1.21.20102009 4th Quarter Newsletter Economic Update: Economic hibernation The US economic decline has abated with 3rd and 4th quarter GDP rising, though shipping volumes, unemployment, new home construction, and bank lending have not shown signs of improvement. Each indicator has stopped declining, but none confirm an economic turnaround. The economy is in hibernation as it isn’t signaling a clear direction of future growth. The true strength of our economy will be more apparent once the government stimulus is turned off. With Congress likely to allow the Bush tax cuts to expire at the end of 2010, the tax increase including the proposed healthcare tax could be $500 billion in a $13 trillion economy, the equivalent of 4% of GDP. Christina Romer, President Obama’s Chairwoman of the Council of Economic Advisors, believes tax cuts have a three times benefit to GDP. If tax increases were to have a similar negative effect, the economy would be thrown back into a recession. Market Update: Pricing perfection The seven-month run in the stock markets in 2009 is a cyclical (multi-month) bull market within a long-term secular (multi-year) bear market. The S&P 500 is 25-30% overpriced (Shiller, GMO). However, this doesn’t preclude stocks from going higher as they did in 1999 and 2007. We all remember how these periods ended. Even after the 2009 run-up, the 10-year average annual return for the S&P 500 index was -0.95% while the US economy grew 51.5%. Investors received all the market risk and no return. This demonstrates the risk of buying over-priced equities. Any continued upward trend in stocks is likely a shift in money flows from fixed income to equities. In 2009, over $350 billion was invested into fixed income funds while net cash flow into stock funds was near zero. The fixed income flows have pushed yields down to low to mid single digits for quality fixed income. If investors decide to move from lower yielding fixed income into stocks, we may well see a continuation of the bull market. However, we don’t believe the economic fundamentals are strong enough to justify significant and sustainable upward equity price appreciation from these levels. Based on historical data, high price to earnings (P/E) ratios for stocks are not conducive to attractive forward returns. On December 31, the S&P had a P/E ratio of 20.1. Historically, the real return (net of inflation) of five different valuation groups has been as follows: Average PE of 8.5 ===> Average 10-year forward real return of 11.0% Average PE of 12.0 ===> Average 10-year forward real return of 8.2% Average PE of 15.0 ===> Average 10-year forward real return of 6.1% Average PE of 17.6 ===> Average 10-year forward real return of 5.7% Average PE of 22.0 ===> Average 10-year forward real return of 3.2% The higher the P/E ratio, the lower the forward returns and vice versa. The S&P500 is priced to return less than 5% per year for 10 years. Portfolio Update: Follow the trend Our “safety first” approach to capital preservation led us toward fixed income investments in the second half of 2009. The stock market correction we expected turned out to be only 7% and the losses were quickly recovered. There is an old saying that you “shouldn’t fight the trend”. In a concession to the bullish trend, we bought high quality domestic and foreign stocks in November and December. We added a high-yield bond position with its 9% yield and the upward trend in prices. We sold our core holding, TCW Total Return Fund, when the manager was forced out. As we have stated in the past, we do not believe equities are fairly priced to “buy and hold” for an extended period. In the current upward trend, please don’t lose sight of the bigger picture: stocks are overpriced and the economic environment is weak. We continue to maintain a cautious stance with a bias towards short-term bonds and high quality stocks.> Thank you for your continued trust and support. Trevor K. Holsinger, CFP