4.27.20102010 1st Quarter Newsletter Economic Update: Better, but compared to what? The economy is steadily improving (manufacturing, consumer spending, GDP growth, unemployment), but the comparisons are against year-ago numbers, which were terrible. A year ago remember, the world was expecting a depression! The GDP growth can be attributed to the replenishment of inventory to replace products sold at fire-sale prices the previous year. The crucial question for our economy today is “where do we go from here”? For the answer to be “sustainable, consistent growth”, the key will be additional demand for goods and services to require the hiring of more workers who can spend more money and thus serve as the catalyst for sustainable economic growth. Don’t bet on it. Economic growth will continue to be imperiled by rising taxes, declining consumption growth, and reduced state (and hopefully) federal government spending. Market Update: Continued pricing perfection The stock market remains expensive (P/E is 21.3) and is priced to return 3.0% per year for the next 7 years. Small cap stocks are now priced to return -2% real return and 1% including inflation per year! Investors have chased risky securities over the past year to the point where valuation levels are similar to the peak of the credit bubble in 2007. This will be corrected as it was in 2000 and 2007. Investors now must have a sustained economic recovery and the absence of any additional credit strains. If this happens, investors would likely only achieve tepid long-term returns from these levels. Historically, long-term bear markets tend to begin and end at approximately the same value and last 15 to 20 years. Presently, we are in the 11th year of a long-term bear market with another 4 to 9 years to go. The last prolonged bear market (1965 to 1981) which is similar to the current market began with less expensive valuations than the beginning of the current bear market in 2000. Long-term Bear markets are very volatile and goe up and down wildly, but don’t make any net positive returns. If March 2009 was the ultimate price low of the secular bear market since 2000, it's not likely to represent the ultimate valuation low. Portfolio Update: Capital Preservation For more than a decade, the stock market has been overpriced. In early 2000, the S&P500 was priced to return 0% per year for 10 years and it returned -0.95% per year with two separate instances where investors have lost about half of their money. With the S&P500 priced to return 3% per year, do we invest in stocks, an aggressive investment with 25-50% loss potential, to receive 3% per year or do we conservatively invest in bonds to receive 4%? We favor the later. Investing is the art of managing the probabilities of risk and reward. Currently, the probability of a 10% or greater decline in the stock market is 77% (Ned Davis Research). At this point, we believe that the risks outweigh the possible rewards. Due to our perception of current market risk and limited market returns, we continue to be underweight stocks. The stocks we do own are high quality and have the best prospective forward returns. Our bond holdings tend to be of short duration to minimize interest rate risk if inflation does return. Thank you for your continued trust and support. Trevor K. Holsinger, CFP