The domestic stock market rally that began early in the fourth quarter of last year continued, uninterrupted, in the first quarter of 2012. The S&P 500 showed increases in 11 of the 13 weeks in the quarter; and, it is now up 30% since bottoming on October 3, 2011. Unlike last year, when 40% of the year’s trading days saw moves of 1% (up or down) or more, so far this year we’ve only had 7 such days (12% of the trading days), and all but 1 of those were up days. The rally is attributable to continuing signs of economic improvement, the best six months of employment growth we’ve seen since 2007, strong corporate earnings, and an easing, at least temporarily, of the sovereign debt crisis in Europe. Overall, it resulted in the best first quarter for the domestic equity market since 1998.

In the fourth quarter of 2011 international equity markets significantly lagged the domestic equity market; however, in the first quarter of 2012 those markets mostly kept pace with the strong domestic equity market. Domestic large capitalization stocks, as measured by the S&P 500, returned 12.6%; small-cap stocks, as measured by the Russell 2000 Index, returned 12.4%, developed international stocks returned 11.0%, and emerging market stocks returned 14.0%. Bond investors didn’t fare as well during the quarter. Tax-exempt bonds returned 0.6%, investment grade taxable corporate bonds returned 3.0%, high yield corporate bonds returned 4.9%, international bonds returned 0.1%, and US Treasury bonds were the poorest performer, returning a negative 1.3%. It was definitely a “risk trade on” quarter in which riskier assets were rewarded with higher returns and most safe haven investments were punished. One of the best indicators of investor comfort level is the volatility index (VIX), commonly referred to as the “fear index”. It declined 33% in the quarter and is now down to levels we haven’t seen since before the financial crisis began in early 2007—investors once again appear to be fearless.

One of the things we noted in our fourth quarter 2011 market update was the poor relative performance of certain hybrid and non-traditional asset classes. Specifically, we identified convertible bonds, preferred stocks and senior bank loans as having provided disappointing returns in the fourth quarter, but as a result offering the best risk/reward characteristics entering the first quarter of 2012. Each of those asset classes rebounded nicely this past quarter. Convertible bonds and preferred stocks returned roughly 9% and our closed-end senior bank loan funds returned approximately 14%. Likewise, our decision in the fourth quarter to reduce exposure to energy infrastructure and increase exposure to real estate investment trusts paid off handsomely in the first quarter as our closed-end REIT funds were up 24% and the energy infrastructure fund we sold to invest in those REIT funds was up less than 2%. The investment world does appear to be moving back to some semblance of pre-financial crisis normalcy.

Despite our cautionary notes, our skepticism of the European “solution” to their sovereign debt crisis, and our general disdain toward the currently dysfunctional domestic political process, we strive to keep pace in strong up markets and significantly outperform in down markets.

One of the ways we do that is through a dynamic and continuous process of reallocating client assets to those asset classes that offer the best risk/reward characteristics at a point in time, and then seeking out the best mix of holdings within those asset classes. We break the investment world down into six primary sleeves: global equities, global fixed income, real assets (infrastructure, REITs, natural resources, precious metals, etc.), absolute return strategies (hedge funds and global allocation strategies), opportunistic strategies (non-traditional fixed income streams such as senior bank loans, convertible bonds, preferred stocks and other equity income strategies), and cash. Each of our portfolio allocation strategies outperformed appropriate market risk benchmarks in the first quarter primarily because each of the aforementioned sleeves outperformed its market benchmark. Said another way, even though client portfolios experienced less volatility (risk) than the market, they were able to outperform market benchmarks in a strong market due to our ability to find undervalued investments in each of our investment sleeves.

With the significant run-up in equity valuations over the past 6 months we remain cautious. As is usually the case, we can give twice as many reasons for the rally to end than we can for the rally to continue. The bullish arguments are: 1) corporate earnings are strong; 2) economic indicators continue to improve; 3) employment growth over the past six months has been the strongest we’ve seen in 5 years; 4) the Federal Reserve remains accommodative; and, 5) there remains a lot of money on the sideline (over the past three years there have been $250 billion of equity fund redemptions and $800 billion of bond fund subscriptions—the retail investor has not participated in this equity market rally). The bearish arguments are: 1) corporate earnings guidance has been lowered; 2) Europe is in a recession; 3) economic growth in China and India is slowing down dramatically; 4) trading volumes are down significantly, suggesting a lack of conviction; 5) the housing market still hasn’t bottomed; 6) $4 pump prices will have an adverse effect on domestic economic growth; 7) we are now 110% above the market lows and only 10% away from the all-time market highs—does anyone feel like this moribund economic environment warrants that level of euphoria?; 8) left unaddressed by Washington, income taxes will return to their pre-Bush tax cut levels at the end of the year; 9) Greece was only the first act in the European sovereign debt crisis play—stay tuned for acts 2-5 (Portugal, Ireland, Spain and Italy); and 10) Iran—anything short of a diplomatic solution, such as a pre-emptive Israeli attack or a nuclear armed Iranian state, could easily derail global economic growth and spook global equity investors.

While we love a good party—we dread the hangover that often follows. Thirty percent over the past 6 months and 110% over the past 3 years isn’t a good party—that’s a GREAT party; but, we’re a bit concerned the guests might be getting a little over-served. On balance, market conditions probably warrant a more defensive posture at this point. We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.

Jim Robinson, Partner, CEO & CIO

DISCLAIMER AND DISCLOSURE

Investment objectives are not projections of expected performance or guarantees of anticipated investment results. There can be no assurance that historical investment performance will be achieved in the future. Data provided herein has not been audited or verified by management and is subject to change. Index information is included merely to show the general trends in certain markets in the periods indicated and is not intended to imply that the funds managed by the manager will be similar to the indices in composition or element of risk. The indices are unmanaged, have no expenses and reflect reinvestment of dividends, interest and distributions. Index’s are provided for illustrative purposes only. Telemus Investment Management, LLC does not warrant the accuracy, adequacy, completeness, or timeliness of any information contained herein or derived from third parties. This document is for informational purposes only and should not be distributed.