April, 2011
By Darren Nyce
Senior Research Analyst, Castle Investment Advisors®, LLC

Managing your investment portfolio is like eating a chair.

While my colleagues are not quite ready to make that a tagline in our marketing brochure, there is a modicum of truth to this odd assertion.

The current book in my cd player (imagine reading that 30 years ago) is Robert Fulghum’s “What on Earth Have I Done?” In one portion he describes meeting a couple of college guys who were given the assignment by their philosophy professor to do something memorable and extraordinary, not dangerous or foolish, but something that would stretch their field of experience. They were then to write about what they learned and how it impacted their outlook on life. So these 2 guys, after consulting their doctor, set out to consume a wooden chair. They purchased an unfinished kitchen chair and proceeded to shave off thin pieces and then sprinkle the small crumbles on their breakfast granola and on their dinner salad.

So what were they learning? In addition to the fact that wood chips taste better when seasoned with cinnamon or lemon pepper, they grasped an understanding that even ambitious goals can be accomplished when you take incremental steps and apply great amounts of persistence.

The takeaway from this unique experiment can be applied to personal character development, relationships, parenting, and of course personal finance. Achieving investment goals requires a similar perseverance and a willingness to apply a step by step approach. We strive to put together a successful long term journey by taking a series of individual steps in the right direction, though many of the steps feel too small to make an impact, when compounded over time they add significant value.

While we remain focused on the long term, here is a market recap of the first quarter of 2011:

Index Q1 2011 1 year Return 3 Year Annualized Return 5 Year Annualized Return
S&P 500 5.92% 15.1% 2.35% 2.62%
Dow Jones Industrial Average 7.07% 16.51% 3.12% 4.87%
NASDAQ 4.83% 15.98% 6.86% 3.52%
Russell 2000 (Smaller Companies) 7.94% 25.79% 8.57% 3.35%
Barclays US Aggregate Bond 0.42% 5.12% 5.3% 6.03%

The market seems to have been driven this past quarter by companies continuing to produce positive earnings surprises and upbeat projections. The sector leader was the natural resources group, both domestically and internationally, powered by a 25% increase in the price of oil since November. Increased merger activity and improving economic data also spurred on the market’s rise, despite many global challenges. The S&P 500 has now produced a positive total return for 7 consecutive months. The last time the index was up 8 straight months was 6/01/06 to 1/31/07.

Other significant events of the quarter include:

  • Unrest boils over in several Arab countries leading to the fall of the Tunisian and Egyptian governments.
  • Japan suffered one of the worst natural and human disasters in history between its major earthquake, the tsunami, and the serious issues at the nuclear facility.
  • The U.S. government kept itself running by passing a series of continuing resolutions, while the politicians struggle to agree on an approved budget and deficit.
  • The Federal Reserve left interest rates unchanged and it recommitted itself to the completion of the $600 billion purchase of Treasury Securities, known as QE2, by June 30.

The economy seems to be staging a slow, steady recovery. A Wells Fargo economist said it this way:

“In the middle of 2009, we said that the economy was getting out of the emergency room and into the recovery area of the hospital. Using that metaphor now, one quarter into 2011, we’d have to say that the economy is out of the hospital and back at home. The patient is doing better but is not quite ready to resume normal activities.”

As is often the case, the data is sending mixed messages. On the bright side we see high corporate profits, increasing exports, and expanding manufacturing output. While on the other hand, rising food and energy prices, falling home prices, and persistently high (but apparently improving) unemployment indicate that we are not yet out of the woods.

As we prepare for the next round of earnings releases, we will be keeping an eye on the impact that rising fuel and other input costs have on companies’ profit margins. We hope to see firms continue to transition from relying on cost cutting to experiencing real revenue growth.

Profit margins have reached near record territory and we are expecting to see some compression in the coming quarters as they return closer to their historical norms. As Jeremy Grantham recently stated, “Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism.” The reason for this mean reversion is that companies earning high profits will attract additional competitors which will force the margins back to a more normal level. The result of lower margins will be lower P/E and other valuation ratios which is why several statistical models are predicting low real returns for the next couple of years.

The bond markets also saw gains this quarter as corporates continued to do well and municipals made a partial recovery from their fourth quarter 2010 sell off. We are interested to see how bonds react when the Fed’s quantitative easing program ends in June. Conventional wisdom says that this should result in a rise in yields, but we are wondering if it will be as pronounced as the consensus would indicate.

On the jobs front, the unemployment rate fell to 8.8%, which is a 1% drop since November; certainly trending in the right direction, but also still quite high. We would like to see the payrolls increase go hand in hand with increases in hours worked and wage income, but so far these gains have remained modest.

We certainly have a mixed bag of economic data that both encourages and concerns. We want to be able to participate in the upward movements of the stock market while doing what we can to defend against things like inflation, rising interest rates, a falling dollar, and the remote chance of another recession. Our philosophy continues to be that a well blended portfolio containing elements of bonds, equities, diversified assets, and tactical investments is the best approach to long term success.

In addition to our normal annual requirements to provide you certain disclosure documents, the SEC in July 2010 adopted amendments to form ADV and related rules. These amendments required a major rewrite of the disclosure “brochure.” Enclosed for your review is our updated version of the ADV Part 2A Brochure.

CIA may send information to clients and other parties electronically, being mindful of the requirement of keeping client information private as outlined within CIA’s Privacy Policy. At any time, clients can request the paper form of the same information. Please let us know if you do not want to receive communications electronically.

The Castle Investment Advisors®, LLC Investment Team

Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.