Tillar-Wenstrup Advisors

Since the turn of the century (2000) investors have not had to think much about tax-friendly investment strategies due to two major bear markets. But times have changed. The stock market is near all-time highs and many, if not all, of investors' loss carry forwards have been used up. More importantly, the Obama administration has already raised tax rates on the wealthy and the outlook is for tax increases to broaden as part of the solution to taming our debt and deficit problems. The bottom line is that investors need a new strategy for this environment.

When it was all said and done not much happened in the final quarter of 2012. Anxiety picked up immediately after the election as the bickering over the fiscal cliff escalated. In the end, the worst-case scenario was avoided at least for a couple of months and stocks ended about where they began the quarter.

To summarize our current position, while we acknowledge there are many risks we feel those are already reflected in the market and stock prices will drift higher as investors begin to recognize the positive developments outlined above. Analysts remain very bearish and continue to recommend a below-average weighting to stocks. Moreover, despite strong returns from equities investors have pulled money from U.S. stock funds for 18 straight months and are largely under-allocated when compared to history.

The stock market has surprised most everyone by rallying of over 11% since bottoming in early June. At that time the market had given up most of its double-digit gain for the year and seemed destined to continue to fall given the poor macro-economic environment . A heavy dose of uncertainty in Europe caused a further exit from investors. Fortunately going into that decline we had accumulated a healthy cash position. After the decline into early June we decided to increase our equity exposure despite the uncertainty for several reasons.

Stock markets retreated in the second quarter of 2012 but the damaged was minor due to a rally in June. After falling almost -9% by June 4th the S&P 500 ended the quarter off by only -2.75%. Our emphasis of Blue Chip stocks helped our performance during the quarter. Small and mid-cap stocks did a little worse, down around -4%, but the real damage continued to be European and emerging market stocks, falling by about -8% and -10%, respectively. The All World Index (ex US) fell over 16%.

There is a very important debate taking place on the best way to fix our economy between those who favor more spending versus those who favor austerity. Recently the spending camp has been very vocal in promoting their theory, including recent papers by Larry Summers, Brad DeLong and Paul McCulley, Zoltan Pozsar and a new book by Paul Krugman. What is not in dispute in the debate is that the private sector is deleveraging as an aftermath of the financial crisis, negatively impacting growth. What is in dispute is the appropriate response.

Overall both risk and return seem muted until something in the current environment changes. As long as yields on assets like bonds and cash remain low, it is hard for stock markets to collapse. But those yields are so low because central banks are frightened about the economic outlook which makes it very hard for a bull run to be sustained. While there has been improvement is some areas of the economy some are struggling to grow beyond previous levels.

So far in 2012 the stock market rally that began in the gloom last October continues to power ahead producing one of the best starts to a year in over a decade. The primary reason for the rekindling of animal spirits is the efforts of the ECB and our Fed. While we applaud these move that reduced the chance of another financial crisis in the short term, we question the speculative response by the stock market because long-term solvency issues still need to be addressed.

Most recent economic news has surprised on the upside, including improvement on the jobs front. We are not willing to argue yet that this is the start of a long-term trend, but it is nonetheless encouraging. We see no compelling reason to make significant changes to our strategy. Well maintain a cash cushion to protect from any downside volatility and continue to emphasize traditional blue chip, high-quality, and deep value stocks. At some point it will be advisable to broaden our portfolio but the time has not yet come.

Despite our macro concerns there are opportunities in the stock market, especially in the mega-cap arena where valuations are attractive and yields are high. Investors are in a unique period of time where they can own very high-quality stocks and generate a sustainable and growing income stream well above money markets and medium term U.S. Treasury securities. High-quality stocks have started to outperform after being ignored over the past decade. We believe this asset class is underrepresented in institutional portfolios and will benefit as this group rediscovers the value in this area.

The quarter was weak. If this is due to factors like the earthquake and high energy prices, the soft patch should end in the second half of 2011. However, even if this plays out, longer term headwinds remain. What has become clear is that we are in a period of suboptimal economic activity, despite aggressive fiscal and monetary policy. Almost all rich countries are still stuck with a toxic mix of modest growth, depressed housing markets, negative real interest rates, even more asset concentration at our financial institutions, and uncomfortably high unemployment and government deficits.

Currently the stock market is rightly focused on the many risks emanating from the macro environment. The European debt crisis, inflation and social unrest in emerging markets, especially China, and our economy has slowed while unemployment remains elevated.Most of these conditions were peculating well before the stock market started its decline in early May. We took advantage of that period to reduce risk in our portfolios by selling some stocks, especially the more cyclically oriented companies. As aresult our portfolios are holding up better than their benchmarks in the current correction.

Recently the financial media has been focused on the end of QE2, the process by which the Fed has been minting new funds to buy back U.S. Treasuries to pressure interest rates down. While they have been successful in driving rates down, the additional borrowing has put additional strains on the rising debt limits the legislature must continually approve. Regardless of whether the Fed officially ends QE2, as of June 30th it will not end the Fed?s Treasury buying spree as they will continue to repurchase Treasuries using the proceeds of maturing mortgages they took over in the financial crises.

The range of possible outcomes for the economy and market is still wide. We believe QE2 is simply a continuation of a boom-and-bust regime. Fundamentals are good now but are unlikely to be sustainable. Printing money to support asset prices cannot go on forever and usually ends in disaster like it did after both the technology and housing busts. Therefore, we dont believe this is a time to be aggressive. We are maintaining our strategy of emphasizing steady-growth businesses, with strong balance sheets, healthy dividends, attractive valuations and exposure to emerging economies.