In this article we will look back and then forward. There are notable aspects to the past year, but an ending that was remarkably unchanged. Then, more importantly, we turn our gaze to the coming year(s). Essentially all the major points from our past year or two of Investment Commentary letters remain in effect – debt burdens, inflation/deflation battle, government intervention, volatility and opportunity, and more. Now though, it is becoming clear that a couple factors – Europe and currency wars – will dominate the next one to ten years (sorry but that’s as exact as it gets for now). Last Year. Incredibly, the S&P 500 started 2011 at 1257.64 and ended the year at 1257.60. That change of only 0.04 points, or 0.0032%, is the smallest annual change in the history of the index. So, it was an historical year of return for the S&P 500! Fun aside, this lack of change in the index masks a pretty rocky road to nowhere. To that point, the S&P 500 hit a high for the year of 1363.61 on April 29, 2011, leaving the index up +8.4% at that point. From there things went downhill, hitting bottom on October 3, 2011 with the index at 1099.23. This was a -19.4% loss from the high, and left the index down -12.6% for the year. The last three months of the year were strongly positive to get back to no change for the year. Looking back on client’s portfolio performance, we are proud to report that clients also finished the year largely unchanged. Why are we proud of this – shouldn’t it be more like “not satisfied, not dissatisfied”? The reason we are proud is that return is not all that matters. Risk also matters. As illustration, if we were to say “which you would prefer: an investment that could return 4% or an investment that could return 6%?” Which should you take? It’s a trick question. You can’t know which one is the best investment without knowing the risk that is being taken to get that potential return. It would be foolish to take the potential 6% return if the risk of loss was ten times higher in that investment. Risk is generally measured by standard deviation of returns – the premise being that the more things can bounce up and down the more risky they are Risk is generally measured by standard deviation of returns – the premise being that the more things can bounce up and down the more risky they are. Another way to speak about this is volatility – again, how far can returns swing up and down. Our strategies dramatically reduced the volatility of the market in 2011. As we mentioned, in 2011 the market went from up +8% to down -12%, a -20% negative swing. In that same time period Highlander clients generally saw their accounts swing from around +2% to +7% to around flat to down -5%. In short, Highlander clients ended up with about the same return as the market with about half the risk. That’s something we are proud of. In particular, our Active Hedge strategy, which returned over +30% in 2011 was important to this success. 2012. We have been writing about the themes of debt, and inflation/deflation consistently for years now. As the backdrop to these themes we’ve also been writing about the economic transition that we are experiencing – in particular from a highly leveraged (debt heavy) world to a lower leverage world. This transition is continuing, but it is not exactly the same now as it was this time last year. In particular, the areas that have taken prominence are European sovereign debt and currency devaluation. European sovereign debt is likely to be the biggest story pushing the market around in 2012. Until there is some clarity about how the massive debts of European countries will be unwound this issue can be expected to dominate other macro-economic market drivers. The problem is that many European countries will not be able to pay back their debts (bonds). At the risk of over simplifying things, suffice it to say that if the European countries which are in trouble are allowed to default then essentially all the major banks in Europe will be rendered insolvent. So, that’s not going to happen (we hope, given the market disaster that would ensue). What is going to happen in Europe? There is some talk of splitting up the European Union, or dropping the Euro as the currency of some or all countries. These routes are fraught with pain and the political will of Europe appears very strongly to favor maintaining the currency union. Another option is for Germany to attempt to pay the debt off for the other countries. Even if this was politically acceptable, it’s not entirely clear Germany could afford it. So, all other things being equal, the logical choice is to devalue the Euro to the point where the debt loads and interest payments aren’t so painful. All other things are not equal though. Firstly, Germany doesn’t like the idea of devaluation. For historical reasons (see the Weimar Republic hyper-inflation) devaluation is now contrary to German DNA. Additionally, Germany exports to its fellow European countries. If the euro is devalued, then more euros will go to purchasing food and other necessities and less to buying German products. Second, a devaluation will have unknown consequences for other countries, and is usually seen as an aggressive act internationally. Third, pretty much every other county in the world is trying to devalue their currencies as well, and they can’t all do it at the same time! We have entered a new age of currency wars. Why would countries be competing to make their currency worth less? In times of prolonged recession or depression a country can lower the value of its currency and gain an export advantage – the goods produced in that country become cheaper on the world market. Demand for these goods goes up, the country’s GDP increases, exporters hire more people, and things look better. In the other countries though, this causes a different situation. In those countries, demand for cheaper imports goes up. With this, demand for domestically produced goods goes down, GDP goes down, domestic companies lay people off, and things slow down. You can see why one country may take umbrage with another’s devaluation. In good times, some of this is okay, in particular to balance payments between countries where an imbalance has occurred. In times like now, this becomes a political powder keg. The upshot of currency wars for investors is that political risk is much higher than in normal times. Who knows what decisions will get made, or won’t get made? Countries may act unilaterally to devalue – think quantitative easing. Other countries may retaliate – for example, China demanding to keep a pegged exchange rate to the US dollar, thereby simply devaluing as fast as the US. This is already happening. Global scale macro issues will push world markets around unpredictably, confounding the ability to forecast short-term effects. Long-term though, the history record is a bit clearer – currency wars lead to inflation. There’s much more to unpack here, which we can leave for future letters. What we believe is important to take for now is that this remains a time for balance in investing. With European debt still in question, we don’t anticipate making major asset allocation changes. For a few years we’ve used the term “conservative balance”, which is still a good guide. We have come off that slightly, and now view assets that can benefit from worldwide devaluations, even if somewhat volatile (like hard assets, commodities and stocks), as having an improved risk-reward outlook long-term. If the outlying very bad result for Europe (all out default) is avoided, we can expect gains in stock and commodity prices and significant losses in purchasing power for anyone caught holding cash or bonds.