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These thoughts were originally shared with our private clients in July.

There are now being shared, unedited to stimulate discussion of these issues and are considered general in nature and not considered specific investment advice. Please feel free to contact us are share your comments. Additionally, please pass this along to anyone who may be interested in our philosophy and point of view.
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Red 39
After a couple of wild swings in June, the stock market has regained its footings and is almost back to its highs for the year. Our Fortress strategy has been in the sweet spot, with most accounts up between 5.5% and 6.5% for the first 6 months, far outdistancing the broader market averages. For example, the S&P 500 returned just 1.5% for 6 months and safe haven hard asset investments like gold lost about 2%. Why did we outperform so handsomely? It was our For a FREE Portfolio decision to commit to a select group of ultra-large cap stocks evaluation, click here. with strong business franchises and very large cash holdings while everyone else stayed on the sidelines. While we didnt coin the term, Fortress stocks are an apt description, especially in this unusual period of extremely low interest rates, high global uncertainty and surprising strength in the Dollar. With impregnable balance sheets, massive cash hordes and large competitive moats around their core businesses, these Fortress stocks have the wherewithal to withstand even the prolonged siege of a global recession. No question, the world is skittish on stocks right now, but these particular companies also have higher credit ratings than Uncle Sam. So why buy the government paper when you can own the real assets and get a higher yield? Hard assets as a safe haven? Not right now. Not only is the dollar strong, but oil and industrial commodities are very sensitive to global demand. Any slacking in consumption could cause a plunge in prices. Last, but certainly not least, we continue to feel quite strongly that low interest rates have created a bond bubble fraught with risk. While the low rates have helped soothe the economic wounds, going forward Washington has to unwind the $1 trillion in deficit spending without allowing interest rates to spike. This has never been attempted before and owning bonds to get a 2% return simply isnt worth the risk. After surveying the warts on this weak field of alternatives, owning the equity of super strong companies with strong cash flows makes a lot of sense to us, especially when they are selling so

cheap. Going into the November election, the overall economy will likely muddle ahead at a very slow level of growth. Nothing too exciting here. However, hidden behind the dreary headlines, we are also witnessing amazing transformations already underway in several specific sectors. As importantly, it also appears the extraordinary growth in these made for America sectors are largely protected from either a global recession or an international geo- political flare-up. To take advantage of this while the herd continues to stay on the sidelines; we are tilting our core strategy with a 5% to 10% allocation into these higher growth sectors. One of the big transformational areas will be Cloud Computing linked with smart mobile devices which then ties into to the entire sector of e-commerce. While the iPhone has now been with us for 5 years, the real game changer here has been the introduction of the iPad in the past 2 years. Shifting from thumb typing to a touch screen has caused an amazing acceleration in e-commerce. There are already over 1.5 billionsmart phones, iPads and other mobile devices filling the ether with tweets, texts, yammers and lord knows what else. However, the real growth is just starting with the number of web connected devices projected to mushroom to over 10 billion within the next 3 years! On the bandwidth supply side of the equation, we see opportunity in owning the companies providing the equipment and softwareto meet this 600% increase in demand. On the consumer demand side of the equation, a world suddenly populated with a couple billion mobile and cloud connected consumers will disrupt all established sales and distribution channels. Anything and everything that can be digitized will be. This will disrupt the business models of all It is time to plan your winter the legacy gatekeepers who have controlled channels of vacation getaway at the luxurious distribution for decades. Even sacred cows like higher Alma Del Pacifico Beach Resort & education and healthcare will be forced to conform to new Spa. Contact the hotel for details. business models and forge new alliances that are now just emerging. After devastating the entire music industry last decade, Apple has just announced a new revenue sharing model which is shaking up the film industry. DittoAmazon, which after conquering the publishing industry is now in the process of bringing Big Box retailers like Best Buys to their knees. Even those bastions of post -adolescent inefficiency, our universities are being challenged. With the student loan bubble about to burst, dont laugh at the on line universities. As one wag has quipped, about the only safe industry left is hair dressing. Of course, none of this is really news. However, the key players are finally learning how to make a profit in businesses with thin margins and requiring huge scale. For those who survive and dominate here, the pot of gold is a long-term river of profits. Because cloud computing by nature is invisible, few people grasp how large this fledgling industry has already become. How big? The huge data centers required to house the computer storage to service the web already account of 1.3% of all the energy consumed in the world! Air conditioning costs to cool the thousands of servers stacked in this bunker like installations is the big cost here. This is more than the total electrical consumption of Mexico, a country of over 112 million people.

Now add the billions of kilowatts consumed constantly, the red and green blinking eyes, the 1.5 billion smart phones and iPads chargers around the world. This consumption will multiply 6X as the number of devices multiplies. Rather than take the risk of investing in e-commerce startups, for the past several years weve opted to participate in this modern day gold rush by selling the picks and shovels to the gold minersapproach. Cisco is the dominant equipment provider for routing traffic and operating the data centers. However, this business is simply too large for a single player to dominate forever. New players are emerging who will find very profitable niches by doing things like increasing bandwidth, lowering power consumption and a dozen other dweebie innovations we cant even fathom. Rather than lament a punk U.S. economy growing at just 2%, doesnt it make sense to increase exposure to a sector which is growing 10X that pace? There is also a decided shift in the consumer side of the business with larger players now getting positioned to control the lifestyle and wallets of the end consumers. The likely result will be a global oligopoly of digital distribution emerging with Apple, Amazon, Google, Microsoft and a few others dividing the world. During this initial phase we have participated via Microsoft which is using its incredible cash flow to assemble a new cloud based model. This model goes beyond word processing software and email and is becoming the spine for work place relationships and communications. MSFT currently has a 90% market share here and they will not cede the high ground willingly. While perhaps not the most exciting play, they have been down this consolidation road at least twice before, first with the MS-DOS operating system and later when they bought their way into the PC office software industry by assembling what is now MS Office. Remember the PC world before MS Office when WordStar, WordPerfect, VisiCalc and Dbase II ruled the desk top? 25 years later, all these early franchises are now forgotten relics and MS Office is near ubiquitous. In the past 18 months or so, MSFT has already started Act III with the acquisition of the web phone company Vonage; a large JV with mobile phone maker Nokia; another one with text book publisher Barnes & Noble; and the addition of Yammer, a social media company. All of this is in preparation of launching the new Windows 8 this fall which will also include touch screen for the laptops. Based on their history, MSFT might not get it right the first time, but they are a very aggressive player with sharp elbows and extremely deep pockets. Over time they will perfect the cloud service lineup and also reap obscene profits. While MSFT gives us an initial position, because the growth rate of e-commerce will be at least 300% faster than the U.S. economy as a whole, we will expand our holdings beyond a core holding in MSFT in order to get in front of this entire sector. The U.S. Energy industry has also experienced an amazing transformation in the past 3 years as fracking technology has caused a radical shift in the long-term cost of natural gas relative to oil. The impact of cheap gas is already being felt as imported oil has dropped from 65% to 61% of our total energy consumption. What intrigues us is not owning the commodity of natural gas, but rather the new opportunities being created in building out the infrastructure and utilizing natural gas rather than oil. Huge amounts of new capital are just now being deployed to take advantage of this large cost differential. The early adapters are the utilities who are starting to convert over to natural gas as a lower cost fuel source for electricity. But the seismic shifts will go well beyond the electric utilities. Cheap natural gas can replace oil in the chemical industry giving U.S. Companies an advantage. Natural gas is also suddenly more competitive with gasoline and diesel for buses, cars and trucks. This brings up the old which comes first the chicken or the egg question of building natural gas fueling

stations without an existing fleet. A partial solution has just been announced with GE and Chesapeake Energy announcing they will be building 500 NG fueling stations. We see our urban bus fleets and then our commercial truck fleets being among the early adapters. Meanwhile, GM has just announced a new bi-fuel truck with a range of 650 miles. Longer term, cheap natural gas will also make hydrogen fuel cells more cost competitive. Residential home heating conversions from oil to gas will also follow. Other opportunities will emerge in related industries such as pipelines and distribution. So if there are some shiny new industry sectors to attract our attention, why is our national mood so, ugly? We have a simple and obvious answer. At its deepest root, this pessimism is based on a deep seeded personal and individual depression and has more to do with world politics or a sluggish economy. Over the past 4 years the average net worth of an American family has plunged by 39%, effectively wiping out all of the national wealth creation of the prior 20 years! Thats right, all the net national wealth created over the past 20 years from the tech boom, the internet and the all too brief golden age of globalization has been vaporized since the 2008 crash. Pretty much 2/3s of the typical Baby Boomers adult work life is gone in a flash. Ouch! This Red 39 is a statistic the press should be focused on, not whether the monthly unemployment statistic is still hovering around 8%. The household savings or net worth is what the 92% who are working are focused on when they survey the family finances. Jobs for the other 8% who are unemployed are a very distant second, and only enter the discussion after the family is secure and whether it is time to replace the old jalopy. This Red 39% plunge in the household net worth is also compounded by the Fed induced environment of very low interest rates. Do the math: After dropping from $139,000 in 2008, the average household net worth is just $78,000. Now a 10 year T-Bill is earning just 1.5% which computes out to less than $1,200 a year or a little over $3 a day. In the math of the new normal thats one meal a day on the $1 menu at McDonalds. Now, thats depressing! The Baby Boomers are now facing the very harsh and sobering reality that Golden Pond was just a mirage. They are no longer soon to be retiring but the no longer able to retire Baby Boomers. What used to be called the Silent Majority is a scared political force that is just finding its voice and will influence the outcome of the national and state elections. The gaping hole in the personal balance sheets and retirement accounts across America is the root of the Tea Party movement. Our conclusion is that this mood will not change unless a miracle cure is found for the net worth crisis. However, behind this cloud of pessimism there are investment opportunities that most refuse to acknowledge. Here are our most recent thoughts on investing in the current environment. 1) Even though the U.S. and Global recoveries are weak, our heavy emphasis on ultra-large cap stockshas worked well with our core equities up an average of 11.4% for the six months. We will continue to focus on ultra-large cap companies with pristine balance sheets, very profitable franchises and huge hordes of cash. 2) For the first time in 50 years, the average dividend yield on all stocks is higher than the average yield on all corporate bonds. Since our Fortress stocks are on the high end of this curve, on a straight yield basis they are a solid alternative to bonds. Also, 60 companies now have a higher credit rating than the U.S. government, making it an easy argument that our holdings also have lower risk than

Government bonds. So if we can own stocks which are yielding more than corporate bonds and also have a higher credit rating than the US government, doesnt this make a lot of sense to look past the pessimism and invest? There is the upside of the equity kicker to also consider! 3) At about 9% of assets, the cash holdings by the S&P 500 are the highest in over 50 years. Some of our companies have cash between 25% and 50% of total assets. Strong cash flow and clean balance sheets should help buffer any downturn by reducing volatility by 25% or more relative to the overall stock market. 4) We also like opportunistic CFOs who have taken advantage of these ridiculously low interest rates to raise even more cash in the bond markets. This should put them in an excellent position to either acquire other companies or reduce the amount of their own stock outstanding. Option 1 will increase future earnings and Option 2 will increase current share price. 5) Johnson & Johnson is a great example. It is the largest diversified health care provider in the world with strong global franchises and has socked away $25 billion of cash (up from $11 billion in 2008). With a pristine balance sheet JNJ has just 50% of the volatility of the average large-cap stock. While we are awaiting the global recovery, JNJ is also paying a 3.65% dividend annually which is more than double the current yield on the 10 year Treasury bill. Did we mention that JNJs stock was also up 2.6% over the first 6 months? Add it all up and weve got a company that has a higher credit rating than the U.S. Government; is paying out twice the yield and weve got the upside of an equity kicker to boot. We look for JNJ to opportunistically deploy its cash stash by more acquisitions or alternatively retiring more of their own stock. 6) Another core holding, Microsoft, has also had great first half (up 14.3%) while also paying an annualized dividend of 2.75%. Cash hoard? MSFT has a massive $55 billion cash stash which is roughly 50% of its total assets. Despite the recent run up, the stock remains very cheap. After netting out cash, MSFT is trading at a P/E ratio of just 5X which is insanely cheap compared to the 16% earnings growth rate its been compounding its earning annually for the last 10 years. But youve heard the PC is dead and yada, yada, yada So just what do you think Microsoft is doing with its $55 billion in cash? Could it be they are using it to assemble a dominant position in cloud computing and social networking? Over the next six months MSFT will launch half dozen major products. Didnt we see them execute this strategy in the 90s when they assembled the MS Office Suite? Recall their competitors screams of anti-trust, copy right infringement etc.? And after 10 years of litigation, who is left after all the lawyers got paid? See our point. MSFT is a ruthless competitor in the business world and with their massive war chest and track record; we wouldnt want to go up against them. In the words of that great American philosopher Mr. T, we pity the fool who stands in Microsofts way. 7) GE is another one of our core holdings with a solid balance sheet which has already had a great year returning 13.5% YTD while paying an annualized dividend of 3.2%. Still the best could be on the way, as GE is selling at less than 50% of its 5 year highs. Since 2008, GE has been repositioning itself for a rapidly changing world both in terms of core businesses and geographic emphasis. On the business side of things, it has decreased the importance of its consumer finance division while increasing exposure to the energy sector. GE is already the worlds largest player in wind turbines and is also a major player in a number of other energy sectors like natural gas as well. GE has been ahead

of the curve geographically by reducing exposure to Europe from 45% to just 20% today. More recently, GE also announced a pull back from China citing the difficulty of doing business and making a profit there. These might prove to be two very smart moves. 8) Is it time to move back into the bank stocks? Our assessment remains the same as just after the crash in 2008. In a word No. With financial leverage reduced by 75%, increased regulation on fees and margins from Washington and Congress backseat driving business decisions, how can banks ever make the types of profits they formerly did? The old grey mare just isnt what she used to be. But there is a profit opportunity that can operate just outside the grasp of the watch dog legislators. We can play this niche through publically traded private equity firms who have moved into the void where banks no longer dare to tread. While Washington has made Jamie Demon their personal whipping boy, his Wall Street colleagues at firms like Apollo, Blackrock and KKR are happy to grab the market opportunities. Without retail deposit bases (also called voters), these companies can work largely outside the reach of pandering legislators and traditional bank regulators. In fact, were counting on these dastardly capitalists to employ every known predatory and opportunistic practice they can figure out to ferret out undervalued assets and make a profit for us. Weve been rewarded with a 7.4% for the first 6 months of 2012 and with an average P/E of fewer than 9X there should be plenty more upside. 9) While we clearly posted some big winners this year, our biggest success has been in the real estate sector. Toll Brothersis up a whopping 41.5% YTD and over 70% since last October. Toll focuses on the higher end market which is the only sector that appears to have cash necessary for a 20% down payment to take advantage of the incredibly low mortgage rates. Business is good. Toll delivered 2,500 homes last year and is now profitable at just 25% of their former volume. Going forward, we see housing demand increasing Del Pacifico introduces the Del nationally for new construction as the housing market is now Pacifico Residents Club. Own a close to being in balance with just 6 months supply on hand. luxurious vacation home at the With tight supply any acceleration in sales will tighten supply fraction of the price. Visit and give Toll the ability to increase profit margins. Toll has theResidence Club website for also has partnered with outside capital investors to gain control details regarding this great over several billion dollars of real estate through its Gibraltar opportunity. subsidiary. This aggressive positioning should pay dividends f for years to come. We will let this continue to run right now, but we dont want to get greedy either. 10) Our early entry in Toll Brothers aside, for the record, we are finally calling a bottom in the U.S. real estate market. The combination of population growth and cheap money has finally worked off most of overbuilding overhang. In 2011 only 302,000 new homes were built, the smallest number since 1963, but since then the U.S. population has doubled. While we do not foresee a return to the good ole days, this long forsaken sector should be rewarding over the next several years. How can you personally play this? The easy and smart play is for individual home owners to lock in these incredibly low interest rates and increase leverage on real estate where possible. With rates below the rate of inflation, Uncle Sam is paying you to borrow. We will be looking to increase exposure here over the next several months.

11) What about this bond bubble? Washington has forced down interest rates well below what we all know to be the real rate of inflation. This is not sustainable. Either the rate of inflation has to fall, or interest rates need to rise. Think about it. If youre getting paid 2 % on a 10 year Treasury Bill when inflation is more like 3% or higher, isnt this the same thing as your voluntarily paying a 1% tax to Uncle Sam for him holding your money? When viewed this way, this is irrational and markets do not stay irrational forever. 12) For every 1% that interest rates rise, the owner of a 30 year bond will lose about 13%. So in rough terms, if rates spike from 1.5% to 3.5%, all the owners of the 30 year bonds could be looking at a 25% or so hair cut! So would you risk a 25% loss to capture a 1.5% return? Again this is not rational. 13) If the Chinese have already cut back their purchase of these low yielding bonds to focus on controlling the worlds supply of natural resources, which suckers are left to buy them ? After a few Oil Sheiks who want to move some petro-dollars to a safer climate ahead of the Muslim Brotherhood, about all that is left are all the U.S. pension and retirement accounts. They will continue to invest by Committee and own T-Bills because they are afraid of the stock market. Now, revisit our comments on Red 39 and the plunging net worth of the retiring Baby Boomers. What happens to the American net worth if the bond market bursts causing retirement account values to plunge? Could the 39% decline in net worth balloon to become Red 50? 14) The question remains, how long can Ben Bernanke and the Fed hold the beach ball of interest rates under water? This is a critical variable to the November presidential election results. We suspect, rates will remain low until after the election, but this is just a guess. 15) One of the only things that have been delaying interest rates returning to a normal equilibrium point has been a surprisingly high demand for Dollars. Sadly, this is not because the U.S. economy is kicking butt. Rather, this is a direct result of a flight to safety due to the sorry mess in Europe and continued instability in the Middle East. More recently we also suspect the Dollar is also benefiting a touch from private capital moving out of both China and Russia. The important point here is the Dollars reprieve is due to political factors which are beyond Bernankes control. Once the crises abate, this money will flow back out, putting upward pressure on US interest rates to stem the tides. Again no one can predict when this will happen, but it is important to recognize a very dangerous and unpredictable game being played out in the bond and currency markets, pushing prices down. 16) This helps explain why Gold is also down 2.5% even though the G-Man Liddy and other TV gold pitchmen have predicted this store of value would have increased during a period of increased global instability. Why? Because the Dollar was strengthened due to the massive inflows into greenbacks which is much larger than the tiny gold market. When the Dollar strengthens, gold falls. This is likely a short term trend, but gold will not shine until these huge foreign inflows abate. Until then we will keep our gold holdings at 5% which is the low end of our long term allocations. 17) A stronger Dollar combined with a global slowdown has also been bad news for oil and other commodities in the short run. Over the past three months the market price of oil has dropped from $120 down to $80. All other commodities have also been hammered and are down 2.5%. We are already at the low end of our allocations with Oil and Commodities at just about 2.5% each. We will

keep an eye towards increasing these positions if a sharp sell off presents itself. 18) While on the topic of commodities, last year we added an initial position in what are known as Rare Earth Minerals which are essential for cell phones and other high tech devices. Last year the WTO imposed sanctions on China for manipulating prices which controls 95% of the worlds supply. Last year we initiated a small position of 2.5% in most portfolios but have not added to these positions due to the potential impact of a global slowdown on prices. Our position here is down 12% which reflects the volatility with China and fears of a global recession. 19) On a new topic that is dryer than dust, but one which you should understand, is the growing risk inmunicipal bond mutual funds. This is a very wonkish analysis that argues there is a specific risk in owning the mutual funds that is higher than just owning muni bonds individually. So, if you dont own a muni bond fund, dont worry. But if you do, read onbecause muni bond fundshave liquidity risk which is in addition to the considerable interest rate risk. This is because the large mutual fund families totally dominate the muni bond markets. In fact, it is not uncommon for 100% of a single bond issue to be owned by a single mutual fund. In fact, a Vanguard, Fidelity, T. Rowe or whomever might be the only Wall Street Company to have researched a specific town or muni bond issuer. While not a problem in normal times, if a specific muni bond fundfaces a wave of mass retail redemptions this might force the fund manager to sell these under researched (and therefore illiquid) bonds into a down market with no buyers. Because open end mutual funds are required by law to meet redemptions with cash on a daily basis, they might have no choice but to sell. Isnt this essentially what happened in 2007 when the banks had to sell their CMOs into a market when there simply werent any buyers? What could trigger a small investor stampede? A rash of municipal bankruptcies? (Stockton, Harrisburg, California?) Eliminating the tax exemption on Muni bond interest? Now having seen in 2008 how the CMOs fell 25% to 75% in value in a matter of months in liquidity squeeze, is it worth the chance of a 25% or 35% loss to capture a 3% return? With the deteriorating state and local finances and potential tax law changes, this is a real, not just an academic risk. Please feel free to give us a call if you would like to discuss this privately. 20) China is another wild card both politically and economically. The potential ripple effect of the dramatic decrease in Chinas GDP growth from 10% to 4% without question, impact global commodity prices as demand slackens. This will also weigh very heavily on all the other emerging stock markets. We continue to review these for a re-entry point, but they have been hammered again this year. We feel much more comfortable avoiding this sector at this time. 21) Despite the Fed running the printing presses for the past 4 years, our counter intuitive call that the Dollar would actually rise has been correct and will continue for the short-term. While this has already contributed to a 20% fall in the price of oil, gold and industrial commodities, a hard landing in China could result in a another 20% decline from current levels . Well keep our eyes open for an opportunity here and could shift to a long-term accumulation phase. 22) The Chinese economy is not only slowing much more dramatically than at first thought, but there is now a real possibility of a crash here. If this happens, it might also disrupt the mysterious political succession that is underway. Already the January front runner, Mr. Bo, has been exiled in disgrace. What if MPH? Lets face the reality that the world largest manufacturing economy is in the hands of

absolute novices who have absolutely no experience in overseeing a market based capitalist economy. While they might have a hundred Stanford, Wharton and Harvard MBAs and PhDs on staff, they also have to answer to Party politicians. What do we really know about who is making the calls and what their real experience is here? Can we simply assume the steady march towards a market economy will continue if there is a hard crash? Or could the Old Guard make a counter move to stem the rampant graft and corruption? With the world looking for China to be the engine for global growth, this could have profound implications. Last words: America is at a cross roads of economic philosophy and the November elections are very uncertain at this time. Its hard to see what will spark the sense of prosperity necessary to improve the national mood over the next 3 months. We suspect the Red 39 influence will be a move pronounced at the state and congressional levels, leaving the White House up for grabs. However, regardless of the mood, it is important to stay invested, but also to keep a careful eye on risk versus returns. Well continue to favor the ultra-large caps which can ride through any storm and do not have direct exposure to rising interest rates. But at the same time start adding some growth to the strategy. Barry Strudwick June 30, 2012 DOW 12,880

Strudwick Wealth Strategies 12 East Eager Street | Baltimore, Maryland 21202 Website: www.noload.com | Email: info@noload.com | Phone: 410-727-6444

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