Market Commentary — 4th Quarter 2010

Equity markets continued their upward march in the fourth quarter and ended 2010 with solid gains. After a 10.8% rise in the fourth quarter, the S&P 500 closed the year up 15.1%. The Dow Jones Industrials improved by 11% in 2010. Despite some headwinds facing economies around the world, increased confidence is helping to drive equity prices higher and volatility lower.

Strong third quarter earnings reports and a generally positive near-term outlook provided by many companies helped push stocks forward early in the fourth quarter. In addition, economic reports released during the quarter added to investor optimism. Initial reports on holiday sales point to a very strong shopping season, possibly one of the best in the past several years. The latest Institute of Supply Management (ISM) report, a measure of business activity, came in at 57, a six month high, and the seventeenth month in a row in which the report was above 50. An ISM reading above 50 indicates that the economy is growing. These and other data points indicate that fourth quarter GDP growth may well have been greater than 3%, up from the mid-2% range currently being forecast. It is widely believed that a real GDP growth in excess of 3% will foster job growth and reduce the unemployment rate, albeit slowly.

Recent monetary and fiscal policy changes also helped to support equity valuations. As expected, in November, the Federal Reserve launched its much anticipated second round of quantitative easing (QE2). Over the next several months, the Federal Reserve will purchase $600 billion in bonds in an effort to keep long-term interest rates low. The ultimate objectives of this program are to spur borrowing by both consumers and businesses, and to increase equity valuations. Simultaneously, Americans voting in the mid-term elections helped ensure that fiscal policy would also be expanded. With the Republicans gaining control of the House and substantially narrowing the Democratic majority in the Senate, the Obama administration reached a compromise to extend the Bush tax cuts to all taxpayers for two years in exchange for a one-year extension of unemployment benefits. The tax bill also contained an unexpected two percentage point reduction in payroll taxes. Interestingly, the administration’s decision to extend the cuts for two years (as opposed to one or three) will likely make tax rates a major campaign issue in the 2012 presidential election.

We continue to view the equity markets favorably, especially relative to fixed income. The great majority of the macro risks we see on the horizon relate directly to the excess leverage employed by governments around the world, and the likely increase in interest rates as investors refuse to finance such unsustainable deficits. Furthermore, while interest rates have increased since last quarter, they remain very low by historical standards. In our opinion, interest rates have little else to do but increase, and therefore provide an unfavorable risk/reward profile at current levels. On the other hand, several factors appear to support further advances in the equity market. Earnings estimates have steadily been increasing amid signs that the economy is recovering. Companies are sitting on large amounts of cash, which we believe will continue to lead to increased M&A activity as well as IPOs. Capital spending, especially in technology, is expected to remain strong over the next year.

While equity markets celebrated the changes in government policy, fixed income markets declined into year-end. Interest rates rose (bond prices move inversely to interest rates) during the quarter on concerns that the increased liquidity brought on by QE2 would lead to higher inflation. In addition, the extension of the Bush tax cuts is projected to increase the deficit by over $400 billion per year over the next two years. With budget deficits before the tax cuts projected to be higher than $1.3 trillion for the foreseeable future, fixed income investors became increasingly concerned with the federal government’s ability to finance growing budget deficits at attractive rates. The potential inflationary pressures also pushed commodity prices higher. Many commodities, including copper, silver, and cotton, reached all-time highs in December and the CRB commodity index improved by 17% in 2010.

Fixed income markets around the world were unnerved by more than just expansionary government policies implemented in the United States. Markets and policy around the globe were tenuous as well. In Europe, sovereign credit default remains a concern. Ireland barely avoided default in November with the help of an 85 billion euro rescue package from the European Union and the implementation of severe austerity measures. Credit spreads on sovereign debt from Portugal, Spain, Italy, and others continue to widen, reflecting fears that these countries will soon need to implement austerity measures of their own and/or seek aid from the European Union. On this side of the Atlantic, burgeoning state and city budget deficits have placed the municipal bond market under pressure as investors demand higher returns to offset the increased risk of default.

Looking into the future, we continue to view the equity markets favorably, especially relative to fixed income. The great majority of the macro risks we see on the horizon relate directly to the excess leverage employed by governments around the world, and the likely increase in interest rates as investors refuse to finance such unsustainable deficits. Furthermore, while interest rates have increased since last quarter, they remain very low by historical standards. In our opinion, interest rates have little else to do but increase, and therefore provide an unfavorable risk/reward profile at current levels.

On the other hand, several factors appear to support further advances in the equity market. Earnings estimates have steadily been increasing amid signs that the economy is recovering. Inflation remains low, and the Federal Reserve’s efforts to keep interest rates from rising substantially are helping to support current equity valuations. Companies are sitting on large amounts of cash, which we believe will continue to lead to increased M&A activity as well as IPOs. Capital spending, especially in technology, is expected to remain strong over the next year.

Historically, every pre-presidential election year (the third year of the presidential cycle) since 1939 has seen the S&P 500 improve, often by double digits. We expect both parties to push legislation that will improve the job outlook as well as the economy as they vie for control of the White House in 2012. Furthermore, institutional investors have predominantly driven the rally since the March 2009 lows, as the public has largely been underweight equities in this period. Any positive change in sentiment amongst small investors would be beneficial for equity markets.

Since our previous letter in the fall, we believe that the economy has continued its path to recovery. In fact, recent reports indicate that manufacturing activity appears to be accelerating from the very slow rates reported earlier in the year. The employment picture is also beginning to show further signs of improvement as initial jobless claims continue to decline, though we still do not expect the unemployment rate to dip below 9% in 2011. Despite rapidly rising raw material costs, inflation appears to be under control domestically as high unemployment and excess manufacturing capacity is hindering pricing power. Unfortunately, this is not the case in emerging markets such as China and Brazil. Rising fuel and food costs in these regions are forcing local governments to contemplate raising rates and slowing growth in order to counteract increasing inflationary pressures. Overall, while many risks lurk on the horizon, we do believe we are on the road to recovery, and that modest economic growth going forward will support further advances in the equity markets.

Market Commentary 3rd Quarter 2011

Market Commentary 2nd Quarter 2011

Market Commentary 1st Quarter 2011

Market Commentary 4th Quarter 2010