2010 Investment Outlook

2009 is now history, and although there is some debate about whether or not we have ended the first decade of the 21st century, it is clear that 2009 is a bookend year to a two-year, 2008-2009 bear-bull market period that investors won’t soon forget. From the lows of early March, last year saw one of the strongest nine-month rallies in history, rising some 67% into year-end in the process. It is astounding to think about how well the equity markets have done these last few months, given the well-known problems of rising unemployment, economic malaise, exploding government deficits, rising commodity prices, and a continuing overall decline in the U.S. dollar. It is simply astonishing to look back over the last 12 to 24 months and see how far the market averages declined, and then recovered. The equity price volatility we have seen these last two years, while certainly providing trading opportunities for the nimble (and lucky, we suspect), also validates the importance of a disciplined, consistent approach to equity selection, asset allocation, and portfolio management. In our minds, it confirms the difficulty of consistently predicting and reacting to the markets gyrations in response to day-to-day events, and the risks in attempting to do so when it is so easy to be wrong.

Maybe even more interesting is how the bond markets have fared these last two years.

Those who believe that bonds provide safety from price volatility may have to rethink that premise after what we experienced. 2008 saw a tremendous worldwide rush to the safety and liquidity of the U.S. Treasury market, and U.S. Treasuries were essentially the only marketable asset class in the world that provided positive returns in 2008. However, 2009 confirmed that financial markets aren’t always as they appear (or as investors hope), and long-term U.S. Treasuries in 2009 generated marked-to-market losses of over 25%. While the liquidity that so many investors seek remained, for many investors, the safety (at least from price volatility) of U.S. Treasuries proved very illusionary. For the rest of the credit markets, like corporate and municipal bonds, their returns reflected mirror images of the U.S. Treasury market; losses in 2008 as investors sold for the safety of Treasuries reversed to strong gains in 2009 as investors regained confidence and desired the higher yields that such vehicles provide. The most telling example are the returns provided in 2009 from so-called “junk bonds” (debt obligations issued by low-quality corporations), which by one measure returned over 58% in 2009, as confidence returned and credit markets healed. Historically, returns in a range of negative 25% to positive 58% make investors think of stock markets, but the last two years have proved that price volatility exists everywhere in the financial world.

What is next for the economy, the stock market, and the bond market?

Well, of course no one really knows for sure, so one has to be careful about making investment decisions based upon predictions. However, we do know that equity markets, from an overall historical valuation perspective, are neither particularly cheap nor particularly overpriced. If the economy continues on the recovery path that it may be currently on, then growing corporate earnings can lead the stock market higher. If, however, the economy stumbles, than it is hard to see how equities show continued price increases in the short run. However, to hope or plan on returns in the next nine months from the stock market that are similar to the last nine months would be foolhardy, at best. It could happen, but it wouldn’t be a bet one should make. The bond market is of course a reflection of interest rates, and here there is an interesting dilemma. The Federal Reserve is keeping short-term interest rates at historically unprecedented lows, as it provides enormous amounts of liquidity to help stimulate the recovery. So while short-term interest rates are providing essentially no returns on invested capital, similar actions by the Federal Reserve in the past, and as well as by other central banks worldwide, have ultimately led to rising levels of inflation and interest rates, both highly detrimental to longer-term fixed-income investors. While we can’t predict which way interest rates will go in the short-term, we can try to limit the potential damage that such a rising interest and inflation rate environment would create on a fixed-income portfolio. We’ll attempt to do just that by keeping our overall, weighted-average fixed-income investment maturities relatively short term, giving up modest incremental income in order to endeavor to preserve ultimate capital purchasing power.

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