Review & Outlook

Winter 2009

Investor's Update
After suffering through one of the worst bear markets in history during 2008, markets made a tremendous recovery in 2009, avoiding what could have been the second Great Depression, thanks to unprecedented liquidity programs by governments around the globe. The riskiest assets (smaller capitalization, higher beta and low financial stability and high yield bonds) were among the best performers. Fiscal stimulus played a substantial role in the recovery. Future growth will have to come from other sources. The year 2009 will also be remembered as the end of the “Lost Decade”. In nearly 200 years of recorded stock-market history, no calendar decade has seen such a dismal performance as that of 2000 - 2009. Not surprisingly, we are happy to usher in a new decade!

On a total return basis, the Dow Jones Industrial Average recorded a positive 22.7% in 2009, while the S&P 500 advanced 26.5% and the NASDAQ increased 45.4%. As good as the returns were domestically, global markets generally faired better with developing economies leading the way. For instance, the Pacific Ex-Japan region was up 71.3% during the year, and the average emerging market equity mutual fund rose 76.1% as measured by Lipper Inc. Commodities advanced substantially as well, including gold oriented funds gaining 50.7%.

Fixed income investors also benefited by taking on more risk and moving away from high quality issues, especially in the Treasury market. The 5 year and 10 year U.S. Treasury posted a loss of 2.7% and 8.10%, respectively, through 2009. The Barclays Capital Intermediate Government Bond Index declined 0.3%, whereas the Barclays Capital Aggregate Bond Index and Barclays Capital Intermediate Government/Credit Bond Index increased 5.9% and 5.2%, respectively. A further sign of the benefit in risk taking was evident in the high yield market as the High Yield Bond Index, as measured by Lipper, advanced a whopping 49.5% during the year.

Economic Outlook
We are starting 2010 in much better shape than last year. Fiscal stimuli and healthy growth overseas have prevented a worldwide economic disaster. Domestically, we expect 4%+ growth in the 4th quarter of 2009. Our best case scenario in 2010 calls for continued economic growth due to current global monetary policies, improving labor markets, an inventory rebuild, a bottoming in the housing market, rapid growth in emerging markets and improved financial balance sheets. The growing importance of consumers in emerging markets should benefit multinational companies’ growth trajectories throughout the year.

While positive, our work suggests the recovery will be below historical norms following a recession. Historically, GDP rises over 5% in the first four quarters of a recovery. This will be extremely difficult to achieve domestically. We believe the slowing of quantitative easing programs by the Fed will leave the market with no main growth driver capable of picking up the slack which will keep the recovery modest by standard rebounds. A combination of elevated unemployment, over leveraged consumers and rising costs in life necessities (oil, gas, electric, select foods and healthcare) should put a crimp in discretionary spending. Current market valuations seem to be pricing in a pick-up in consumer spending which is a concern for us. Consumers have changed over the past few years from net spenders to net savers and purses are getting tighter. Since the U.S. consumer makes up 2/3’s of GDP, we find it hard to believe that growth will be anything but substandard. This is not your typical economic recovery and markets are pricing in a very rosy scenario.

Therefore, growth in 2010 will likely be front-end loaded as fiscal stimulus programs are scheduled to peak by mid-year resulting in yearly GDP growth in the 3% - 4% range. The risk of another serious downturn is real; however, that is not our forecast at the moment.

Capital Market Analysis
Next year’s market returns will be primarily dependent upon government exit strategies from the current super-expansionary monetary policy which usually leads to a reassessment in risk taking by investors. We expect the major central banks to start exiting their liquidity programs in mid-to-late 2010. The prospect and process of withdrawal may have unintended consequences. We believe government bond markets will be the first victim, namely longer-term yields. The 10-year U.S. Treasury yield has already bounced from 2.05% to 3.84%, raising the cost of borrowing substantially. This trend should continue and fixed income investors should take note. Thus, we continue to stress quality spread issues with neutral to slightly below benchmark duration along with a reduction in U.S. Treasury exposure. Municipal investors should focus on the highest of quality issues, sacrificing yield in return for preservation of principal. Most state and county balance sheets need much improvement which will be difficult to achieve as tax receipts have declined significantly with little sign of improvement.

For equity investors, we expect fundamental data to continue the positive trend in the short-term. This could result in further advances in select sectors of the economy. However, a lot of this positive news has been priced in based upon the markets huge advance from March, namely a 67% rebound in the S&P 500. We feel that a cautious but participatory approach to equities makes sense. The choppy, trading range environment could be widened in the S&P from 900 – 1225. Stronger growth will likely come from emerging economies and exposure to companies that benefit from that area should be emphasized

Summary
As a result, we are cautiously participating in the market’s advance. Positive, short-term news may continue to fuel this rally but sustainable long-term growth cannot be driven primarily by government spending. Any combination of higher fiscal & budget deficits, higher interest rates, a fiscally challenged U.S. consumer, tight credit conditions, a slowly recovering job market, rising number of defaults on commercial real estate loans, and Middle East instability could derail this economic recovery. We believe the markets are pricing in the best case scenario detailed above and any divergence could be met with a revaluation in the capital markets. We remain exposed to the market in anticipation of short-term advances but have our exit strategy in place should this recovery become more suspect. The recent market advance is only beneficial to market participants if you preserve the gains you have already obtained!

We appreciate your confidence and business. Please do not hesitate to call if you have any questions or if we can be of assistance.