The Markets	3/31/11    Close	12/31/10    Close	1st  Qtr.  Change	3/31/10                          Close	12 Mo. Change	YTD       Change
Dow	12,320	11,578	+6.41%	10,857	+13.48%	+6.41%
NASDAQ	2,781	2,653	+4.82%	2,398	+15.97%	+4.82%
S&P 500	1,326	1,258	+5.41%	1,169	+13.43%	+5.41%
MSCI EAFE	1,703	1,650	+3.21%	1,584	+7.51%	+3.21%
10-yr Treas. yield	3.45%	3.31%	+0.14%	3.83%	-0.38%	+0.14%
Fed funds rate	0to.25%	0to.25%	n/a	0 to.25%	n/a	n/a

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

World events far overshadowed the markets and domestic economic news. Widespread unrest in the Middle East began with the overthrow of the longstanding regime in Tunisia, with similar results soon to follow in Egypt. Yemen and even Syria experienced growing protests as did US ally Bahrain. Libya provided the most direct impact to the US, with Muammar Gaddafi seemingly on his way out, then staging a harsh military comeback, followed by a no-fly zone and heavy airstrikes from a UN coalition led by the US. At the same time, Japan suffered the tragic effects of a massive earthquake and tsunami, which caused significant radiation leaks from a nuclear plant. The financial crisis reared its head again as Portugal rejected an austerity plan, its prime minister resigned and the third bailout by the EU (following Greece and Ireland) appears imminent.

Through it all the Dow shrugged off the highest oil prices in 30 months, absorbed the uncertainties to the Japanese economy and the future of nuclear power and weathered the turmoil in the Middle East to turn in its best quarter since 1999. International developed markets understandably lagged the US market but were still positive. In the midst of some significant volatility (the yield on the 10-year Treasury swung between 3.2% and 3.7%) the slight upward trend in rates continued.

Depending on the point of reference, the Treasury has made a “profit” on the funds used for the financial bailout. Less than $300 billion of the authorized $700 billion for banks was actually used and banks have repaid $251 billion on $245 billion in outlays. The Treasury also announced plans to begin selling its huge inventory of mortgage-backed bonds, hopefully also at a profit. Of course, all this does not consider the rest of the government’s investment in AIG, automakers, direct holdings of bank stock or exposure to Fannie Mae and Freddie Mac. Still, several large banks were allowed to increase their dividends, although Bank of America’s request for a dividend increase was specifically denied.

The jobs outlook showed some steady, if glacial, progress, unless of course you are one of the 13.5 million still unemployed. For the fourth month in a row private employers added over 200,000 jobs, softening the blow of reductions in public jobs. Planned layoffs in the quarter were down 28% from 2010 and the overall unemployment rate dropped to 8.8%, the lowest in two years. Still, the labor force participation of 58.5% is the lowest in 27 years, reflecting the many workers who have dropped out of the labor force in frustration, and hourly wages increased only 1.7% from the prior year.

Fourth quarter GDP growth was increased to 3.1% from 2.8% with growth for all of 2010 at 2.9%. Indicators for both the manufacturing and service sectors were the strongest in seven and five years, respectively. Consumer confidence was off from its three-year high in February but remained positive and consumer spending outpaced personal income growth. Household wealth recovered significantly, with total debt levels (including mortgages) at the lowest levels since 2004; debt levels are still well above long-term trends. Housing is still a dark spot, with new home sales at half the level needed for a healthy market and prices for existing homes down another 5.2% from the year earlier.

Looking Forward

The big issue that is still looming overhead can be summed up in three words – budgets, budgets, and budgets. World events have provided a distraction, but at federal, state and local levels dramatic measures will have to be taken. Political philosophies aside, it is irresponsible to just nibble around the edges of budget deficits, and some combination of redefining the role of government and raising revenues is the only way out. In 2011 the federal government will spend $200 billion on debt interest alone, at a time of historically low interest rates. Even if rates stay low, in ten years those interest payments are projected to rise to $928 billion. That is more than the projected spending on Medicare in that year and nearly double the non-security discretionary spending.

State and local budgets are, for the most part, supposed to be balanced by law. All those deficits we read about are being masked by more borrowing and accounting gimmicks. And while public unions make a convenient villain in the debate about public worker health care and pensions, it is really the ignorance and lack of courage of politicians who created the problems by first agreeing to some loose and generous rules and then neglecting their responsibility to fund the benefits. Neither of those things happens as often in the private sector because private companies are subject o much more stringent funding rules and penalties.

The greatest consequence of the Middle East, at least in the near term, will not be the spike in oil prices, although that will be an irritant for consumers. Rather, the degree to which the US is militarily involved could create yet another budgetary strain and could exhaust the already overstretched military. The public’s patience with war is also wearing thin, which is ironic considering we have been engaged in two long wars with a remarkably small impact on the general public.

Our Portfolios

Low interest rates and simple passage of time have led many investors to really stretch for higher yields, sacrificing quality in the process. (Indeed, one goal of low interest rates is to support prices in other assets. It has also been said that these low rates have forced us all to become speculators.) The “spread”, or difference in yield between high yield (junk) bonds and investment grade bonds, is at historic lows. There is even strong demand for securities backed by subprime mortgages as their prices have largely recovered and stabilized. This is yet another example of evaluating risk by looking backward rather than forward.

The part of portfolio management that is often overlooked is risk management. Similar to asset allocation, risk management is best viewed on a long-term basis, with the fundamental understanding that risk always comes home to roost. Not only that, but risk usually raises its ugly head rapidly and unexpectedly. So, while we typically have a portion of our portfolios allocated to higher-risk fixed income, we have been very careful not to be seduced into taking on more risk than is prudent. We are more than willing to accept lower yields for the time being in return for avoiding the potential for a large loss of principal.

While we are always looking to implement long-term asset allocations, there is still some room for “tactical” investment management, which means making adjustments within a broad asset class or choosing when to buy or sell. We are absolutely not “market-timers” and do not want to create any expectation that we have any magical insight into market ups and downs. But given the relatively steady rise in the stock markets, it is always better to buy when there is at least a slight downward turn, and we were able to do that to a small degree in mid-March.

The Hook

It happened again recently – a provocative headline regarding retirement planning that declared “Stop Saving So Much for Retirement”. (Such headlines are just as prevalent in matters of health, relationships and politics.) As usual, further examination proved that the headline is supported by a pretty silly premise that is either quite obvious or has only a very specific application. (Oh, you mean that if I delay retirement for eight years, delay drawing on my savings and earn much higher Social Security benefits I’ll be better off than if I’d retired eight years earlier? Revolutionary.)

So, the “hook” worked in getting me to read the rest of the article and the author was quite clear in the analysis. The danger is that in these days of sound bites and short attention spans, too many readers will take the headline at its face value and not look critically at the entire concept (not to mention those who don’t have the skills to evaluate the message). And in this case it is more potentially dangerous because it seems to offer simple relief to a very common fear.

There are really only four variables when thinking about or planning for retirement – how much is saved along the way, how much is spent in retirement, how long is spent in retirement (how long to work on the front end, how long one lives on the back end) and how much is earned on retirement savings. There are volumes of research on savings rates and withdrawal rates and strategies, not to mention mountains of information on how to project retirement needs, how to invest for and in retirement, etc., etc.

But despite the best efforts of very smart people, only a few of these variables can actually be controlled or directly influenced by an individual. Diversification and asset allocation are important principles and can make conservative projections of returns more reliable but investment returns are volatile and largely unpredictable. Investing more aggressively to make up for shortcomings in other areas is more likely to backfire than to be successful; if earning higher returns were easy we’d all do it. Likewise, how long one lives is not something to be definitively planned and is probably best left to fate.

That leaves, with varying degrees of precision and control, how long to work, how much to save and how much to spend. Working tenure can be greatly impacted by health issues, job skills and the health of the economy. Retirement spending should be evaluated at least ten years prior to retirement and well before becoming too invested, financially or emotionally, in a particular lifestyle or retirement scenario. Saving is a relatively straightforward concept – more is better and earlier is better still. If that discipline puts you ahead of your ultimate goal, then you will have far more control over how long to work and how much to spend.

Keep the concepts in mind first and foremost and the details will successfully follow.