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Despite a general sense of unease that has permeated much of the commentary about the global economy and the capital markets, the U.S. stock market has logged an impressive run from the lows in October to now. Clearly all the world’s problems and challenges remain unsolved, but the market seems to be largely ignoring them. Is this reasonable? The grizzled Wall Street veteran might respond to that with “Mr. Market is always right,” – that is to say that the market will do what it does regardless of what we think it should do or what we deem “reasonable.” Most investors would love to know the actual “why” to the market’s actions; most would gladly pay dearly for some “secret” insight as to how the market works, and more importantly where it is going. Something inside the human psyche craves knowledge and more especially hidden knowledge – something no one else knows that may unlock fortune, fame or the future. To many, Bernie Madoff seemed to have this gift, this secret way of making money in the markets. Alas, like so many purported magicians and soothsayers before him, he turned out to be a charlatan. Is there some kind of “Holy Grail” of investing that holds the key to consistent outperformance and the realization of all one’s capital market dreams? We will attempt to address this question after the review.

First Quarter Review
For the quarter, the S&P 500 rose 12%, following a similar return in the last three months of 2011. Not only did the market rise dramatically in the first quarter, but it moved upward in nearly a straight line without any significant pull backs. Volatility, which had been quite high in the middle of 2010, was not only low, but moved to the lowest levels seen over the last five years. Since the lows of last October, the market is higher by nearly 30%.

Whatever new fundamental developments that might have emerged in the first quarter seemed to matter little to the market. Europe continues its gradual slide into recession, although the Greek crisis seems to be on hold for now. A slowdown in China continues to be discussed in strategy conferences, but here too, the market cared little about these warnings. Gasoline prices are approaching the highs last seen in 2008, and yet they appear to have had only a limited impact on consumer spending and none on the stock market.

No, almost nothing seemed to matter to the stock market in the first quarter; it just moved higher. That said, there is little evidence that the market is meaningfully overbought or expensive. Despite the excellent showing of the market in recent months, retail investor enthusiasm for stocks (usually a pretty good contra-indicator) is quite muted. Retail investors appear to be shifting cash into bond funds more so than equity ones. Sentiment surveys suggest a slightly better mood among retail investors regarding the stock market, but the funds flow data do not suggest that retail investors have been big players in this rally.

Bond returns were modest for the quarter. Hints that the Federal Reserve may be unwilling to add further stimulus pushed up rates near the end of the quarter. Some economists are suggesting that U.S. Government bond yields are actually below the rate of current inflation. That is to say, real returns on these bonds may be zero or even negative. The backup in rates also underscored the negative price impact higher rates can have on bonds and more especially bond funds.

Here’s what the first quarter looked like by the numbers:

Index 1st Qtr 2012 Year to Date Trailing 12 Months
Dow Jones Industrial Average 8.7% 8.7% 9.6%
S&P 500 12.5% 12.5% 8.1%
NASDAQ 18.7% 18.7% 11.2%
Russell 2000 12.4% 12.4% -0.2%
MSCI EAFE 11.6% 11.6% -5.5%
MSCI EAFE Small Cap 16.2% 16.2% -4.6%
MSCI Emerging Markets 13.7% 13.7% -9.9%
Barclays Aggregate Bond 0.3% 0.3% 7.3%
Barclays Municipal Bond 1.2% 1.2% 11.7%
Dow Jones Commodities 0.2% 0.2% -17.6%

Philosopher’s Stone
To the ancient and medieval alchemist, the Philosopher’s Stone was the ultimate goal – a substance that could turn base metals (such as lead) into gold or silver. The alchemist viewed all matter as being comprised of four basic elements – fire, water, air, and earth. The transmuting of lead into gold could be accomplished by simply rearranging the elemental construction of the original metal. The agent of this change was the Philosopher’s Stone. According to legend, the 13th century scientist (and now Catholic Saint) Albertus Magnus discovered a real Philosopher’s Stone and actually passed it down to his pupil Thomas Aquinas. Where this magic gem now may be is lost in the mists of history.

It may be impossible to quantify the amount of time, effort and money spent on the search for this mythical token. We are led to wonder: if the efforts to find these alchemy secrets had been directed to other endeavors, might we have moved out of the dark ages a little faster? The entire quest of turning lead into gold missed one important economic fundamental – if one could make gold at will, would it continue to be of great value? Part of gold’s appeal is its scarcity (at least relative to iron or lead). The story of King Midas may be instructional here. When everything he touched turned to gold, he amassed huge amounts of the metal, but could not find happiness (and ultimately lost something most precious to him).

The application to the investment business is obvious. We would all like to find some gizmo, token or talisman that no one else has that would guarantee making money in the capital markets. And as preposterous as the existence of an investment Philosopher’s Stone may appear, we see advertisements daily hawking some kind of secret method for making money in the markets, available for a nominal fee. Logic would suggest that someone is buying these products in the hope of “making a killing” in the market. Better logic would suggest that on average, the buyers of these products are producing no better than average returns (ignoring the costs of the products.) There is no Philosopher’s Stone of investing.

El Dorado
As the Spanish conquistadors explored the New World, the legend of a lost city made of gold, “El Dorado,” began to spread. Here again, the amount of effort expended to find this unimaginable treasure is mind boggling. Many expeditions were launched with the express purpose of finding this mythical place. Some good came from these ventures – Fransico de Orellana was able to discover the Amazon River on one of these excursions, traversing the continent from Ecuador to the Atlantic Ocean. But for the most part, these trips resulted in disappointment, disease and death.

Yet, the mystery of this legend lived on for centuries, and even now in popular culture and entertainment (“National Treasure,” the Indiana Jones movies, etc.), the notion of a “city of gold” emerges now and again. The underlying attraction here is that we would like to believe that somewhere there must be something of great value hidden just waiting to be discovered.

In the capital markets too, many investors are drawn to the idea that there is some kind of mystical place (Goldman Sachs’ trading floor perhaps?) where the secrets of the investing universe can be found. We all know that the investment process is highly complex, and yet, there are some professional investors who always seem to know the right thing to do and the right time to do it. Alas, there is no city of gold for investors; the “secret” of investing cannot be discovered in a physical place. Further proof of this might be inferred by where Warren Buffett, arguably one of the best investors of all times, lives. Omaha is no El Dorado.

Cold Fusion
In more modern times, we see the quest for the amazing in the guise of cold fusion. As everyone knows, nuclear fusion is the process by which massive amounts of energy are created by the fusing of two hydrogen atoms. This combination also spins off subatomic particles which help other hydrogen atoms to combine. In a controlled fusion cycle, a great deal of energy is created using a very cheap fuel that is arguably the most abundant substance in the universe, and which, by the way, is available here on earth in seawater. Fusion power provides a higher amount of energy per unit of fuel than any other technology currently in use. On paper, fusion power looks like a fantastic way to generate energy. There is one catch, however; it works best (or maybe only) with temperatures around 15,000,000 K.

Thus, the ability to generate fusion power in a lower temperature environment would be a huge boon for our planet and would no doubt bring fame and fortune to those who could attain this knowledge. Despite a well-publicized experiment in the late 1980s, cold fusion has remained an elusive dream. Yet, because we can imagine it (and see it manifest daily by our sun), many still think we might get there some day.

The investment connection here is clear. Many people think that the “secret” to investing is having knowledge that no one else has. True, there is information that could easily lead to above-market returns. The Securities and Exchange Commission identifies this as “insider information” and has made it illegal to use in the investment process. Recent convictions have underscored the huge risk inherent in insider trading. Despite what some may suggest, there is no secret knowledge or legally-obtainable information that holds the “secret” to making money in the capital markets.

The Reality of Investing
The hard, cold truth about the investment process is that there is no secret tool, place or knowledge that will lead to outsized, risk-free, consistent gains. This simple fact is well documented by the best minds in the industry. Famous investors from Benjamin Graham to Bruce Berkowitz will tell you the same thing – it’s hard work, and not everyone is cut out for it. Like so many business endeavors, success in investing is a combination of knowledge, hard work, consistency and a bit of luck. This is not to say that it’s a random function; hard work applied consistently will usually lead to outperformance.

One of the fundamental fallacies of the “get rich quick” schemes we see frequently advertised can be explained by the concept of arbitrage. Assume that you have stumbled onto a trading relationship that seems to work very well. For example, you can make money in XYZ stock buy buying it when the price of gold moves upward through its 200-day moving average and then selling it when gold retraces 5%. You have observed this relationship and in your back testing can see that it works 90% of the time.

“Aha,” you may say, “I’ve discovered the secret to making money in the markets.” This is what everyone says whenever they find a correlation that seems to be a “sure thing.” Sometimes you can make money doing this; other times a person make turn this “secret” into one of those products hawked so aggressively in the media. In the long run, all of these correlations tend to break down.

For years, investors could make what looked like “easy money” by simply trading the price spread between the shares of General Electric and Westinghouse. Back then, these two companies were similar in size, product line and business models. The idea was simple – whenever the price difference between these two companies reached a certain level, one would simply sell (or even short) the more expensive one and buy the lower priced one. Eventually, the price pendulum would swing the other way, and one could reverse the trade, locking in some nice gains. Over time, this relationship broke down because General Electric began improving and changing in dramatic ways, while Westinghouse began a secular decline. This kind of “pair trade” still exists in the market, but the professionals know that these relationships do not last forever. The market is incredibly dynamic and ever changing; something that works today is not likely to work tomorrow. This is one key reason the investment business is so challenging.

So what is the “secret” to investing? In our view, the secret is that there is no secret, just as there is no secret to swinging a golf club, losing weight or being happy. To be a successful investor is to commit oneself to a life-long study of the markets, economics, company fundamentals, human behavior and a host of other sub-disciplines. Investing is one of the few worthwhile endeavors which some people think can be accomplished simply by reading a book about it. One would never attempt to fly an airplane or perform brain surgery simply by reading a book, but sensible people all the time think that they can invest just because they read a book about it.

This is probably the most important “secret” of the investment process: “don’t attempt to do this at home!”

The Outlook
We find it always useful to reiterate wise sayings from great investors. Sir John Templeton suggested that “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

In our assessment, we are clearly still in the “skepticism” phase of this bull market. The current bull market began three years ago amid the massive pessimism born of the global financial crisis. That we still see a great deal of skepticism despite the S&P 500 being up about 100% since then is very telling. People are still worried about the jobs market and housing market in the U.S, economic growth here and in Europe and the potential for a slowdown in China. Many of these worries have persisted throughout the bull market.

Using Sir John’s maxim as a guide, investors should actually be worried about only one thing – euphoria! Only when we see widespread happiness (the exact opposite of the widespread panic witnessed in 2009), should we begin to think about the end of the bull market. Our view right now is that this kind of euphoria is nowhere to be seen.

The current earnings reporting season may give us some clues to the future, but all indications suggest this will be another good quarter for corporate profits. Interest rates and inflation both remain low; another huge positive. Cash levels remain very high, and cash continues to flow freely at most companies.

We would note a couple of “technical” factors for the reader’s consideration. First, another famous saying, “Sell in May and go away,” has been the operative tactic over the past two years. We saw huge mid-year corrections in both 2010 and 2011. Will it happen again this year? This may be one unspoken fear out there keeping any bubbles of enthusiasm in check. The higher the expectation of a correction, the lower its chance of happening, in our view. Time will tell.

Second, everyone knows we are going to elect a new President in the U.S. this year. Many folks have analyzed the impact of presidential elections on the stock market, and, according to one study by Ken Fisher, the two best possible outcomes in an election year are either 1) re-electing a Democrat or 2) electing a Republican. We are willing to go out on a limb here and predict that one of those outcomes is very likely this year. This might be another factor in helping the stock market to close the year in positive territory.

Sincerely,

Wolf Group Capital Advisors