The Markets	3/31/10   Close	12/31/09      Close	1st   Qtr.  Change	3/31/09 Close	12 Mo. Change	YTD       Change
Dow	10,857	10,428	+4.11%	7,609	+42.69%	+4.11%
NASDAQ	2,398	2,269	+5.69%	1,529	+56.83%	+5.69%
S&P 500	1,169	1,115	+4.84%	798	+46.49%	+4.84%
MSCI EAFE	1,584	1,581	+0.22%	1,056	+50.00%	+0.22%
10-yr Treas. yield	3.83%	3.81%	+0.02%	2.69%	+1.14%	+0.02%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to 25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

As is obvious from the 12 month returns in the above chart, a year ago was the quarter in which the stock markets hit their bottom, and the returns from the exact bottom are even better. The quarterly returns of the EAFE index reflect the dollar strengthening against the euro as Greece was able to borrow new funds and gain implied support from other euro countries to address its budget crisis.

On the political front, the acrimonious health care issue was temporarily resolved with the passing of the 2,200+ page reform bill. Now attention in Washington has returned to jobs, just after the end of the quarter it was announced that over 162,000 jobs were added in March, the most in three years. Still, unemployment stayed at 9.7%, and the “underemployment” rate, which considers part-time workers who would prefer to be fulltime, remains at over 16%. Productivity grew at over 6% in the fourth quarter, further damping demand for new workers. Both Fed chairman Bernanke and Treasury secretary Geithner indicated that unemployment will remain high for some time.

Fed chairman Bernanke was confirmed for a second term in a very close vote and the Fed repeated their refrain of willingness to keep interest rates low “for an extended period”. The debate over financial regulatory reform will likely remain a debate, although former Fed chairman Volcker proposed a rule to curb banks from trading with their own capital and Sen. Dodd introduced his own reform bill. Internationally, both the European Central Bank and the Bank of England kept rates at current levels. China resisted pressure to allow its currency to rise in value, although they did confirm their commitment to buying US debt and they raised reserve requirements for Chinese banks to slow growth.

Factory orders increased for 11 months in a row while core inflation remained dormant at 1.3% for the prior twelve months. Consumer spending began to pick up, with retail sales up nearly 4% from a year earlier, but incomes did not keep pace, leading to a decline in the savings rate. The decline in home prices showed signs of moderating, but there is still a nine-month inventory of homes for sale and a huge number of homes either in or near foreclosure that could hit the market.

Banks have anxiously been repaying much of their bailout funds, and much of that payback has generated a profit for the government. On March 31, the Fed’s program of buying mortgage securities ended. The Fed also raised its discount rate, which applies to overnight loans from the Fed to banks, as a means to “step away” from emergency lending. The government’s direct involvement, however, is far from over, with guarantees to Fannie Mae and Freddie Mac still open-ended and with the Fed sitting on over $1.2 trillion of mortgage securities that were purchased to provide liquidity to the mortgage market.

And in an epilogue to the financial crisis, the government’s report concluded that Lehman Brothers was responsible for its own demise by taking huge risks and moving those risky assets off its balance sheet.

Looking Forward

In addition to their mortgage holdings, the Fed is holding hundreds of billions of Treasuries and corporate securities. How and when they dispose of these huge holdings could have even greater impact than their widely anticipated decisions on interest rates. Keep in mind that the Fed has direct influence only on short-term rates, with other rates set by the supply of borrowers seeking investor funds, the market’s demand for income returns and outlook for inflation. Selling these securities could add to the upward pressure on rates that will be caused by increased government borrowing to fund huge deficits. And even without selling the securities they already hold, the end of the Fed’s buying could cause mortgage rates to inch up. Despite all the government intervention, overall liquidity remains a concern, with total bank loans outstanding dropping 7.4% in 2009, the biggest decline since 1942.

And that’s not all. The extended program to give tax credits to homebuyers ends with sales contracts signed by April 30. The end of the original program last fall saw a drop in home sales, and it will be interesting to see if home sales drop again once the program is over. There is credible evidence that short-term gimmicks to spur demand simply steal purchases from the future rather than create new demand. While the depth of the crisis called for dramatic action, we now have to deal with the consequences of unwinding these government programs and trying to return to the underlying economic demand. That demand has continued to be weak.

The worst of the crisis in Greece has passed, but other euro zone countries like Spain and Portugal (whose debt was downgraded) are still in dire straits. It is not clear that the more healthy euro economies have the influence to enforce fiscal discipline, nor does it appear that there is much interest in either guaranteeing the debt of weaker economies or directly bailing them out. The ultimate results could range from the euro crisis being resolved just as the US government deficits take their toll (bad for the dollar) to, conceivably, an unraveling of the 1993 Maastricht Treaty that created the euro in the first place (an upheaval to all of Europe, but probably good for the dollar).

Our Portfolios

Given the low interest rate environment, it may be more difficult to manage the fixed income portion of portfolios than the stock allocation. The temptation to “stretch for yield” is always difficult to resist, and even more so these days. It seems that most stock dividend cuts have been absorbed, and some companies are suggesting that they may restore or increase dividends, so dividend-paying stocks may be a more reliable source of income than longer term or even intermediate bonds.

As noted in last quarter’s review, we are still cautious with additions to stock allocations, and have typically used exchange-traded funds with trailing stop loss orders. Exchange-traded funds also offer the ability to enter a purchase order below the current price, eliminating the need to “time” a rising market. The beauty of both stop loss and buy limit orders is that decisions can be made more objectively rather than reacting to daily market fluctuations. It is a more disciplined approach to a market that still has some large unknowns.

When to Wear White

It’s a cliche advice column letter (and if you know anyone whose circumstances resemble these, please don’t take offense; this is not meant to make light of real problems). A woman describes her situation as follows: just lost her job, fourth husband in prison, alcoholic third husband keeps asking for money, elderly parents just moved in, health insurance cancelled, just diagnosed with diabetes, teenage daughter is pregnant, teenage son is in a gang and dropped out of school, the house has mold and the dog just bit the kid next door. The problem for which she is asking advice – is it okay to wear white before Memorial Day?

When to wear white is a legitimate question, and she may have been told repeatedly and with authority that it is very important. It may be that the opinion of those who will be scrutinizing her wardrobe has great value to her. She may not have the skills or the support to address any other problem. Or it may be that with the rest of her life so overwhelming, this issue is all she can focus on and regain some sense of control. Regardless, any objective observer would immediately recognize that she has much bigger issues and that whether and when she wears white really doesn’t matter.

The same is very true of personal financial and investment decisions. We are bombarded by talking heads who drone on seriously and at great length on the implications of daily economic data and the prospects of some obscure company, all in the interest of besting other talking heads. We are inundated with emphatic investment gurus, publications of every stripe and innumerable blogs and online commentators compelling us to act NOW on some trivial investment. In truth, all these things should be viewed as entertainment, with the understanding that they can do real damage to unsuspecting or uninformed followers. Before worrying about the details, first come to grips with really important issues like understanding risk, managing spending and debt and establishing even a broad long-term financial plan.

If this is all so obvious, why does the emphasis on short-term thinking persist? First is ego; it is just not exciting or glamorous to dismiss all the noise and focus on fundamentals. Second is the herd mentality; if everyone else is seduced by the hype, it must be the right way to go. Third, of course, is money; it is an open secret that to make lots of money in the investment business, you don’t have to actually be a good investor, you just have to convince enough other people that they can’t be good investors without you, and the best way to do that is to nurture the idea that you have some special insight. Keep them baffled and they’ll keep coming back.

Ironically, there are celebrated examples of focusing on basic principles and taking the long view. Even the talking heads speak reverently of Benjamin Graham, the father of value investing. One of Graham’s students, Warren Buffett, is widely acknowledged as one of the greatest investors of all time, and certainly can’t be described as a short-term trader. One investment manager produced a series of tongue-in-cheek notepads concerning financial media; the version for television warns “CORROSIVE – Television channels may disseminate toxic hype which eats away at investor confidence in long-term portfolio performance. Danger to financial health can be remedied by changing the station immediately.” And there are plenty of financial advisors who are most concerned with the big issues and understand that consciously doing nothing can be as important as haphazardly doing something.

So, wear white whenever you want, as long as you don’t ignore your more important problems.