Written by Nathan White, Chief Investment Officer, Paragon Wealth Manage
Taken from Paragon’s 4Qtr 2011 print newsletter

After all was said and done 2011 was indicative of a bifurcated world of governments behaving badly while the private sector continued to grow.  The deflationary effects of winding down the credit bubble continue to be pitted against the inflationary moves of central banks.  Despite calls for a recession the U.S. economy continued to grow and add jobs at a mediocre pace.  The recovery continues but it is the slowest recovery post World War II.

We had a difficult year trying to balance safety and growth and therefore underperformed both of our benchmarks.  The primary reason for our underperformance was the market volatility.  Volatility makes timing the moves in and out of the market very tricky.  The large percentage moves up and down and lack of clear trends create a challenging environment.  The moves that we made to protect against the downside came at the expense of missing the very modest upside made in the equity markets last year. After all was said and done the bottom never completely fell out from under the markets and although hindsight is 20/20 there was no sure way at the time to know for certain that was not to be the case.  We focus on what the market is doing at the present rather than gambling on a future unknown forecast.    I think this was best exemplified by the view of Civil War General U.S. Grant of whom it was said “was not given to intensive speculation on possible future disasters, he preferred to meet them when they came, having long since discovered that few of them ever did.”  Over the long-run this strategy has been the most beneficial for us and we continue to hold to it.

Periods of low volatility (usually associated with positive returns) naturally follow periods of high volatility (usually associated with negative returns).  The recent environment has been highly volatile and people tend to always extrapolate recent events into the future.  Almost every investment outlook I have read for 2012 says that it will be like 2011! I hear a lot of things like “volatility is the new normal, markets will be stuck in a range, etc.  While I understand these views and agree with much of the logic there is no way to know for what will happen in 2012.  In fact, when everyone goes to the same side of the boat you often want to be on the other!

Managed Income  

We eschewed government bonds in 2011 and they ended up being the best performing asset class.  Obviously we were wrong.  However, our view is still the same and we find most government bonds unattractive.  People are trading short-term safety for long-term risk – not a wise move!  We believe that bonds are on their last gasp of good returns (exacerbated by the recent volatility) because as rates across the spectrum near zero there is significantly diminished opportunity for capital gains.  This portends lower future returns for bonds from this point as bond investors could now face the reverse of the past 30 years – capital losses offsetting their yields.  Today’s current rock bottom yields will exacerbate the initial pain as they offer virtually no return to protect against this reversal.  Add in some inflation and the pain gets even deeper.

We attempt to construct our Managed Income Portfolio as an inflation hedged portfolio that provides more conservative investors with the income and modest growth they need to maintain their standard of living over time.  Traditionally, government bonds have been a significant portion of the allocation for these kinds of investors but as I have been pointing out we feel at this point they offer low returns and high risk.  I do not view them as the risk-free asset that much of investment theory espouses.  Within our Managed Income portfolio we currently see the areas of opportunity with preferred stocks and high yield bonds still attractive on a relative basis.  We continue to favor corporate bonds over government bonds with maturities being of short to intermediate duration.  We also like dividend paying stocks as this area offers relatively attractive yields that can grow and are supported by strong corporate balance sheets.  Over time these dividend payers offer probably the best defense against inflation but even though they tend to be less volatile than the rest of the equity market they are not immune to the market’s swings.

Uncertainty cuts both ways  

Uncertainty creates both opportunities and risks and we therefore currently hold 10-15% cash positions to protect against the risks and take advantage of opportunities.  We continue to believe that this flexibility will pay-off but it has contributed to our near-term underperformance.  We are patiently waiting for a high conviction idea that we can really hang our hat on – a good trend (which tend to have the best risk/rewards payoffs).  It has not yet materialized but we are monitoring a few opportunities that look to have good potential.

One are of opportunity we are watching is Emerging Markets.  We have not had a significant exposure to this area for some time but we are seeing signs of opportunity.  Historically, Emerging Market valuations have run at a premium of around 15 to 20 percent above the S&P500 and right now they are at about a 15 to 20 percent discount.  With continuing favorable demographics and economic development we don’t think this condition will last.

To be certain there are still many concerns facing the markets and economy.  The first is still the continuing debt crisis in Europe.  There is still a great degree of uncertainty regarding the true magnitude of the problem and what the actual effects could be and how much is already priced in by the markets.  They seem to constantly be doing just enough to keep kicking the can down the road while they struggle to find a common solution.  It’s an ugly task that just keeps going back and forth.  In the end, self-preservation is a strong emotion and they won’t willingly drive themselves off a cliff.  At home we also still face continuing political uncertainty with the upcoming and election and its accompanying issues such as regulation, taxes, and spending.   However, good corporate profits and strengthening economic growth combined with overall lower valuations diminish the downside risks.  Our models are currently cautiously bullish with equities being the overall best place to be on a risk-adjusted basis.   While downside risks remain, if these pressures ease there is actually significant upside potential that could surprise many.

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Disclaimer

Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.