January 22, 2013

Year End 2012 Investment Commentary

For a few years now, we have said the most likely outcome for the developed world economy since the financial crisis of 2008, could be years of below-normal growth. This view was based on the assessment that excessive debt levels in the United States and around the developed world had to be reduced, and that this lengthy period of deleveraging could suppress spending and be a drag on economic growth. We also believed that stocks were not fully pricing in the slow growth environment or the full risks of the Fiscal Cliff as we will discuss more in this commentary. Our expectation of periods of increased volatility has largely been correct over the past four years. While we, like many, have been surprised at the resiliency and rebound in the strength of the stock market and corporate earnings. In general we believe our portfolios have performed well, while managing risk at the same time. We acknowledge that while clear progress appears to have been made, the deleveraging process is not nearly complete. In our view the risk of another crisis has declined, but it remains possible and should not readily be dismissed. Reducing the growth of debt at the right pace and in the right way is necessary, but not easily achieved. The risk is that this goal is not achieved, or that it is only achieved after political dysfunction triggers a crisis. This year looks to be an important year as politicians are charged with putting in place a viable longer-term plan. If this is not done in 2013, the risk is that it wont be done until after the next presidential election, unless a crisis comes first. The lost time means we will face a larger problem with tougher choices and likely even greater consequences. The markets will be watching and may not behave well if there is inaction long into the future. Europe also made some progress in 2012but most of that progress has been in the form of buying time by reducing borrowing costs and thereby lessening the tail risk of an imminent Eurozone breakup. There has been some improvement in the peripheral countries as most seem likely to have current account surpluses in 2013; capital flight appears to have stopped, and there are signs that the push for austerity may soften a bit.

It remains an open question whether European governments will be able to make the right decisions with respect to growth policies, pursuing competitive balance, debt relief, and the fiscal and banking integration that is needed to hold together the single currency over the long run. As challenging as the politics are in the United States, the challenges are even greater in Europe where countries with different cultures and economic characteristics are being asked to give up some of their economic sovereignty. Solving these problems will take a long time and along the way, they could trigger more social unrest. As in the United States, Europes problems are about debt-related economic headwinds and the threat of political mishandling of a fragile economy. One important distinction between the investment prospects for the United States and Europe is that European stocks appear cheaper and we are looking for opportunities to add to our portfolios. It is Important to Consider the Optimistic Scenario An important part of our investment discipline is to challenge our own conclusions through debate among our team and exposing ourselves to alternative points of view through our reading and working our extensive industry network. Most important, our scenario approach forces us to think through a variety of possible outcomes. We recognize a variety of bullish factors that could drive stocks higher over the next few years. These include: As we move further along in the deleveraging process, expected returns for stocks could improve as we anticipate a return to more normal earnings growth in the later years. The passage of time has also meant that an enormous amount of froth may have been taken out of stock prices. The stock market, as measured by the S&P 500, is at a level first reached 13 years ago and multiples are much more reasonable than they were. The risk of another financial crisis that leads to deflation has declined. Time has allowed for some healing, some deleveraging has occurred, and Europe has made some progress. Over time, this should have some impact on investor risk-taking, especially if this trend continues. Relative valuations driven by the Feds low interest-rate policies could continue to play a big role in stock returns going forward. Valuations are in a fair-value range on many absolute measures. If one assumes that macro forces will result in belowaverage earnings growth, stocks might look overvalued at this point. However, if

economic growth gradually improves, tail-risk fears subside, and as time further distances investors from the financial crisis, investors could find stocks far more appealing than bonds or cash. If politicians can agree upon a credible plan for long-term deficit reduction, that could go a long way toward mitigating concerns about future debt build-up and related policy errors. In the United States, the corporate sector is sitting on a lot of cash that could be used for capital investment and hiring as some of the uncertainty recedes. In Europe, while the fear of policy errors is justified, it is also possible that 2013 could see progress toward banking and fiscal union and a return to growth later in the year. The global economy has experienced some encouraging macro developments. In the United States, housing is now starting to be a driver of growth, rather than a drag on growth. Credit markets also continue to improve with easier lending standards. The labor market is slowly healing, though it still remains historically weak. Outside the United States, the growth slowdown in the emerging markets may have ended and there are numerous signs that Chinas economy is picking up. Even Europe, currently in recession, could start growing again in the second half of 2013.

The odds of the bullish case playing out may be increasing. There is no easy road out of our debt bind and there are consequences to that reality. The only easy road would be robust growth, but this is close to a mutually exclusive condition with a deleveraging global economy. Despite somewhat improved odds of a more bullish scenario, we believe it is more likely to see a slow-growth environment with a continuation of some aversion to risk. In this environment, corporate earnings should be challenged as we believe growth through cost cutting has largely played out. Revenue growth needs to be a driver and ultimately, that will depend on demand.

How This Impacts Portfolio Positioning Our portfolio positioning for the second half of 2012 reflected several considerations: 1) Caution because of elevated risks and low expected returns. This is why our portfolios were underweight stocks relative to our tactical maximum allocation. 2) Higher return expectations for foreign stock markets and the future reallocation for part of our cash holdings.

3) Decent fixed-income opportunities outside the investment-grade bond market, including parts of the mortgage market and high-yield bonds. Overall, in many of our portfolios, most of the equity underweight comes from international stocks. Some of that underweight is offset by the performance of our tactical and strategic fixed income holdings. During 2012, our fixed-income positions added value to our portfolios and helped to offset the impact of our equity underweight. Our view is that there is still potential for excess returns from our fixed-income positions in the future. Most of the fixed income positions we hold pay much higher yields than the bond index and have less interest-rate risk. The lower-interestrate risk is a function of lower duration and more credit exposure, which we expect to perform better in a rising interest-rate environment.

For illustrative purposes only and is not indicative of any investment. The timely payment of principal and interest of government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government. Bonds are typically intended to provide income and/or diversification. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. An investment cannot be made directly into an index. Past performance is no guarantee of future results.

Technically Speaking As we have been discussing so far, 2012 was a year fraught with the headlines of global debt and a showdown in Washington that literally went to the very last minute. It was also a year in which anyone waking up to the financial media knew if that particular day was a risk on or risk off day in other words, should the investor be invested that day or not. This volatility shows investors can choose one of two ways of dealing with it. The first is to have a diversified portfolio spread amongst many different asset classes primarily made up of stocks, bonds, and commodities. The problem with this school of thought is that each of these asset classes have become more highly correlated to one another. Over the last few years, having assets invested in commodities to act as a hedge against market declines no longer offers the offset or partial protection that investors had grown accustomed to. As can be seen in the chart below, stocks and commodities have become more closely correlated, meaning stocks and commodities are more likely to perform similarly than a few years ago.

0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 -0.30 2000-0107

Rolling Commodity Correlations with Stocks

2001-01- 2002-01- 2003-01- 200 4-01- 2005-01- 2006-01- 2007-01- 2008-01- 2 009-01- 2010-01- 2011-01- 201 2-0107 07 07 07 07 07 07 07 07 07 07 07

For illustrative purposes only and is not indicative of any investment. An investment cannot be made directly into an index. Past performance is no guarantee of future results.

The second way for investors to try and deal with the increased volatility is to take a more tactical approach to investing. At Compass, we use a four-point approach in managing each of our model portfolios to help us determine whether we are utilizing Wealth Accumulation or Wealth Preservation strategies. Fundamental Analysis Quantitative Analysis Technical Analysis Risk Management

The next chart should help you see this more clearly.

For illustrative purposes only and is not indicative of any investment. The data does not assume reinvestment of income and does not account for possible taxes, transaction costs, fees, expenses or sales charges. An investment cannot be made directly into an index. Past performance is no guarantee of future results.

During the fourth quarter, you can clearly see the red downward trend line defined by a series of lower highs made each time the S&P 500 started to rally. Because of this, during the fourth quarter we were primarily in our defensive, Wealth Preservation mode. Our overall exposure to equities was decreased, and exposure to such asset classes as bonds and cash increased. As we headed into year end, the threat posed by going over the fiscal cliff offered too much risk for the reward of being fully invested. Smart investing can mean erring on the side of caution. It is much easier to add equity exposure to a portfolio when the markets start a new rally than try to reduce equity exposure when there is a sudden drop. Risk management needs to be stressed.

As we started 2013, a temporary Band-Aid came out of Washington and the markets began to climb. The first step in shifting the offense back onto the field was to have the S&P 500 break through the red downward trend line seen below. At that break, we began to increase our equity exposure once again in each of our model portfolios.

For illustrative purposes only and is not indicative of any investment. The data does not assume reinvestment of income and does not account for possible taxes, transaction costs, fees, expenses or sales charges. An investment cannot be made directly into an index. Past performance is no guarantee of future results.

The next step in our Wealth Accumulation strategy was the ability for the S&P 500 to break through overhead resistance levels, marked in green dashes. It is our thought that if the markets are indeed going to rally higher, we first need to trade through 1470.96 and 1474.51 respectively.

For illustrative purposes only and is not indicative of any investment. The data does not assume reinvestment of income and does not account for possible taxes, transaction costs, fees, expenses or sales charges. An investment cannot be made directly into an index. Past performance is no guarantee of future results.

As you can now see in the chart above, we believe we have the requirements for what could lead to a sustainable rally for the near term: Reverse the series of lower highs and the downward trend of the S&P 500. Break through resistance levels of 1470.96 and 1474.51 respectively. What was once resistance is now support.

We have increased our exposure to areas we see as generating the best relative strength - Mid Cap and Small Cap equities as well as Emerging Market Equities. We would imagine that as we embark on the 1500 level for the S&P 500, there will be increased talk of the October 7, 2007 S&P 500 all time high of 1565.15. The important thing for investors to do is to remain disciplined and not get caught up in the emotional frenzy that is sure to start. We have had a very nice welcome to the new year and we would like to see some of this quick rally digest itself from being short term overbought. Preferably this comes in the form of a sideways trading market for a little while. As always, we will continue to keep you informed and we encourage everyone to visit our website at www.compasstactical.com and follow us on Twitter at @CompassAssetMgt.

We appreciate your confidence and trust! Best Regards, Robert D. Yarosz Director, President The Compass Asset Management Team
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Thomas W. Rendl, Jr. Lead Portfolio Manager