Dreher Company, Inc.

After having experienced a dramatic downturn (-13.87%) in equity markets in 3Q-2011, the volatility continued with a remarkable rebound of +11.80% in the fourth quarter.  Healthier retail sales coupled with a downward trend in unemployment claims and the unemployment rate were the primary motivators for this rapid recovery.  Continued disarray associated with the EEU's sovereign debt situation contributed to constant strength in U.S. Treasury prices.  Concern still remains regarding the ultimate impact of the EEU situation upon the balance sheets of the global money center banks, many of which were down-graded in November/December.

Though the U.S. equity markets finished 2011 near or slightly ahead of break-even, impending national and global challenges in the coming year provide some caution in terms of performance expectations.  Following are some of the key topics that we will be focusing upon in the coming quarters:

Domestic Challenges

• Deficit Management - With less than two months remaining before the Federal government's budget deficit ceiling is upon us again, no meaningful agreement has been achieved regarding long term reduction in the deficit trend of the U.S. budget.  Congress and the President still have not even resolved whether the payroll tax deduction will be extended or rescinded, nor have they determined if, how or for how long continuing emergency unemployment benefits will be funded.  Whether U.S. citizens and businesses like it or not, it seems unlikely that meaningful progress will be made in these key areas until after the Fall elections.
• Employment - On the positive side, payrolls have climbed steadily from the 2k number in August to 139k in December.  This increasing trend is certainly welcome, but the pace falls short of even covering the pace of working-age population growth, which is 200k-250k per month.  While we expect payroll growth to remain positive, the pace of growth is likely to flatten in the next few quarters.  Real average hourly earnings, however, are down 1.5% in the last year.  With public sector employment expected to continue shrinking in 2012, there is more pressure than ever for private payrolls to pick up the slack and find some motivation for businesses to risk further hiring.
• Housing Industry - The Fed and Congress are both searching for ways to positively impact the U.S. housing market.  New and existing home sales seem to be showing some rebound, but home values continued to decline in 2011 with average prices now down 33% since 2006.  This is due in part to investor concerns over the significant number of underwater and/or delinquent loans that ultimately must be dealt with either through foreclosures or government-sponsored rental conversion programs.  Either way, the desired goal is to see a reversal to a positive trend in home values, but the prospect for this seems likely to be at least 1 or 2 years way.     
• Election-Year Politics - Aside from the normal distractions caused by campaign rhetoric from all political sides, two key pieces of legislative reform from 2009 are still poorly-defined and are causing major problems for U.S. businesses in resolving personnel and capital investment planning decisions for 2012 and beyond.  Both the Dodd-Frank and the Medical Reform bills have kept the banking industry on their heels and have created genuine paranoia for all businesses in quantifying the on-going business costs that may result from these still partially-written initiatives.  Add to that the uncertainty over potential tax code changes and it's easy to appreciate the dilemma that U.S. businesses are facing. 

Fixed Income Markets - In light of the Fed's continued easing posture and the on-going EEU sovereign debt problems, Treasury rates are expected to remain relatively range-bound for the bulk of 2012.  This applies as well to U.S. corporate bond rates.  The real challenge is protecting against mid-term (5-10 year maturity) total return risk.  With current coupon levels at record lows, potential deterioration of principal value if and when market rates begin to increase will play a major role in liquidity reinvestment decisions in 2012 and beyond. 

As you will have seen from the preceding comments, we are cautiously optimistic about performance expectations for U.S. investments in the coming year.  From a global perspective, there is actually some room for optimism regarding improved performance by foreign economies as well.  This is particularly true with entities such as Germany, China and a number of emerging market nations.  The bottom line is that most world economies are faced with tough fiscal decisions in this continuing recovery process, but progress is evident in many of the key economies.  It may well be another year, however, before we will able to quantify an actual shift toward global economic expansion.