The Markets	3/31/12   Close	12/31/11    Close	1st   Qtr.  Change	3/31/11    Close	12 Mo. Change	YTD       Change
Dow	13,212	12,218	+8.14%	12,320	+7.24%	+8.14%
NASDAQ	3,092	2,605	+18.69%	2,781	+11.18%	+18.69%
S&P 500	1,408	1,258	+11.92%	1,326	+6.18%	+11.92%
MSCI EAFE	1,553	1,413	+9.91%	1,703	-8.81%	+9.91%
10-yr Treas. yield	2.22%	1.87%	+0.35%	3.45%	-1.23%	+0.35%
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)

Stocks took up where they left off in the fourth quarter and got off to their best first quarter since 1998. The recent boost put all the major US indices in positive territory for the prior twelve months, and even international stocks continued to recover a lot of lost ground. The enthusiasm for stocks led to a minor sell-off in Treasury bonds and the benchmark 10-year Treasury yield bounced off extremely low levels. Still, savers are scrambling to make up lost income as low yields on “safe” choices such as certificates of deposit and bank accounts are well into their fourth year.

An improving jobs picture was a major reason for higher confidence in stocks and the economy. Over 200,000 jobs were added in each month of the quarter, dropping unemployment to 8.3%. For all of 2011, 1.6 million jobs were added as compared to 940,000 in 2010 but we still have 6 million fewer jobs than in 2007. New unemployment claims have been gradually but steadily declining, and the four week average was at its lowest in four years. Still, the Fed noted that the job market is still weak despite these recent gains and that the US still needs faster growth. The market has interpreted the Fed comments to mean that there would be further Fed support if necessary, including a possible Fed purchase of long-term bonds to alleviate inflation fears even though increases in producer and consumer prices overall have been reasonable so far.

The other development was the agreement by 80% of Greece’s creditors to accept a bond swap that will reduce the value of their investments by at least 50% and probably closer to 75%. That agreement provided a respite for concerns over Europe but soon there were revised estimates that the European rescue fund for governments would ultimately need to be twice its current size of 500 billion euros. This is after European drew $1.3 trillion in low-cost three-year loans from the European Central Bank and S&P downgraded the debt of nine European countries and the bailout fund itself.

Gas prices hit the magic $4 a gallon level, even with decreasing demand, as several refineries closed because they were unable to pass on the higher cost of imported oil. Releases from strategic reserves will have little impact, as the supply of oil is not the problem. Higher amounts of domestic and Canadian oil and a shuffling of refining capacity will hopefully stem the price rise. Home prices hit their lowest levels in nine years and although sales of existing home sales hit their highest levels since the homebuyer tax credits in May, 2011 they are still only 75% of the level needed for a healthy market.

The net result was an increase in fourth quarter 2011 GDP of 3% and a full year 2011 increase of 1.7%, a decline from 2010’s increase of 3.0%. Slower growth in Asia (China lowered its growth target to 7.5% from the 8% that had been in place for eight years), the never-ending saga of the European debt crisis and slowing inventory growth balanced the good news and resulted in forecasts of an increase of 2.5% for first quarter 2012 GDP. Consumer spending finished the quarter on a strong note but incomes have not kept pace and the savings rate continued to decline to 3.7%.

The results of the most recent “stress tests” of large banks were released and 19 of the 20 largest banks passed (Ally Financial, the former subsidiary of GM, was the only bank to fail). None of the banks were required to raise additional capital but four (Citibank, Ally, MetLife and SunTrust) were required to re-submit their capital plans and Citibank was denied the option to increase its dividend or buy back more of its own stock. The Treasury sold the last of the mortgage bonds it had purchased to prop up lenders, making a $25 billion profit on its overall mortgage transactions. The government has been repaid 80% of its TARP bailout funds but still has stakes in GM, AIG and Ally.

Looking Forward

A number of recent developments could (finally!!) help the housing market regain its footing. Bank of America began a program to accept houses back from borrowers, rather than foreclosing, and allowing those same folks to rent the house for a few years. Fannie Mae and Freddie Mac are considering selling foreclosed properties in bulk to investment pools which will then be obligated to maintain them and will also seek to earn a return by renting or reselling the properties. And several lenders have begun refinancing mortgages to lower rates for homeowners who have stayed current with their payments, a group that has been largely ignored. Sure, they still owe more than the house is currently worth but the lower payments make it more likely that they will stay and pay.

This may mean that we are heading to a more “rational” housing market in which supply and demand reach some balance and a seller can expect to sell a house if it is priced appropriately. That does not necessarily mean prices will rise, or even stop going down, but it is an important step. On the other hand, the combination of the housing slump, weak economy and high gasoline prices may mean housing will transition to a new housing model that leaves some types of homes far less desirable. Robert Shiller, co-creator of the S&P/Case-Shiller Index of housing prices, says the shift toward renting and city living could mean “that we will never in our lifetime see a rebound in these prices in the suburbs.”

The future rate of economic growth is always on the radar, but the next several quarters will be critical. Growth will have to pick up from 2011’s anemic level to support continued improvement in hiring and overall economic confidence. And in this “what have you done for me lately” world, the state of the economy in the summer and fall will likely have a significant impact on the presidential election.

Our Portfolios

These days there seems to be new “consensus wisdom” every time you turn around. Right now the wisdom is that dividend-paying stocks are less risky than bonds and other income investments and pay more income to boot. Bonds will indeed decrease in value if interest rates were to rise, but descriptions of the risk like “plummet” and “catastrophe” are simply inflammatory. Bond traders who live and die on very slight price movements may see a catastrophe, but a long-term investor with bonds as part of a diversified portfolio will certainly not face ruin from changes in interest rates.

There is some validity to the current propensity for stocks. Risk evaluations should always be forward-looking rather backward-looking. Interest rates can’t go much lower and any rally in bonds would likely be short-lived like the Treasury rally in mid-2011. We’ve been on a 30-year bull market for bonds since the Fed battled inflation in the late 70’s and early 80’s. At the same time, the economy appears to be slowly regaining its footing, and if things continue to improve stocks will have plenty of room to run. The income advantage of many stocks is clear, particularly as long as dividends have a preferential tax rate compared to interest income.

That long bond bull market has not been entirely smooth and history can at least give us some sense of relative risk and return for bonds and stocks. In the last 20 years, the likelihood that quarterly returns would be positive is roughly similar for US stocks and investment grade bonds (70% for stocks and 75% for bonds). The degree to which returns can vary, however, is huge. In 2008 stocks fell over 22% in one quarter alone and fell 37% for the year. Over the last ten years the worst of bonds’ ten negative quarters was -2.46%. The last negative full year for bonds was in 1999, and even when the Fed was increasing short-term interest rates 4.25% from June, 2003 to June, 2006 (rising interest rates would typically mean a drop in bond prices) bonds had six slightly negative quarters but each full year was positive.

Stocks clearly offer higher potential positive returns in exchange for that higher risk, growing over 30% in four of the last 30 years and as much as 16% in one quarter alone. And what about the shaky finances of state and local governments and the debt crisis in Europe, which could lead to widespread problems in all debt markets? It is true that relying solely on the past leaves one vulnerable to a “black swan” scenario that we have never seen before. Still, massive disruption in bond markets would so destabilize overall economic activity that stocks would suffer even worse than bonds. The bottom line is that maintaining a bond allocation in a diversified portfolio is prudent for long-term risk management and balancing the greater risks and returns of stocks.

Two Dismal Pictures

I recently had the time to read two books by Michael Lewis, The Big Short, which illustrates the mortgage bubble through the eyes of several contrarian, misfit investors, and Boomerang , which is a cultural and financial tour of the global debt crisis. Although Lewis ends Boomerang with a clumsy vignette that our resilience, creativity and hard work will somehow pull us through, the cumulative picture painted by these two stories is really, really ugly.

The mortgage crisis is portrayed as the result of aggressive lenders, accommodating Wall Street financial engineers and an unwitting public. The rating agencies are completely clueless and are actually manipulated by Wall Street once the rating agencies’ methodologies become known. Thus securities which are made up of slices of other securities which are actually full of worthless mortgages all magically become rated at the highest quality. Since the ratings are high grade, Wall Street does not have to disclose details about their holdings nor do they have to maintain adequate capital. Wall Street salesmen were aggressive and lacked disclosure at best and committed fraud at worst. And there are plenty of buyers of these securities, whether Japanese insurance companies and pension funds, German banks or Wall Street itself.

Lewis omits any discussion of government’s role in the mortgage mess, other than to say regulators were asleep at the wheel. There is little question that the assumed government guarantee of Fannie Mae and Freddie Mac contributed to false confidence, despite the fact that these “government sponsored entities” were designed explicitly to not have direct government backing. Although the contrarians all made plenty of money, they regretted that they did so as a result of so much financial damage. Interestingly, they also came to realize that their participation in the game actually enabled the bubble to grow larger than it otherwise might have.

Boomerang is a much less technical story and the history and culture which led to the debt crisis are fascinating. (Who knew the Germans’ Achilles heel is that they expect everyone to play by the rules and not lie, or that changes to the laws regarding Icelandic fishing rights contributed to Iceland’s debt binge.) As for public debt, Benjamin Franklin’s idea pretty well sums things up: “When the people find they can vote themselves money, that will herald the end of the republic.” This is as true of the US as it is of Greece.

There are two themes common to the mortgage bubble and global debt crisis. The first is that we somehow have to reverse the mentality of “I have to get mine now because everyone else is getting his” and return to the triumph of long-term responsibility over short-term benefit. This is not easy when we are still stuck with “too big to fail” and Wall Street seems to have skated through with the least pain of any of the players. The second is that delaying solutions to these debt problems will only make things worse. Time may heal all wounds, but in matters of public debt time also opens new and larger wounds.