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February 2, 2012

Dear Clients and Friends:

When I think of Groundhog Day two things come to mind. First, the hope that the furry little mammal will predict a quick end to winter and second, the Bill Murray movie of the same title where Bill finds himself in a seemingly endless time loop, repeating Groundhog Day in Punxsutawney, PA day after day after day.

Groundhog Day seems to be an appropriate metaphor for our current economic and political climate. Even though a year has passed, we are still faced with many of the same challenges. Housing prices are still falling, far too many people are out of work, there is no certainty in the tax structure, no consensus on needed regulation, no serious steps to control our national debt, and Europe is still a mess. Every day seems like deja vu all over again.

Unlike Punxsutawney Phil, we cannot predict whether these concerns will keep us in a rut for an extended winter or whether spring is just around the corner. There are glimmers of hope. The American spirit is an optimistic one, born from humble beginnings and many hardships. Every day is a new day and a chance to make it unlike any of the others that came before it. We can embrace our "can do" American spirit or resign ourselves that our fate depends upon the actions of others.

As personal financial advisors, it is important that we stay up to date in the various segments of planning, such as taxation, investments, financing, insurance, education, retirement, and estate planning. Equally important is our role of reminding you to keep actions aligned with goals. The current advertising campaign by Fidelity, urging customers to stay on the green path to reach their goal, is instructive. The study of behavioral finance plays a very important role in understanding how behaviors and attitudes impact the achievement of financial security. Here are some examples of behaviors that are self-destructive:

Self-Destructive Behavior

Comments

Confusing spending "wants" with spending "needs"

Be aware of lifestyle creep that impairs financial security

Chasing hot investment tips from friends or acquaintances

How often do they speak of their losses?

Procrastination

The enemy of progress

Adding to recent winning investments and selling out of favor ones

Buying high and selling low is seldom a good strategy

Be aware of any behavior that seems appropriate and logical but may actually hinder the achievement of more important long-term goals. We strongly encourage you to discuss those impulses with us before giving in. We want to "keep you on the path" while internal and external forces want to push you off.

Investment Commentary – Portfolio Changes

Throughout the year, we accumulate investment ideas that merit consideration. After reviewing all of the strategies, we have determined that the Ironclad Managed Risk Fund (IRONX) should replace Calamos Convertible Bond/Growth & Income, Ivy Asset Strategy, and the Pimco Global Multi-Asset funds in the Satellite Strategies area of the portfolio.

IRONX provides equity exposure with reduced downside risk inherent in the mechanics of the strategy. The strategy is modeled after the Put-Write Index (PUT) developed by the Chicago Board of Options Exchange (CBOE). It involves selling put options for downside protection to market participants, in exchange for a monthly premium. This is the equivalent of selling insurance to protect investors on the downside of the S&P 500 on a consistent, systematic basis. The result is a strategy that delivers long-term returns comparable to the S&P 500 with 2/3 of the volatility, as measured by standard deviation. In other words, the volatility of the strategy is comparable to a 66%/34% stock/bond portfolio with returns that are on par with equities over full market cycles. Below, we have charted the returns of PUT vs. a 66%/34% portfolio over rolling 3-year periods to illustrate the attractiveness of this strategy.

The PUT strategy beat a 66%/34% portfolio 17 out of 23 rolling 3-year periods using a systematic, repeatable process with comparable risk. The chart below shows how this would look from a total return perspective from 1987 to 2011.

If you have any questions regarding this strategy, please contact Ravi in our office.

Comments on Current Fund Holdings

Evermore Global Value Fund (EVGIX) - This fund had a difficult 2011, but we have full confidence in the manager’s ability to deliver over longer periods. The fund has all the attributes we look for in an outperformer, including:

- Small asset base

- Concentrated portfolio (50 names or less)

- Experienced manager groomed at a firm we hold in high regard (Mutual Series)

- Sizeable stake of the manager’s liquid net worth invested in the fund (80% between fund and the company)

A key reason for the fund’s poor performance in 2011 is their sizable stake in Europe, with above average exposure to Spain. While most would believe that this is an area that should be avoided, a contrarian approach makes more sense. Ultimately, stocks will trade at prices based on future cash flows, which depends on being able to deliver the company’s product or service to its customers in a profitable, consistent manner. Where a company is domiciled means less and less in a global economy. However, companies

that trade on European exchanges or are domiciled in European countries are being painted with a broad brush and inheriting the downside from the region’s "headlines," rather than underlying company fundamentals. This is known as headline risk and permeates through the financial markets on a regular basis. The knee jerk reaction is, "Why would I want to be in Europe?" even if this has little or nothing to do with the sustainable profitability of the company owned by the fund.

Rising Rate Opportunity Fund (RRPIX) - A bond or CD holder gets compensated in the form of interest payments (yield) and the return of principal at the end of the term. The interest earned depends on two factors; one, how long we lend (maturity), and two, the probability the lender will make timely payments of interest and principal (credit risk). Both longer maturities and greater credit risk are compensated by higher interest rates. If we hold a collection of bonds, as is the case in a bond fund or a laddered bond portfolio, the interest rate will ultimately depend on the average maturity and average credit risk of the individual holdings. For example, T-bills will yield the lowest since they are short-term and considered virtually risk-free.

Below is a snapshot of yields as of January 31, 2012 for high quality bonds:

Maturity

Treasury Yields

AAA
Corporate Bond Yields
AA
Corporate Bond Yields
A
Corporate Bond Yields

2 Year  

0.21%

0.56%

0.63%

1.09%

5 Year  

0.71%

1.77%

1.79%

1.90%

10 Year  

1.83%

2.28%

3.22%

3.35%

20 Year  

2.64%

4.39%

4.65%

4.87%

Bond prices are inversely correlated with prevailing interest rates. The logic for this is pretty straightforward. For example, if you purchase a 10-year Treasury bond today at 2% and the rates increase to 3%, your bond will have to fall in value if someone were to purchase it from you. Your bond will fall in price enough today so that between the future price appreciation (from the market value decrease to face value at maturity) and the 2% interest payments, the total return will be exactly 3% annualized. The magnitude in the rise/fall of the price will be greater in bonds with longer maturities than those with shorter maturities with given changes in interest rates. This should be intuitive as well. In keeping with the example above, if the bond had been a 30-year Treasury and rates went up by 1%, your bond would have to fall by a much greater amount, as it is paying 1% less for a full 30 years.

It is believed that Fed policy is effectively reducing intermediate to longer dated Treasury rates by about 0.50%, than would otherwise be determined by market participants. Remember, the Fed only has direct control of short-term rates. However, it can influence longer term rates by increasing demand through bond purchases in the open market. If Japan or China decided that they were not being adequately compensated (in the form of an adequate interest rate) for the risk of holding Treasuries, rates would suddenly rise. The only way the Fed could counter a rate increase would be to step up their purchasing of Treasuries to substitute for the lack of demand from others. This can only be done for so long without triggering a major devaluation in the dollar and high inflation.

We continue to believe that the Treasury market is overvalued relative to the rest of the bond market. With inflation running around 2%, buying a 10-year Treasury produces negative real returns, not even factoring in taxes (return less inflation). The 30-year Treasury is trading around 3%, which, after taxes, will produce close to a 0% real return.

The purpose of using the Rising Rate Opportunities Fund is to hedge out (lessen) the interest rate volatility of the high quality bond funds in the portfolio. The Rising Rate fund takes an inverse position of the 30-year Treasury bond. In other words, if rates rise, this fund also rises at the same rate that the 30-year bond would fall (as it does when rates go up). In theory, the price movement of this fund will mitigate the movement of the other bond funds by moving in the opposite direction if rates were to rise. Conversely, the same happens if rates were to fall. However, there are no perfect hedges. It is possible for Treasury rates to fall, and at the same time, rates on corporate bonds to fall less by comparison, stay the same, or even rise. This was the case in 2011. Over time, Treasury rates and high quality corporate bonds will correlate.

Corporate balance sheets are strong and therefore should be in solid shape to honor their interest and principal obligations. The extra yield pickup of corporates over Treasuries will be in the +1% range in the intermediate bond space. Getting 3% instead of 2% may not seem exciting, but it translates into 50% more income, no paltry sum. Spending some of this extra yield on insurance through holding the Rising Rate Opportunity Fund is prudent. At some point, rates between corporate and Treasuries will converge. When that happens, the Rising Rate Opportunity fund will smooth out the downside of the other high quality bonds in the portfolio.

Annual Net Worth Statements

We are in the process of preparing personal Net Worth Statements as of December 31, 2011. Taking a picture of your assets and liabilities on an annual basis provides us with the ability to improve our services to you. Some examples include:

- Should any existing financial accounts be consolidated in the interest of simplification?

- What is the nature of any current debt? Should any be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement accumulation or distribution planning?

- Have there been any additions to personal property requiring insurance coordination?

- Were there any purchases or sales of real estate?

- Were there any changes in asset ownership not communicated to us that could impact estate planning?

Once we have prepared and delivered these statements, we ask that clients notify us of any necessary corrections.

Tax Planning in 2012

The consensus opinion seems to be that Congressional gridlock will remain in place during the current election year. The fate of a significant number of tax provisions lay in the balance. Some of the key tax provisions expected to expire on or before December 31, 2012 include:

- The temporary payroll tax cut

- Reduced capital gain and qualified dividend rates for individuals

- 10% individual income tax rate

- Reduction in other individual income tax rates from 28%, 31%, 36%, and 39.6%

- American opportunity tax credit

- Phase-out threshold for marriage penalty relief

- The standard deduction for married filers at double that of unmarried filers

- Repeal of overall limitation on itemized deductions

- Repeal of the personal exemption phase-outs ("PEP") for high income taxpayers

- Reduction in the maximum estate and gift tax rate to 35%

- Increase in estate and gift tax exemption to $5 million (indexed for inflation)

- "Portability" rules permitting a surviving spouse to use the unused estate and gift tax exemptions of the last deceased spouse


Source:
http://schweikert.house.gov/News/DocumentSingle.aspx?DocumentID=273435

Staff Additions

We are pleased to announce that Bud Mauger, CFP® and Heidi O’Malley have joined the firm. Bud has a Bachelor of Arts degree with a concentration in Economics. He has over fifteen years of investment experience, most recently as a Vice President of Fidelity Investments. Prior to Fidelity, Bud worked for Merrill Lynch and Prudential. He will direct new business development efforts in addition to serving as a lead advisor for several clients. Heidi has a Bachelor of Science in Business Administration and worked several years in the banking industry, with a focus on operations. She will provide administrative, operational, and client service support.

Information for Tax Return Preparation

We will soon mail all clients a summary of financial planning and investment advisory fees paid in 2011, as well as a report of realized gains and losses from Fidelity accounts. It is very important that your tax preparer receives this information and uses our tax cost basis on your return. Let us know if you would like copies of these reports sent to your tax preparer.

Taxable gains and losses presented as supplemental information on Form 1099s from Fidelity may not agree with our records. In addition, if you were not a client of Schiavi + Dattani for the entire 2011 year, gains and losses that occurred prior to our management will have to come from your own records, or those of your previous brokerage accounts.

Annual Delivery of Privacy Statement

We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.

Information Filing - Securities and Exchange Commission (SEC)

We will soon be filing our annual update of Form ADV with the SEC. During 2011 the agency changed the format and the information required in Part II of the ADV. As a result, we think clients should receive a copy of our most recent filing. We expect to get this to you in the coming weeks. Please contact Vincent if you have any questions. 
We continue to work daily to earn your trust and confidence.

Best Regards,
 
Vincent A. Schiavi, CFP®, CPA/ PFS                Ravi P. Dattani, CFP®, CPA
President                                                        Vice-President
 

Enclosures



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