The turn of the calendar always brings hope, but uncertainty abounds heading into 2012. Of primary concern is the European situation and the potential for contagion that spreads beyond the means to prevent mass destruction of wealth and political systems. Defaults by either Italy or Spain or both would shake the global financial system and could push the world into recession and extended economic malaise. EU Finance ministers agreed in December to a framework for holding the European Union together, but the devil will be in the details and volatility will follow.

Outside of Europe, the geopolitical landscape is changing with the death of North Korea’s leader and tensions in many Middle Eastern countries are elevated. And the upcoming U.S. election encourages political gridlock. Uncertainty on many fronts will likely leave interest rates anchored at historically low levels and keep a lid on economic growth.

On the home front, economic indicators have moved higher suggesting the growth story is intact. The unemployment rate dropped to 8.6 percent, ISM service and manufacturing activity surveys ticked up, and retail sales for the holiday season were encouraging. While activity is far from robust, GDP growth of 2-3 percent in 2012 would be a welcome improvement.

Equity

2011 was a year equity investors will not soon forget and volatility was elevated due to geopolitical concerns on all fronts. Nevertheless, U.S. economic indicators made modest improvements and the stock market finished strong, with the S&P 500 Index closing the year up 2.1 percent. Consistent with investors favoring larger stocks over the last twelve months, the Dow Jones Industrial Average closed the year up 5.6 percent. Given the high volatility in the market, it is no surprise that the leading sectors for stocks were Utilities, Consumer Staples, and Healthcare. With healthy corporate earnings, inflation in check, and U.S. economic data improving, the equity market appears to be well positioned for further appreciation. However, investors are curbing their enthusiasm due to lingering risks at home and abroad.

As we move into the new year, global economic headwinds present a challenging environment for equity investors. Given the U.S. political environment, many investors are wondering if recent improvements in consumer and business confidence are sustainable. In Europe, leaders continue to their halting steps toward addressing sovereign debt problems. At this point, the main question on investors’ minds is, “Will these measures be implemented in time to avert a global economic slowdown?” And, slowing growth in emerging markets has also fueled caution among equity investors.

Nevertheless, the global economy is well positioned to deliver modest, but positive, growth. Inflation is in check and monetary policy remains very accommodative, enhancing corporate earnings prospects and consumer spending. Given attractive valuations, equities will likely be the asset class that benefits most when stronger signals of global economic improvement emerge.

Fixed Income

The fixed income markets have resembled a hurricane during the past few quarters with tremendous volatility and winds shifting directions without much warning. The biggest question that remains is if we are emerging from the storm or do we find ourselves in the uncomfortable calm of the eye? Only time will tell, but from our perspective it appears the sun is trying to emerge through the economic storm clouds.

Interest rates, as measured by the 10-year Treasury bond, moved within a broad range during the fourth quarter and ended very close to where they started at 1.9 percent. In fact, looking at interest rates across various bond maturities, the interest rate curve was little changed. For the year, interest rates experienced significant volatility while declining over 1.5 percent as measured by intermediate and longer maturity Treasury rates. This decline resulted in strong total returns for most fixed income securities in 2011.

Weathering the global storm will take some time given the magnitude of the issues, but the markets will eventually return their focus on the fundamentals that drive long-term performance for investors. We look forward to helping our clients successfully navigate through these challenging times into 2012 and beyond.

There is currently an interesting technical issue playing out in the corporate bond market resulting in “off-the-run” corporate bonds occasionally offering sizable additional spread when compared to “on-the-run” bonds from the same issuer with similar maturities. Once a new security is issued of a certain maturity, previously issued securities with similar maturities become “off-the-run” bonds. Because these are less frequently traded, they can be less expensive and carry a slightly greater yield.

This primarily comes from the fact that many total return or actively managed portfolios, during times of stress, gravitate toward recently issued and more liquid “on-the-run” bonds and sell out of “off-the-run” bonds. This drives spreads wider for the off-the-run bonds and offers some advantages for buyers who can take on a little less liquidity. This issue is currently magnified by the fact that many banks and broker/dealers have reduced their corporate bond holdings for risk reduction purposes and to respond to upcoming regulatory changes.

A key consideration is that “off-the-run” bonds are generally higher coupon bonds issued in higher yield environments (as opposed to our current ultra-low yield environment) and therefore carry higher dollar prices. With treasury yields bouncing near all time lows and bond dollar prices near highs, it can be difficult to take advantage of these and other corporate opportunities in the current environment.

However, by reassessing the dollar limits we are used to and the liquidity risk we are willing to take, we can buy shorter maturity bonds at attractive spread and yield levels. This option can help manage average duration and support client yield targets.

As we’ve mentioned before, the market volatility has been extraordinary the past few months, and with the lowered global growth prospects, we don’t anticipate an end to these conditions soon. The market reacts rashly on economic data, news out of Europe (particularly news about the failure of their leaders to act cohesively), and continued political partisanship in the U.S.

There are several potential results we could see over the next 12 months; however, these fall into three main categories: a 10-20 percent up move in the market, a flat to 10 percent up move, or a 10-20 percent down move in the market.

A large move upward could happen if economic policies result in stronger than expected growth, corporate profit expectations are met, and the European situation stabilizes. Fortunately for us, the U.S. market has not shown quite the drop that international markets have, and over 55 percent of the S&P 500 companies have a higher yield than that of the 10-year Treasury. Additionally, when better economic conditions arise, U.S. equities will likely be one of the first asset classes to benefit given that cautiousness will not leave the market overnight.

A large move downward would be likely if the U.S. enters a recession, Europe’s ills turn into a contagion, and corporate profit expectations are not met. While Europe is definitely a concern, we have seen hints of increased cooperation among leaders. Additionally, the Europeans have succeeded in reaching agreements that stave off contagion every time it’s been necessary. In the U.S., the typical signs of recession have not appeared, although the slower growth has certainly felt negative enough. We have not seen the large private sector payroll drops, accelerated inflation, or inventory increases that would signal a recessionary period.

The last option – and, probably the most likely one – is that the market remains flat to up 10 percent. The most likely case for the next twelve months is that the U.S. ekes out GDP growth of 1-2 percent, which will keep profits up, but not encourage enough hiring to meaningfully reduce unemployment. This case also assumes that Europe continues to muddle through their debt and cooperation issues.

While we urge caution, stock valuations are low, balance sheets are strong, and continued low interest rates support future earnings growth prospects. Also, equity market improvement will occur if favorable policies are enacted, well before demonstrable improvement in economic data. We continue to watch the situations in Europe and Washington closely and will revise our potential outcomes if we see meaningful change occur.

The small cap equity universe provides ample investment opportunities in every economic sector and industry. This universe also provides an information advantage for small cap managers with the skill and commitment to identify attractive investment opportunities. And, small cap stocks have had strong historical returns.

A Large and Diverse Investable Universe The small cap equity universe, consisting of stocks with a market capitalization of up to $2.5 billion, includes over 1,500 stocks, representing nearly 80 percent of all publicly traded U.S. companies. Also, the universe continues to expand through company spinoffs and initial public offerings, providing ample investment opportunities in every economic sector and industry.

Information Advantage While many investors gravitate toward large cap, better known stocks, the large size of the small cap universe leads to information inefficiency, offering a better chance for outperformance. Specifically, the dearth of professional investment research on small cap companies leads to an information advantage for investment managers with strong research capabilities and a commitment to finding the “hidden gems” before the crowd. On the whole, the information inefficiency in the small cap universe leads to greater potential value from active management.

Strong Growth and Appreciation Potential Higher earnings growth potential and greater flexibility in responding to changing market conditions are a few of the reasons that small cap stocks have outperformed mid and large cap stocks over the long term, through numerous economic and market cycles. Since July 1979, the Russell 2000 has appreciated by 8.9 percent annually, outpacing the S&P 500, which has appreciated by 8.1 percent annually. Over the last ten years, the Russell 2000 outperformed the S&P 500 by an average of 4.3 percent annually, including dividends. Despite the rally since 2009, we believe small cap stocks have room for further appreciation given their attractive valuation relative to earnings growth potential.

Critics may point out that small cap stocks exhibit higher volatility than large cap stocks. Although such an assertion is true, small caps have a low correlation to most asset classes, leading to the achievement of greater portfolio efficiency (greater return for a given level of risk) when added to many asset allocation strategies. Overall, the strong historical returns of small cap stocks underscore the importance of including them in a well diversified asset allocation strategy.

Past performance does not guarantee future results. The analysis above is subject to changes in economic and market conditions. Future results may vary. This does not constitute an asset allocation or investment recommendation. Investors should consider their investment objectives, risks and expenses carefully before investing. Investments are not FDIC insured and may lose value.

The U.S. downgrade by S&P had a direct and immediate impact on issues explicitly backed by Treasuries and agencies or leases from the federal government. However, the declining credit quality of the U.S. indirectly affects the credit of all municipal issuers that rely on federal transfers. Moody’s has placed five state outlooks on negative (MD, VA, SC, TN, NM), and more actions are likely over the next few weeks as the rating agencies continue their reviews.

State and local governments are preparing for reduced federal monies as a result of the cuts negotiated during the debt ceiling debates, and future cuts will happen through legislation or automatic reductions by the end of the year. Higher education entities can expect changes in student loan programs that reduce funding, and hospitals must adjust for lower Medicare and Medicaid reimbursements. The transportation, education and housing sectors represent some of the larger line items in the discretionary, non-defense portion of the package so the effect on these sectors will depend on the extent and timing of reductions ultimately enacted.

According to Barclays Capital, before the stimulus package states received approximately 28% of their general revenues from the federal government. The deficit reduction plan could represent a reduction of around 3% of revenues which would be meaningful but manageable. Positively, states have long been required to balance their budgets so they have been adjusting to declining federal support for a while. And they have recently begun to see increasing revenues which will help cushion the blow. Local municipalities get roughly 4% of their revenues from the federal government but another 33% from states. However, we expect the new austerity to be manageable for municipal issuers in general. And S&P has clearly stated that the U.S. sovereign credit rating is just one factor in rating a state or local government issuer.

Our conclusion is that the creditworthiness of municipal bonds in client portfolios will not be materially impacted by these austerity measures. We focus on credits with financial cushion and flexibility, and these entities have typically weathered this challenging environment by making difficult budget decisions to preserve their financial positions. While the pressure of lower federal funding is ongoing, we expect client muni portfolios to remain strong.

The recent market volatility has led many investors to question their equity and asset allocation strategies. While it is important to broadly diversify portfolios for the long-term, it is also important to require each piece of your equity allocation to do more to support your strategic goals than simply outperform a benchmark. One asset class capable of delivering added support during turbulent times is dividend paying stocks.

In particular, dividend paying stocks have outperformed non-dividend paying stocks over many market cycles.* And, companies that can pay dividends, and even more importantly, have the strength and operating transparency to increase their dividends, have historically shown more stability during volatile equity markets. In addition, dividend growers outperform during rising interest rate environments, which we are likely to face over the next few years.*

Since June 30, the equity market has declined in a necessary but fast and unpleasant pullback. Dividend paying stocks, and the Miles Capital All-Cap Equity Income Strategy, have performed significantly better than the broader equity market during this period. In addition, the All-Cap Equity Income Strategy currently has a 4.2 percent dividend yield, which compares favorably to other equity strategies, bonds, and Treasuries – the current yield on the 10-year Treasury is 2.1 percent. With interest rates expected to remain low for an extended period of time and higher than average market volatility likely to continue, dividend paying stocks are an attractive addition to a bond or equity portfolio.

*Source: Ned Davis Research. Further distribution prohibited without prior permission. All rights reserved. See NDR Disclaimer at www.ndr.com.

Past performance does not guarantee future results. This does not constitute an asset allocation or investment recommendation. Investors should consider their investment objectives, risks and expenses carefully before investing. Investments are not FDIC insured and may lose value.

The equity markets have been extremely volatile for the last two weeks, and we know that this leads to increased uncertainty. Economic data has been soft for some time, pointing toward tempered long-term growth prospects of 1-2 percent GDP in the U.S. and Europe. Additionally, concerns about housing, unemployment, outsized sovereign debt, and emerging market inflation have not abated. Given this picture, the 1st and 2nd quarter market gains were premature. Unfortunately, the market needs to adjust expectations for the long-term and now seems to be coming to terms with this.

In the short term, we expect to continue to see high market volatility. While 4 percent drops are concerning, they are not as uncommon as they once were. The fast pace of the information flow and increased selling of bundles of stocks due to the prevalence of various financial instruments have lead to increased market action. This does not mean we are headed for a recession or a market crisis. The high level of volatility and daily swings mask the sideways nature of today’s market, which is in line with lowered expectations for growth. In addition, we do not see inflated asset prices or weak company financials, which would increase our concerns.

During the 2nd quarter, we had concerns about the potential for a pullback as expectations for growth were adjusted downward. We repositioned our strategies with lower volatility names, and are therefore well positioned for a volatile-but-sideways market.

While the issue of the debt ceiling is not new, U.S. political leaders cannot reach an agreement on raising the debt ceiling which has raised the possibility of a downgrade for the U.S. Government’s AAA debt rating. Both S&P and Moody’s have placed the U.S. rating on review for possible downgrade (to AA) while they await a conclusion to the debate in Washington. We expect an eventual agreement to be reached to raise the debt ceiling and thus avoiding a default situation on U.S. obligations but the credibility of any long term deficit reduction plan could still leave the door open for a possible downgrade. U.S. government securities trading at anything other than its long standing AAA rating has some implications across various markets and investors.

Fixed Income
Although we don’t want to dismiss investor concerns about forced selling of U.S. Treasuries entirely, a review of the holders of Treasuries and their objectives indicates that few investors will be forced sellers of government securities if a downgrade occurs. While a downgrade would come with long term cost, we don’t anticipate that a large and quick reallocation away from Treasuries will occur. Treasuries should remain the most stable and the most liquid financial asset in the world.

Equity
A downgrade of U.S. debt to AA may push the stock market down 5 percent to 10 percent in the short term but not inhibit long term appreciation. The reasons for the downgrade are well known and partially accounted for by the equity market at the current levels.

Money Market
US money market funds come in many different forms but those governed under 2a-7 money market rules have no ratings trigger for U.S. government guaranteed securities so we wouldn’t expect these money funds to be forced sellers of Treasury holdings if a downgrade was to occur. Other short term financing instruments may be impacted by a downgrade but are beyond the scope of this brief.

After rising 5.4% in the first quarter, the S&P 500 Index dropping 0.4% during the second (leaving it up 5.0% for the year) as a result of growing economic concerns:

• Weak employment and housing reports;
• Renewed fears that Greece will default on its debt obligations;
• The end of the Federal Reserve’s quantitative easing program;
• Grid-lock in Washington about the U.S. debt ceiling and other issues;
• Uncertainty around whether or not emerging market economies, such as China, will continue to successfully rein in inflation.

In the short term, slowing growth in emerging markets and continuing sluggish growth in developed markets could lead to a modest market pullback and more volatility as investors calibrate their portfolios to better align them with expectations of slower global growth. However, we do not expect the U.S. or global economy to return to a recession.

While economic headwinds may limit the upside of the equity market through the remainder of this year, the market downside also appears to be limited due to the low interest rate environment and strong financial position of most large corporations.

Beyond 2011, we expect to gain more clarity on the economic situation in the U.S. and abroad. With greater clarity comes higher probability of stocks resuming their advance, although at a slower but more controlled pace.

It is a truism that financial institutions exist to lend funds to corporations and individuals. And simple mathematics dictate that over the long haul financial institutions must earn more from their clients than they pay for their own cost of capital or they would go out of business. Thus, over time one would expect securities of financial institutions to offer lower yields than those offered by non-financial corporations. However, events associated with The Great Recession have created a temporary reversal of this long-term norm.

The healing process for Financials is well underway and this has been expressed in the market place by gradual reversion of Financial spreads towards long term norms. The process has been choppy at times but re-regulation, an accommodative Federal Reserve, capital raising activities, and a moderate global recovery are all working together to shore up financial institution balance sheets and to restore confidence in the financial system. As of April 2011 the Financial fear premium has declined to 0.40% above Industrials.

The world has changed and we do not predict that Financials will trade as tightly inside Industrials as they did during the early 2000’s. But we do expect the fear premium to continue to compress and Financials will ultimately trade inside of Industrials. This expectation drives our overweight in the sector.

Weakness in consumer spending, housing, and employment led the equity market lower in May, with the S&P 500 Index declining 1.4 percent during the month. Despite the decline, the Index is still up 7.0 percent for the year as many investors remain optimistic about the long term prospects for the equity market. This sentiment is consistent with the expectations of many corporate management teams who expect earnings to continue to grow, particularly as a result of activity in emerging markets. However, a degree of caution is warranted as negative economic surprises could cause short-term pullbacks in the equity market as we move through the remainder of this year.

Given the ferocious debt ceiling debates, it seems everything is on the table (including tax reform) which increases the odds that any tax break for municipal bonds may go away. The Office of Management and Budget produces a list of “tax expenditures” which are benefits under the current tax code such as unemployment benefits or workers comp payments. The municipal bond tax exemption shows up on this list and the perception that it favors the wealthy puts that particular tax break in the limelight. However, the exemption is cheaper funding for municipalities, which is also important, and there is a limited benefit to eliminating this break ($143B over 10yrs) but that doesn’t mean it wouldn’t be part of a final solution.

Our view is that there is no good way to ballpark the odds on the tax break for munis being revoked, but it would certainly generate significant outcry from a vocal portion of the voting public. And it seems unlikely that current bonds would lose their exemption, more likely that future issuance is affected. Overall, we do not believe clients have to worry just yet.

U.S. housing data out earlier this week continued to disappoint. April housing starts of 523,000 were nearly 50,000 below expectations and new building permits were also a disappointment. Although a double dip in housing could occur, the drop would likely be shallow given that housing activity remains near all-time lows. One key to improvement is reduction in the “shadow” housing inventory, which consists of homes in foreclosure. However, such a reduction will take months, particularly if high unemployment persists.