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Fourth Quarter 2010 Quarterly Newsletter

posted on

The Sky Seldom Falls

"I've been through some terrible things in my life, some of which actually happened."
- Mark Twain
"How much pain they have cost us, the evils which have never happened."
- Thomas Jefferson
"But what torments of grief you endured from the evil which never arrived."
- Ralph Waldo Emerson

As the three smart guys above say in varying shades of tasteful English, we tend to worry about a bunch of stuff that never actually happens. Y2K, Bird Flu, and Killer Bees would probably fit in this category. We may laugh about them now, but I assure you that the first time you heard about them, there were probably no chuckles. In fact, most likely just the opposite reaction occurred. The human psyche will often travel to the farthest, and often scariest, realms when trying to figure out how to prepare for a potentially negative event. That's just how most of us are built.

Unfortunately, that's often not the best way to behave in the investment world — for a couple of reasons. First, when you find out about something that may be "bad" for the financial markets, chances are that lots of other people have heard about it before you did. So if you are going to react, you won't be first in line, and you will most likely be doing the same thing as all the other lemmings. That never really works out very well. Second, you will find that rarely does your worst case scenario take place. Unfortunately, many investors will both assume the worst and flip on the panic switch, which leaves little chance for a positive end result.

Want a couple of recent examples? You may remember the fall of 2008, when the US Treasury started doling out the TARP (Troubled Asset Relief Program) funds to unsavory characters, like big banks, insurance companies and even poorly run car companies. Few conservatives or liberals seemed to back the idea. Talking heads from all cable channels shrieked disapproval. "Why give taxpayer dollars to these poorly run entities?" "Doesn't capitalism stand for survival of the fittest?" "That's money down the drain." Global markets tanked. Does that bring back memories?

Well, here we are two years later, and few have been closely following this continuing story. In early December 2010, Citibank completed a public offering of their stock, which allowed the US Government to not only recoup their "investment" of $45 billion of TARP funds, but an additional gain of $10.5 billion. But this wasn't the first payback that had taken place. Many banks have already paid off all their TARP funds, with interest. In November, General Motors significantly reduced the amount owed, and in 2011 AIG is expected to repay all of its TARP funds, plus a tidy profit. In fact, more than half of the TARP funds have already been repaid, and it is anticipated that the Treasury will recoup all the funds loaned, plus make a profit. But this story isn't being reported as loudly as it was back in 2008. Sometimes happy endings just aren't that exciting.

The second example has to do with our economy. As of right now — this very minute, the US economy is above where it was before the recession started in late 2007. We are serious. Want proof? The best measure of our economy is the GDP (Gross Domestic Product). The GDP represents the final value of all goods and services produced in the US. The GDP is reported quarterly, at the end of the quarter. Here are the last 11 quarters of reported GDP percentage moves, starting with the 1st quarter of 2008, when the economy was starting to recede, and ending with the 3rd quarter of 2010: -0.7, .06, -4.0, -6.8, -4.9, -0.7, 1.6, 5.0, 3.7, 1.7, 2.6. If you do the math, you will see that they total a -1.9. In other words, at the end of September 2010, we were 1.9% below the pre-recession highs of late 2007. The forecasted estimate of the 4th quarter 2010 GDP is 2.7. That means that as of the end of the 2010, our economy was producing more goods and services than at the peak of 2007, before the recession. Interestingly, even though the GDP is above its past high, the Dow Jones Industrial Average, and the S&P 500 Index are both over 20% below their 2007 highs. What might that tell you about the valuation level of the current stock market?

With all the moaning and groaning about the very real pain resulting from housing prices, unemployment, political in-fighting and Lindsay Lohan's private life, don't lose sight of the fact that our economic engine and capitalistic structure continues to work. That story seems to be lost in the shuffle. The TARP funds and GDP growth are two examples of financial results that few would have believed possible just a couple of years ago. At that time, there were plenty of Chicken Littles concerned about the sky falling. But as Mark Twain and his friends clearly remind us, often the worst does NOT happen, and rather then shielding your head from a falling sky, it is better to keep it, and your spirits, up, and not miss the beauty of the horizon and the opportunity that usually accompanies difficult times.

New Year's (Investor) Resolutions

Our northern friend Brad Steiman from DFA-Canada came up with a great top 10 New Year's Resolution List that we would like to share with you, with our editorial comments added for good measure. Obviously we'd like to believe our clients already know all these, but just in case:

1. Don't confuse entertainment with advice. Jim Cramer fans: are you listening?
2. Stop searching for tomorrow's star money manager. There simply are no gurus.
3. Do not base any investment on a forecast. Snow in July is a better bet.
4. Think long term, and use your risk sensitivity when determining your reward objectives.
5. TIME IN the market is much more important than TIMING the market.
6. Follow your plan, and rebalance, as opposed to chasing recent winners.
7. Diversification is the closest thing to a free lunch. And yes, there is such a thing.
8. Some financial risks are worth taking, and some are not. Know which are which.
9. Mutual fund expense ratios are important. They directly relate to higher performance.
10. The more you understand Modern Portfolio Theory, the easier you will sleep.

Fourth Quarter 2010 Asset Class Performance



In 2010, a prominent researcher who had predicted the '08-'09 bear market expected the "biggest coordinated asset bust ever." The leading global financial magazine, The Economist's January '10 cover story warned that US stocks were "nearly 50% overvalued." The January indicator for 2010 signaled poor market performance for the remainder of the year. BP's Deepwater Horizon Oil Spill was the largest (and most videoed) in US history. On May 6th, the markets experienced a technical "flash crash" that saw the Dow Jones Industrial Average plunge 1100 points in a few minutes. Hundreds of banks failed in 2010, continuing to show weakness in our banking system. Congress passed expensive and complicated healthcare and tax laws. Residential housing remained weak. Greece and Ireland's governments experienced severe monetary problems that placed their debt near junk bond status.

Even with all the above, the global equity markets climbed this wall of worry rather easily. All equity asset classes, except International Large Caps (thanks Greece and Ireland), had extremely attractive double digit annual returns. There was also a distinct difference in asset class returns based on their style and size. Small outperformed Large, and Value beat Growth. This occurred Domestically, Internationally and even with Emerging Markets. The precise size and value tilts that we use in building the equity portion of your portfolios once again showed the long term reason following the academically-based methodology that we use. Interestingly, the fourth quarter experienced an increase in interest rates, and the corresponding negative returns in intermediate and long term fixed income. Our decision to shorten the average duration of our income/hybrid asset class vehicles over the last year appears to be well grounded. Whether or not this is the start of the long anticipated rate increases won't be known for several more quarters. But it does show that equity market returns are not necessarily tied to the returns of bond markets.

It will be interesting to see if the first part of 2011 will continue the gains of 2010, or will the markets take a breather. Regardless, your next report will be read in a much warmer environment — outside, if not in the financial markets. Enjoy your winter and the fun that accompanies it.

Sincerely,


Frederick F. Kramer IV, JD
Chief Investment Officer
DIXON HUGHES WEALTH ADVISORS LLC