YEAR OF THE RECESSION TRADE

January 212 YEAR OF THE RECESSION TRADE We would categorize stock market leadership in 211 as defensive. US stocks outperformed international stocks, in both the Emerging and Developed areas, due to their greater perceived relative safety. Sectors such as Staples, Utilities, Telecommunications and Health Care outperformed the broader market, as the earnings and cash flow of companies in these areas are generally more stable and tend to be less sensitive to declines in the economy. Essentially investors thought process regarding those areas is, regardless of how bad the economic condition, people still need necessities like toothpaste, electricity, communication, and medicine. Other common features of top performing equities for 211 include larger market capitalizations, lower volatility (beta), and notably, companies who pay cash dividends on a regular basis. In observing year-to-date cumulative mutual fund flows through October, the category dubbed Equity Income was far and away the winner (beneficiary), with net inflows of over $24 billion whereas equity mutual funds as a whole saw net outflows, according to data from Lipper. There are a few reasons for this type of market behavior. The rise in popularity of dividend-oriented strategies is partially the result of the ongoing hunt for yield among income-oriented investors. Over the past few years we have highlighted the relative attractiveness of an income-oriented equity portfolio compared to bonds in the current ultralow interest rate environment. More broadly speaking however, investors defensively rotated out of perceived riskier assets into safer ones over the course of 211 in a classic recession trade, driven by increased fears of global economic slowing. Dividend-oriented portfolios happen to fit this safer profile as they tend to be comprised of conservative, more mature, and lower growth companies. The divergence of returns between cyclical stocks, those whose earnings are more sensitive to the business cycle, and defensive stocks became increasingly apparent as the year progressed, especially as the market sold off in July and August. Through the end of the year, despite an especially strong fourth quarter for cyclical stocks driven by a flurry of better-than-expected data, the outperformance of defensive stocks held for 211. 12 Performance of S&P 5 "Cyclical" Versus "Defensive" Stocks in 211 Indexed at 1 as of 12/31/1; Total Return 115 11 15 1 95 9 85 Defensive Sectors: +14% (Health Care, Staples, Utilities, Telecom) S&P 5 Index: +2% Cyclical Sectors: -2% (Energy, Materials, Industrials, Tech, Consumer Discretionary, Financials) 8 12/31 2/28 4/3 6/3 8/31 1/31 12/31 Source: FactSet

The S&P 5 certainly saw its share of volatility during 211. The index started the year with an approximate 9% gain, followed by a 17% decline, followed by a 13% gain to end the year in positive territory, up 2.1% on a total return basis. We find the end result to be somewhat remarkable in a year which endured numerous challenges, namely: the European sovereign debt crisis, a US credit rating downgrade, ongoing gridlock in Washington, elevated inflation and commodity prices early in the year, signs of slowdown in Emerging Markets later in the year, and the Japanese tsunami disaster. Given all of these headwinds, we attribute the resilience of the stock market to several factors, the foremost being the health of US corporations. Strong balance sheets and record earnings, cash flow, and profitability stand in marked contrast to the precarious financial state of many overleveraged consumers and governments. Moreover stock valuations continue to appear attractive both on an historical basis as well as versus other assets, which have served as a support. MOMENTUM SHIFTING IN THE MULTI-SPEED GLOBAL ECONOMY US economic data has been the source of much welcomed positive surprises throughout the fourth quarter, and has helped to drive equities higher. As a result, economists are now predicting 2.8% real GDP growth for the fourth quarter of 211, up from 2.% just a few months ago. We are hopeful that the positive economic momentum can continue into 212, where the full year consensus real GDP growth estimate for the US remains around 2.%. Housing data seems to be bottoming as housing starts and inventory data have been better than expected. While the bulk of the recent improvement in housing starts is related to strength in the multi-family segment, it appears that single-unit starts have found a floor. Going forward housing should not be the drag it has been for the past few years, and may even be a (gasp!) contributor to growth in the next 12-24 months. The most recent survey of small businesses from National Federation of Independent Businesses (NFIB) showed improvement for the second month in a row, with notable improvements in hiring as more small businesses are now creating jobs rather than cutting them. While overall activity and sentiment remains subpar, it appears that small business owners are getting used to the uncertainty of the macro environment and are pushing ahead, albeit cautiously. Recent US employment data echoes the NFIB survey results. The employment situation is improving, but is still below optimal. Positively, the four week moving average of initial unemployment claims has broken through the 4k threshold frequently referenced by economists as somewhat of a tipping point, as seen in the chart below to the left. We feel that the real story of the US employment picture, however, is told by the chart showing Total US Employment at the bottom right. Past recoveries have seen the aggregate workforce rebound back to the long term trend line which represents a 1.9% annual growth rate over the past 5 years. As shown in the chart, there is a shortfall of approximately 12.5 million jobs between the current total workforce and the long term trend. While there has been some improvement in growth of the overall workforce since the official end of the recession, the current gap implies that the job market is still operating meaningfully below its potential. We expect employment data in 212 to show a continued gradual healing of the labor market, but still at a slower pace than we would like. US Initial Unemployment Claims 4 week moving avg; thousands Total US Employment Aggregate NonFarm Employment, millions 8 145 6 135 Actual Total Employment Gap 125 4 115 2 15 Total US Employment Trend 95 85 81 86 91 96 1 6 11 81 86 91 96 1 6 11 Source: US Department of Labor - 2 - Source: US Department of Labor

On the international front, fundamentals have deteriorated over the past 3-6 months. This is especially evident in the performance of international stocks, as the MSCI EAFE Index (the broad index for international developed markets) and the MSCI Emerging Markets Index (the broad index for international emerging markets) are down approximately 12% and 18% for the year, respectively. Europe s handling of its sovereign debt problems continues to be the biggest wildcard in regard to the possibility of a negative financial event, and has served as a massive overhang on world stock markets, especially outside of the US. In the meantime, from an economic standpoint, Europe is operating at recession levels due to austerity programs and uncertainty. In observing the numerous summits and policy actions which have not produced a clear solution, it is probably safe to assume that the Europeans will continue to chip away at their problems in an incrementalist fashion. To the market s discontent there will be no all-encompassing bazooka approach to shoring up liquidity, dealing with the debt of certain problem countries, and forming a plan for fixing the flaws of the eurozone s structure going forward. We continue to believe that European policy makers will continue to only take action as prompted by market forces. That said, twelve months from now we do believe that the fiscal make-up of the Eurozone will look notably different than it does today. In order to prevent the seizing up of their government bond markets and avoid runs on their banks, European policy makers will be forced to take action through the year. Signs of slowing in the emerging markets have recently gotten significant attention from the financial press and market participants. This is largely because over the past ten years these economies have been the main driver of global economic growth. While we acknowledge that a slowdown in the emerging world is a legitimate concern, it s important to point out that these economies are still in much better shape than the developed world, in a few critical ways. To put it simply, they have better growth prospects and less debt. As can be observed in the following chart, according to forecasts from the International Monetary Fund (IMF) emerging market economies combined are expected to grow approximately 6.4% in 212, while their government debt ratios (debt-to-gdp) average just 4%. This contrasts sharply with developed market economies which are expected to grow just 1.6% in 212 with government debt ratios averaging a much higher 98%. 11% 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Global Growth Rates versus Debt Levels 211 IMF Growth Rate Estimate (Left Axis) 21 Debt/GDP Ratio (Right Axis) 22% 2% 18% 16% 14% 12% 1% 8% 6% 4% 2% % -1% China India All Emerging Markets Russia Brazil Canada Eurozone All Developed Markets US UK Japan -2% Source: IMF - 3 -

Make no mistake, while emerging market investing presents a host of additional risk factors to consider (political risk, social stability, regulatory environment, etc.), the basic fundamental picture in many of these countries is quite good. A significant portion of their growth is being driven not just by exporting cheaper goods to the developed world via an undervalued currency, but by an emerging middle class of consumers. Even if their economies cool somewhat, low debt levels and continued internal demand should enable many of these emerging markets to continue to do relatively well. 212 OUTLOOK PRIMING THE PUMP On August 31 st, in response to slowing growth and evidence of subsiding inflation, Brazil s central bank surprised the market as it slashed interest rates from 12.5% to 12%. Since that time, central banks worldwide have announced more than 5 easing moves in what can be described as the beginning of a global easing cycle. With the threat of inflation continuing to subside, the door will be wide open for central banks to engage in further monetary easing activities in 212. To illustrate the state of global monetary policy, the following graph takes into account the policy stances of 14 of the world s central banks, plotting the difference between the number of countries which are tightening versus easing. It can be observed that since the end of October, central banks have increasingly been in easing mode, a trend that we believe will continue as inflation pressures recede. Our own Federal Reserve has pledged to keep interest rates low for the foreseeable future, likely through 213. 4 2 Diffusion Index Of All Central Bank Policy-Rate Actions (14 Central Banks) Net TIGHTENING of Global Monetary Policy (restricts: liquidity, growth, asset prices, inflation) 4 2 Early stages of a global easing cycle! -2-2 -4 Net EASING of Global Monetary Policy (supports higher: liquidity, growth, asset prices, inflation) -4-6 -6 199 1992 1994 1996 1998 2 22 24 26 28 21 212 214 Source: Wolf Trahan & Co. We believe that the combination of central bank easing and lower inflation will serve as a stimulus for growth going forward, albeit with somewhat of a lag. As this stimulus begins to take effect, the benefits will be seen in the form of stronger consumer confidence, housing, and employment. Lower inflation alone will continue to act as a de facto tax cut for consumers in the form of lower prices at the pump, cheaper energy costs and smaller bills at the grocery store. It is our view that this stimulus in the pipeline, in tandem with the potential for Europe to avert disaster in the next six to twelve months, could eventually provide the fuel for an equity market rally similar to what we witnessed in 29. While this rally would likely be less extreme given we are currently above the depressed levels of 29, the leadership during that period was composed of the more cyclical equity groups, which is a dynamic we think would be similar this time around. Current equity market valuations would be supportive of a rally as stocks are similarly cheap. In fact, in 211 stocks have actually gotten cheaper as prices have been flat while the earnings and cash flows of corporations have increased substantially. - 4 -

INVESTMENT POLICY To summarize the news flow and headlines in 211, the word chaotic comes to mind. To summarize the year end returns of the S&P 5, boring is probably an accurate term. While this doesn t capture the volatility of the year, it is a testament to the financial strength of US corporations as well as low valuation levels, both of which should serve as support for stocks going forward. Still, we expect volatility to remain elevated going into 212, driven by continued European headlines as well as US political developments in an election year. Despite its sluggishness, it appears that the US economy is improving in critical areas such as the job market and to some extent housing. Given what we see as substantial stimulus in the pipeline, principally in the form of lower inflation and a global central bank easing cycle, we do not think this is the time to increase defensiveness in portfolios. Defensive strategies outperformed throughout 211 and are currently in favor. While protestors were busy with Occupy Wall Street this past year, investors were engaged in Occupy Safety, and still are. It is our view that investors should take advantage of market volatility in the first half of 212 and, on a measured basis, increase cyclicality in portfolios. This is not to suggest investors abandon principles of diversification among asset classes, geographies and sectors, which is the foremost priority for portfolios, but rather to rotate from defensiveness to cyclicality at the margin. Areas that would fit the cyclical bill would primarily be the Energy, Materials, Industrial and Technology sectors, as well as Consumer Discretionary, and Financials. In terms of stock selection within these areas, we urge a strong focus on high quality balance sheets, discount valuations, secular and company specific catalysts, and solid management teams whose first priority is creating shareholder value. The major known risks of Europe, slowing emerging markets, and the upcoming election should provide opportunity for investors to capitalize during periods in which the market is temporarily fleeing for safety, or in risk-off mode. - 5 -