January 2011

Dear Clients and Friends,

The stock market enjoyed a good year. The last four months of the year were particularly strong and the market has been advancing for almost two years with only a brief interruption in the spring resulting from the Greek sovereign debt crisis.

Stock markets around the globe performed well, with thirty-seven of forty-five developed countries achieving positive returns in both local currency and US dollars. In general the US and emerging markets performed better than other developed countries.

Since 2007 the Fed has purchased about $1.4 trillion of US Treasury securities to help lower interest rates (a process termed quantitative easing (QE)). In November the Fed announced “QE II”, the intention to purchase an additional $0.6 trillion of securities. As a result of this move, rates on the 10 year US Treasury bond declined from 3.8% at the beginning of the year to less than 2.5% in the fall. In spite of QE II, a strengthening economy caused rates to rise, and ended the year at 3.3%.

Over the course of the year, declining bond yields provided a catalyst for advances in the bond market. As memories of the 2007-2008 credit crisis began to fade and fixed income investors began to focus on achieving higher yields, fixed income investments with greater credit or interest rate risk investments, such as preferred REIT’s and emerging markets income funds, did especially well.

Precious metals also did particularly well as investors became concerned about inflation and sovereign debt risk.

Returns for key indexes (including dividends) were:

Economic and Market Outlook

Don’t fight the Fed QE will have several effects. Low interest rates will likely reduce the value of the dollar and help US exports while making imported goods more expensive. It may also help boost the price of stocks, precious metals and natural resources but eventually will increase the overall inflation rate. While QE II was also intended to keep mortgage rates artificially low, the strengthening economy has caused interest rates to rise in recent months, although they still remain low by historical standards.

The Federal Reserve has said they intend to hold interest rates down for the foreseeable future and the general rule of Wall Street is “do not fight the Fed” since the stock market frequently rises during periods of Fed easing.

Stock returns are usually significantly higher during the second half of a presidential term and historically the third year of the “presidential cycle” has been much better for stocks than the other three. Of course past performance does not promise future results but does provide another reason to be cautiously optimistic.

The US economy has gradually been building momentum, and many economists expect it to grow in excess of 3.5% in 2011. The two year extension of the Bush tax cuts provides more certainty in the financial markets, provides additional money in consumers’ pockets and should be positive for economic activity. However this may also be offset by higher fuel prices and rising mortgage rates.

Europe is taking a very different approach to their economic difficulties by reducing spending while also increasing taxes. That may not benefit the European economy over the near term, but should put them on more stable footing in the long term. Unfortunately there is still sovereign debt risk in Europe and the markets remain vulnerable to a default by several countries, especially Portugal, Spain, Belgium and Austria.

Investment Strategy

The market environment is attractive, however concerns over the European sovereign debt crisis continue to highlight the need to be cautious.

Preferred stocks, dividend paying stocks and higher yielding US and emerging market bonds are benefiting from low interest rates and should continue to be relatively attractive as long as the Fed keeps rates low. It is likely that this favorable environment will continue through the first half of 2011.

High quality large cap and dividend paying US stocks are a relatively conservative way to participate in market advances. We believe individual stocks such as Berkshire Hathaway, Coca-Cola, Johnson & Johnson, JP Morgan Chase, Wal-Mart, and Microsoft offer investors the opportunity to purchase quality companies at reasonable prices. Mutual funds that are well-positioned to benefit from investments in undervalued large and mid-cap stocks include, Vanguard Dividend Appreciation (ETF), Fairholme, andYacktman. They also provide a way to participate in market advances, while controlling the level of risk.

Funds investing in Preferred REITs such as Forward Select Income and emerging market bond funds such as TCW Emerging Markets Bond offer higher yields with reasonable risk levels and should continue to benefit from the low interest rate environment.

Emerging market countries should have stronger growth than developed countries which are weighted down by heavy national debts. We continue to favor lower risk emerging markets funds such asMatthews Asian Growth & Income and Matthews Asia Dividend, which should benefit from the rapid growth of the emerging countries in Asia.

Due to the high levels of national debt we are cautious about investing in many developed countries in Europe and Japan., however we believe that conservative foreign and global stocks and funds such asFirst Eagle Sogen Global should perform well with acceptable levels of risk.

Although interest rates on corporate, municipal bonds and emerging market bonds have also declined, their spread over US Treasuries remains high compared to historic levels. Funds such asPimco Total Return, Vanguard Short Term Bond (both the open end fund and ETF), FPA New Income,American Century Tax Free , Vanguard Intermediate Term Tax Exempt , and TCW Emerging Markets Incomerepresent good opportunities for investors. In order to diversify credit risk and keep costs low, corporate and municipal bond mutual funds are usually more appropriate than individual bonds for most investors. Eaton Vance Global Macro Absolute Return fund is a low volatility global bond fund with a “go anywhere” mandate and has the authority to “short” the debt of sovereign governments such as Greece. 

According to the Consumer Price Index (CPI) there are few signs of inflation, however the CPI may be a flawed index as food and energy costs have been climbing. It would be prudent to include inflation resistant investments in a portfolio in the event this becomes an issue in the future. Potential strategies include increasing allocations to TIPS (Treasury Inflation Protected Securities) through funds such Black Rock Inflation Protected Bond Fund and iShares TIP ETF. A less conservative approach is to include precious metals or gold funds such as First Eagle Gold. Other funds with a flexible mandate, such as First Eagle Global, Permanent Fund, and Pimco All Asset may also invest in TIPS as well as precious metals.

Recently passed tax legislation did much more than just extend the “Bush tax cuts” for two years. Among its provisions, it lowers the employee portion of Social Security tax by 2% in 2011. For 2010 and 2011 it enables charitable donations to be made from IRA accounts. It also provides for a $5 million estate tax exemption and portability of the exemption between spouses, thereby reducing the need for spousal bypass trusts. Your accountant and / or estate planning attorney can provide you with more detailed information.