After a busy three months during which we settled into a new office and continue to work toward converting to an enhanced technology platform (finally), it’s time to review the state of the economy and the performance of capital markets. The landscape is certainly as complex as it has ever been and as a result, we are pleased to translate the wall of headline noise into meaningful analysis that can help you, our client, formulate reasonable conclusions.

By all accounts, it was a strong quarter for equities but more importantly, one in which the market leadership decisively changed hands as we transitioned into 2012. What does this mean? In 2011, the equity market eked out a gain largely on the back of Healthcare, Utilities and Consumer Staples – the steady, dividend paying and less cyclical businesses. In the highly volatile year that was 2011, these “lower octane” sectors held their own and proved to be a nice place to hide. Once we transitioned into 2012, however, these sectors ceased to outperform and the leadership was handed off to the Financials as well as the Small-Cap, Mid-Cap and Emerging Market asset classes.

When the quarter wrapped up, the S&P 500 logged its best first quarter since 1998 (+12%) and the tenth best first quarter on record. It also represented the continuation of an impressive rally that began last October (+24.5% since then). It was only last summer that investors seemingly despised stocks, chucking even the strongest companies overboard only to do an about-face and buy stocks handover fist beginning early October. What’s behind the move?

Call it a double-edged sword and certainly controversial, but central bankers (i.e. “the Fed” in the United States and the European Central Bank in the Eurozone) have come to the rescue once again. Now we won’t get into all the gory details but suffice it to say the spigot is “on” both here and in Europe, which is enough to provide a meaningful amount of stimulus and liquidity to the banking system, the economy and, as we witnessed in the past six months, the equity markets. While it has been good for returns, the downside (i.e. other edge of the sword) is that at some point the stimulus will be withdrawn and thus far we’ve not seen evidence that the market and/or economy will react favorably to this.

To be clear, there were a number of positive developments outside of the synthetic influence of central bankers. Going forward, the larger question is whether the economy can endure a handoff from a recovery propped up by intervention and artificial stimulus to one that has regained its own footing and momentum. The signs are definitely getting more encouraging. For example, although the employment data were weaker-than-expected in March, the three preceding months each showed additions to nonfarm payrolls of over 200,000.  Corporate earnings, the tried and true driver of stock prices in a “normal” environment, have been strong and set a record in aggregate for 2011. The automobile industry also continues to show signs of resurgence as consumers seek to replace their aging vehicles with more efficient U.S.-manufactured options. According to a report from the University of Michigan Transportation Research Institute, fuel economy of new vehicles is higher than ever: 24.1 miles per gallon. United States lightweight motor vehicle sales are running at levels not seen since 2008—more than 14 million on an annualized basis.

But enough about the past, let’s now turn to the unwieldy task of peering into the future and setting some reasonable expectations for what to expect for risk and return going forward. First, bonds feel like the best place to be for those seeking less risk, but given their strong run over the past two decades, they will likely become more volatile. See the graph below for an indication of just how strong the appetite has been for bonds over the past three years—yes, you’re reading correctly, $770 Billion has flowed into bond funds over the past three years alone. This smells like a bubble to us. This doesn’t mean we abandon the asset class as bonds are a critical component of just about any investment strategy. Instead, we will continue to seek attractive yields without taking on the risk of purchasing very long-dated bonds, which do not react well to spikes in interest rates.

On the flip side, equities look extremely attractive relative to bonds, but also relative to their own historical valuations. In viewing the graph below, think of the various metrics as different ways of vetting the “price tag” on the market. Lower means “cheaper,” but also less optimism/greater aversion to risk. Other than “SMID” (Small- and Mid-Cap companies), markets look quite inexpensive. We like this dynamic, as we’re buying undervalued companies rather than wildly overvalued firms. Perhaps the greater question is why are markets so inexpensive if the economy and corporate earnings truly are getting better.

This is where we loop back to the double-edged sword of central bank intervention. The second guessing surrounding the massive structural issues facing the U.S. and European economies leads to a diminished enthusiasm for equities—not to be confused with a fundamental flaw with equities. In addition, the constant specter of more or less stimulus (also referred to frequently as “quantitative easing” or “QE”), results in bouts of unnerving volatility. For the balance of 2012, we expect additional periods of sharp market gains and losses, but likely not to the same degree as 2008 and 2011. And, with the S&P 500 already up more than 10% for the year, don’t be surprised to see us oscillate around current levels through the balance of 2012. We’ve taken steps to adapt to this type of environment.

For many months now, we’ve alluded to a shift in our “platform” to one that is more user-friendly for you and for both our investment and operations team here. It’s finally upon us. As I write, our team is diligently gearing up for the conversion and on May 1, 2012, your assets will have seamlessly shifted to our new vendor “FIS.” Most importantly, if you’re an on-line user (and if you’re not, we urge you to take advantage of this), the log on page will change as will the depth of data you’ll be able to glean from this portal. Keep an eye on your mailbox for further details and/or your email inbox if you were previously using the State Street online portal.

If we should not see you as we transition from spring to summer, we wish you the best during this beautiful time of year.

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