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Second Quarter 2010 Quarterly Newsletter

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A Fool and His Money Are Soon Parted (Hers Too)

We're not quietly intimating that investors who buy stocks based on research reports are foolish. Rather, we are emphatically shouting it from the rooftops. You may remember that after the high tech stock craze of the late 1990's, and their subsequent huge crash in the early 2000's, the SEC handed out some huge fines and reached settlement with ten Wall Street firms. These firms agreed that they would separate their investment banking business from their research departments.

Why the separation? The SEC noticed that when a public company hired a Wall Street firm to raise capital, that firm's research department just happened to overwhelmingly recommend that their retail customers buy that stock. It gets worse. Evidence then came to light that a certain firm's research staff actually made in-house jokes about how poor the buy-rated company's financials really were. This finally got the SEC into gear. That's when Wall Street's dirty little secret came to light: research departments usually recommended that their banking clients' stock be purchased -- regardless of actual merit.

Since 2003, the research departments of Wall Street's largest firms have been totally separated from their investment banking counterparts. Consequently, one would think that the problem of faulty research recommendations might finally be cured. Well, unfortunately, that has not been the case. In a recent research report by McKinsey*, it was reported that analysts are still overwhelmingly too optimistic - and it has been that way for the past 25 years. It was noted that on average, earnings forecasts were nearly 100% too high. In fact, from 1985 through 2008 actual earnings on S&P 500 stocks were less than their initial estimates in every year but two.
*reported in Bloomberg Businessweek "For Analysts, Things Are Always Looking Up" 6/14/10

Why this unbalanced view of earnings? Analysts get most of their information from the public companies they follow, which obviously has an incentive to be as positive as possible. Also, most analysts don't feel comfortable being too damaging to a company's stock price, and in the process potentially risk future access to their followed companies' financial caretakers. So it appears that the separation of the research and investment banking departments of Wall Street firms really hasn't done much to improve the reliability of stock research reports.

Obviously, anyone familiar with Dixon Hughes Wealth Advisors realizes that this is a moot subject for our clients. We espouse objective academic research that shows most active management of portfolios fails miserably over the long term. The subject of this report is only one reason for active management's inferiority. Just check back to past quarterly reports to read about a myriad of other reasons why active management simply hasn't worked over time. Asset class investing combined with Modern Portfolio Theory, on the other hand, has proven the best methodology for growing wealth over the long term. And it works without the foolishness of ever reading even one single analyst's research report.

30% of the Time, I'm 100% Right

We all know that statistics can not only be confusing, but sometimes downright misleading. In the wrong hands, numbers can be manipulated to look any way the presenter wants them to appear. This happens frequently in the investment world. When performance numbers reign supreme, we often find the truth somewhere beneath the layer of sales-y jargon. Mutual funds that use active management (stock picking and market timing) will often attempt to convince investors to use them by showing data that obviously supports their cause. For instance, the chart below shows a 10 year average of actively managed mutual funds performance versus that of their corresponding index benchmarks.

The blue numbers stem from a search of Morningstar's database, and shows the percentage of active managers that did not beat their benchmark index. For example, in the lower right hand box representing Large Value managers, the blue number says that only 36.87% of them did not beat their benchmark index - meaning that over 60% of them did. If you look at all of the other blue numbers, you find that active managers, apparently, did a very good job in beating their benchmark indexes.

But before you get too excited, make sure you understand the other side of the story. What the Morningstar numbers fail to take into consideration are all the active mutual funds that went out of business or performed poorly and were merged into other funds during that 10 year period. This is called Survivor Bias. If you add back those funds into the total, you see a completely different picture. Now when you view the red numbers, you see what actually happened. The large majority of the active managers underperformed. Unfortunately, when someone purchases an active fund, no one gives you a crystal ball and tells you exactly which ones will survive. This is one further reason active management has proven a poor methodology for the serious, long term investor, and why Dixon Hughes Wealth Advisors espouses Nobel Prize winning Modern Portfolio Theory along with passive (not active) asset class management.

Second Quarter 2010 Asset Class Performance

After more than a year of strong market performance, starting from the bottom of the Great (ugh) Bear Market of 2008, we finally had a meaningful pullback during the month of June. It was not totally unexpected, yet is still wasn't pleasant to experience. After the bellweather S&P 500 rose more than 80% from the the bear market's bottom, and some asset classes more than doubled, the second quarter had all equity classes experiencing pullbacks ranging from generous single to low double digits. This eclipsed the positive returns of the first quarter, and dragged most asset classes year-to-date performance into negative territory.

As can be seen in the above chart, there were no equity asset classes that allowed you to hide from the market's correction. Large and Small, Core and Value all got hammered. International Large Caps showed slightly worse performance, undoubtedly due to the double whammy of both poor equity markets and lower currency (Euros) valuations.

Despite the pullback, economic conditions are on balance still positive. Retail sales have weakened a bit, and new employment figures, though positve, have also slowed. But corporate earnings continue to beat estimates. In addition, inventories are still low, which means more industrial production is needed to get them to normal levels - good signs for industrial growth. International debt securities, posterized by Greece, continue making headlines and furrowing brows of investors concerned that a dramatic slowing of European economies will spill over into the US.

All these mixed signals often challenge a long term investor, teasing them into potentially trying to sidestep this market consolidation. But as we have experienced several times over the past decade, attempting to time the ebb and flow of the markets doesn't work. Selling when there is fear and buying when things look cheery is the exact wrong formula for long term success. It is quite normal for meaningful pullbacks during bull markets. This consolidation is perfectly understandable considering the incredible 14 month uptrend that occurred following the 2008 bear market.


Frederick F. Kramer IV, JD
Chief Investment Officer