Happy New Year! As I take my seat to pen the quarterly letter, I’m looking out on a fresh snow which is a useful reminder that it is indeed winter in spite of the fact that yesterday it was fifty degrees, sunny and overwhelmingly brown. The abrupt shift from October-like weather to finally a more winter-like scene is comparable to how 2011 unfolded—a continuous seesaw between absurd levels of volatility followed by calm and a seemingly stable economic outlook. I’m sure it wore on your nerves after a while as it did ours (and in our profession, we’re supposed to be immune to these ebbs and flows!). Indeed, by year end and stretching back to 2008, I think we’re all experiencing a bit of “crisis fatigue.”  

So, just where are we in the long path out of the dark days of 2008? The lead-up to 2008 was marked by what many are referring to as a global “Debt Super-cycle.” Following 2008, the U.S. took wide-sweeping and at times controversial action to de-leverage and recapitalize banks. Although the U.S. certainly is not completely out of the woods, we have a head start on the Eurozone, which is now struggling with its own version of the U.S.’s 2008 housing/banking crisis.

In the case of Europe, contrary to the genesis of the crisis in the U.S., things started unraveling from the top down as fiscally profligate governments coupled with stalling economic growth led to serious concerns about whether or not European countries can make good on their debts. As confidence waned banks have grown more and more concerned about their “insurance policies” (credit default swaps) on this debt, and in many cases rushed to sell the bonds causing yields to spike. Panic ensued as funding costs rose and credit rating downgrades piled up, leading to an accelerating downward spiral.   

Bringing this back to the equity and bond markets, the intense volatility was born from the ongoing tug of war pitting an undeniably improving U.S. economy against apocalyptic European scenarios pouring forth in the news headlines. The result was peak to trough swings in the Dow Jones, S&P 500 and Nasdaq of more than 22% before finally reaching levels which turned out to be almost exactly where we started 2011.

Along the way, the year was littered with surprises that befuddled even the most seasoned investment strategists. For example, many expected interest rates to finally rise after literally years spent at abnormally low levels. Instead, the 10-year U.S. Treasury yield declined from 3.7% in early February to 1.9% at yearend. In addition, many called for a recovery in bank stocks and then watched despairingly as the financial sector declined more than 18%. Meredith Whitney, an analyst regarded for a controversial and prescient report on Citigroup in 2007, proclaimed on a broadcast of the CBS program 60 Minutes that dozens of counties, cities and towns in the United States would have “hundreds of billions” of dollars in losses after defaulting on their debt. In fact, municipal bond defaults in 2011 were tame and well within norms.

But perhaps the biggest shock came to those who perpetually remark that the U.S. is in decline, based on lack of innovation and a disappearing middle class. Even as U.S. debt was downgraded by one rating agency (Standard & Poor’s), investors flocked to U.S. Treasuries and the cost of borrowing for the government declined. Meanwhile, the S&P 500 was up 2% and Emerging Markets declined 18%. As we’ve often noted in these quarterly letters, we believe the employment picture in the U.S. is critical to a healthy equity market, and, here too, the story got considerably better. In fact, nonfarm payrolls grew the most since 2006 (approximately 1.4 million compared to 2.0 million).

The stabilization and indeed strength of globally-oriented U.S. corporations is suddenly a compelling, and one might add, increasingly popular story, particularly as the Eurozone remains in the Twilight Zone. Although the U.S. equity market was up only 2% in 2011, earnings were up more than 15% year-over-year. In other words, companies grew their earnings significantly, but given the overwhelming macroeconomic concerns, stock prices did not universally advance in parallel with the strong corporate performance.

And, it’s not just a case of the U.S. being “the best house in a bad neighborhood.” In fact (not opinion), U.S. companies continue to lead the world in innovation. According to Thomson Reuters’ Top 100 Innovators report (as reported in the November 16, 2011 edition of The Economist), the U.S. continues to lead the pack from an innovation standpoint. Of the 100 companies on the list, 40 are American (based on patent activity from 2005-2010) and six of the top ten are American companies. Strong innovation combined with record profitability and healthy cash positions should enable this strength to continue.

So as we head into 2012, we’re definitely cognizant of the dire scenarios that might play out in Europe and cause further volatility and possibly a global recession. However, we continue to believe that the more likely scenario is that a resolution to relieve the debt burden on European countries is reached, albeit with much compromise and consternation from the divided northern and southern tier countries. Meanwhile, the U.S. is on the path of a self-sustaining recovery and growth, which, barring a significant disruption from Europe, will lead to the continuation of positive equity market performance.

Thank you for your business and we look forward to meeting and speaking with you as the year progresses.

Sincerely,

Charles N. Leach, III, Chief Investment Officer

Your Berkshire Bank Wealth Management Team:

Charles N. Leach, III, Chief Investment Officer

Kenneth B. Walker, Director of Investment Research

Richard R. Bleser, Portfolio Manager and Investment Analyst