In the second quarter of 2011 we saw two events that had a direct impact on how we have deployed capital in the markets.

First and most obvious is the weakness in the prices of equities in the "weaker dollar trade". For the last 10 years, as the dollar has weakened, the prices of natural resources and the related equities have outpaced the broad market by a wide margin.

The trend favoring these natural resources hasn't been smooth sailing and last quarter was a fine example of a period when these equities did not fare particularly well. Our energy holdings and precious metals securities did noticeably worse than broad market averages and the gaps were particularly noticeable when compared to high growth, high P/E large cap companies.

Second, the weakness in these equities reversed our main risk indicator from offense to defense. In response we took defensive measures building some cash reserves, long-dated Treasury bonds and a position in the US dollar in our ETF style. To date, market participants have moved into Treasuries and the dollar when the market has been moving lower. In the Equity Income accounts we replaced all equities yielding less than the 20 year US Treasury with an ETF mimicking the price and yield behavior of the 20 year Treasury bond.

These moves have had the effect of greatly dampening price volatility.

The strong market rally at the very end of the quarter put our main indicator back on offense. However a rally that moves as far and as fast as it did is not, in our experience, a time to put offense back on the field. We are looking carefully at the pullback here to determine whether we should begin to add back higher yielding common stock.

The big question is whether or not the second quarter's pullback in the "weaker dollar trade" is a buying opportunity or the end of a 10 year trend in market price action.

The best possible news for everyone on the planet would be that it is now time to step away from gold, silver, energy, agriculture and materials stocks. The reality we see is that the world's central banks are not finished moving damaged debt instruments onto their balance sheets. The most visible of these debts right now are in Europe where the poorer nations are quite obviously not going to be able to repay Germany, France and the United Kingdom's banks what they are owed. Less obvious are the public debts hidden in the unfunded liabilities relating to social programs and public pensions both in Europe and in the United States.

The history of these types of events is both frightening and reassuring. Sovereign debt default is a common event throughout history and banking crises that involve actually writing off bad debts do not result in the end of the world.

These are, while in the process of moving from crisis to resolution, turbulent times for those holding assets denominated in the currencies involved in the debt crisis. Throughout history the political response has been to pay bad debts with newly created money and hope that the natural resilience of humanity overcomes the cash flow problem. Historically speaking these policies are failures of epic proportion more often than not.

While these "extend and pretend" policies are in effect people witness rising prices for the things they need everyday. The endgame of these policies is always a political event that results in the world's sovereigns and investment banks finally writing off the bad debts and all of this is accompanied by a serious inflation. The history of these events shows a common thread; there is a delay averaging around 6 years between the beginnings of an inflationary monetary policy and a dramatic rise in the price level.

We are globally still somewhere in the "muddling middle" of this process.

Our job as investment managers, we are convinced, is to recognize that the investment environment we have to work within is characterized by this uncomfortable and historically common set of circumstances.

The second quarter of this year was difficult for us mostly as a result of a sizeable pullback in the securities associated with defending purchasing power in an inflationary environment. We spend a large part of our time looking to see if there is some change in the world that would allow us to move away from this posture but we have not yet convinced ourselves that this is the case. For now, we remain in a defensive stance and believe the long term move upwards in the hard asset, weaker currency trade is not over.

Clarke Van Meter

Michael Van Meter

July, 2011