporate bonds, which we currently favor, can greatly reduce volatility if misfortune or an unlikely event makes an appearance in 2012. Risks including the euro mess, the Middle East, and a less-than-robust U.S. economy are potential triggers for widespread market disruptions.

As most of us are all too aware, the stock market is an emotional and volatile place. Diversification is not about maximizing returns. Diversification is about reducing risk. A portfolio invested, by example, 50% in corporate bonds, 40% stocks, and 10% in gold and currencies should have much less downside volatility than a portfolio invested primarily in stocks.

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,

Matthew A. Young
President and Chief Executive Officer

P.S. The homepage of Younginvestments.com reads “Dividends and Interest. Cash Flow Is Our Focus.” For 2012, we continue to believe conservative retired and soon-to-be-retired investors are well advised to concentrate on the dividends and interest theme. A continuous stream of cash should provide comfort in an environment where stock volatility could remain high.

P.P.S. “Dividends are a bonus in up markets and provide comfort during slides. Over time, dividends have provided about 44% of the U.S. stock market’s annualized total return of 10%. And they are sure to remain an important component of returns if appreciation is hard to come by in coming years, as we expect. Thanks to dividends, you can make money even if the market essentially goes nowhere.” Kiplinger’s Personal Finance, January 2012

P.P.P.S. The fact that a company pays a dividend is only one criterion in our stock selection process. Beyond a cash payment, we seek high-quality companies, dominant in their industry, with high barriers to entry, strong balance sheets (in our opinion) and a manageable payout ratio. We believe that limiting our purchases to this type of company will allow our clients to sleep better at night and appreciate a continuous stream of cash payments during what should be an eventful 2012. The yield on our Retirement Compounders equity program is 5.1%.*

*Yield as of 1/23/2012

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.