The Markets	12/31/09   Close	9/30/09      Close	4th  Qtr.  Change	12/31/08        Close	12 Mo. Change	YTD       Change
Dow	10,428	9,712	+7.37%	8,776	+18.82%	+18.82%
NASDAQ	2,269	2,122	+6.93%	1,577	+43.88%	+43.88%
S&P500	1,115	1,057	+5.49%	903	+23.48%	+23.48%
MSCI EAFE	1,581	1,553	+1.80%	1,237	+27.81%	+27.81%
10-yr Treas. yield	3.81%	3.31%	+0.50%	2.24%	+1.57%	+1.57%
Fedfunds	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)

Stock markets continued their recovery in the fourth quarter, adding to the Dow’s best annual performance since 2003. The broader S&P 500 and the technology-heavy NASDAQ composite also had their best year since 2003. The Dow finished nearly 60% off its lows from March, 2009 but is still 26% below its all-time high from October, 2007. Still, the market recovery was a welcome relief for investors.

Long-term performance is still weak. The Dow is down more than 9% over the last ten years, with the S&P 500 down 24% and the NASDAQ, still reeling from the tech bust, down 44%. (These returns do not include dividends, which help soften the fall.) Even the MSCI EAFE, which benefitted from the weak dollar, is down over 10% over the last ten years. With interest rates at historic lows, bonds had a very positive ten year record, gaining over 88% for the period, despite the financial crisis of the last several years.

The market recovery was driven by enough good news to further convince investors that the worst had passed. Third quarter GDP grew at 2.8%, although that was revised down from the initial figure of 3.5%. First-time jobless claims fell during the quarter by over 100,000 to a 17-month low and the overall unemployment rate closed at 10% after blipping up to 10.2%. The Treasury now expects to recover all but $45 billion of the TARP funds, although they could lose more from new loans in the future. Productivity rose by the most in six years, the trade deficit is half the level from 2008, consumer spending rose from the dead, home sales improved (albeit due to first-time homebuyer incentives, which were broadened to all homebuyers) and inflation remains dormant. Manufacturing activity grew, although capacity utilization remained 10% below long-term averages, indicating plenty more room for growth before major investment is required. Through it all the Fed indicated that deterioration in jobs was “abating” while reiterating its willingness to keep rates low for an “extended period”.

There are other signs that we are not yet fully out of the woods. Mortgage delinquencies spread more rapidly to “prime” borrowers who had previously been able to maintain their payments and bankruptcy filings continue to rise dramatically. The government funneled $3.8 billion in additional funds to GMAC and announced it would cover unlimited losses at mortgage lenders Freddie Mac and Fannie Mae for the next three years. This unlimited guarantee comes on top of $111 billion already provided by the government and does not include a plan for eventually ending government’s role. Dubai, which had gone on a construction binge in an effort to transform itself into a financial center, suspended its debt payments and had to be bailed out by other United Arab Emirates. Spain, Ireland and Greece, which all use the euro as their currency, are staggering under heavy debt, although Greece seems the closest to default due to its reluctance to take drastic action and its relatively small economy.

Looking Forward

The dollar had almost as wild a ride as the stock market in 2009 and heads into 2010 as a big question mark. Based on a JP Morgan index that tracks the dollar against a basket of 16 currencies, the dollar was up 8% in the spring, reversed to being down 8% in the fall and then rallied sharply to finish the year down just 5%.

The dangers to the dollar are well known – huge and growing deficits accompanied by heavy government borrowing and extremely low interest rates. Those deficits and government stimulus programs are spurring inflation concerns, which could send the dollar lower. Low interest rates encourage the borrowing of dollars to buy other currencies, stocks and commodities, and countries such as Australia and Norway have already raised their interest rates to manage growth.

Doomsayers also point to China’s huge reserve of dollars and artificially low currency valuation and raise the possibility that the dollar’s status as the world’s reserve currency could be at risk. While even minor news in this area can affect the dollar, such as rumblings from China and Russia that having multiple reserve currencies is a good idea, it is unlikely that the dollar will be replaced anytime soon. The euro is plagued by the diverse economic performance of the countries that use it, while any “artificial” currency that could be created by an organization like the International Monetary Fund is purely theory at this point.

The fate of the dollar could hinge on the performance of the US economy compared to its global competitors. Indeed, the late dollar rally was driven largely by the improving news in the economy, bolstered by the difficulties in Greece and Dubai. The dollar will still benefit from its status as the safest available haven when other economies struggle, and could be further strengthened if the Fed abandons its low interest rate policy mid-year as many observers expect.

Our Portfolios

A portfolio designed for certain inflation would be heavily weighted in commodities, cash and inflation-protected government securities, while one designed for deflation would be almost completely invested in long-term bonds and cash. In our opinion, the risk to bonds of rising interest rates outweighs the risk of deflation to a diversified portfolio. Accordingly, we have maintained positions that tilt slightly toward guarding against inflation.

Likewise, prospects for the dollar, and the appeal of foreign investments, are unclear. Despite the possibility of some smaller economy blowing up, we are also maintaining a broadly diversified neutral position on international holdings. Over time the benefits of exposure to global economies far outweighs unpredictable currency fluctuations.

As for US stocks, it is still more appropriate to call the market recovery a rally rather than a bull market. Core positions will be held regardless, but any additions to stocks will only be made in combination with steps to limit losses if the economy and market falter again.

Bring Back Risk – Please!!

In all the navel-gazing around the financial crisis, “deregulation” is often cited as a contributing factor and the fairness and efficiency of “free markets” has been called into question. While both points may have merit, they are actually quite distinct from each other.

A truly free market regulates risk and return through the free flow of capital. High returns attract more capital, which drives returns down to a level commensurate with the risk. Likewise, capital flees areas of high risk and low returns, increasing returns to a level commensurate with the risk. (In practice, fear and greed usually make the pendulum swing wider than it has to, driving returns temporarily lower or higher than necessary, but eventually markets settle down to an appropriate equilibrium.)

There is no question that regulation of financial firms was reduced in the last decade by both political parties to fit their respective interests and agendas. The net result was a gross distortion of the market as risk was nearly eliminated by implicit government guarantees and very easy money. Rather than driving down returns, these factors allowed the bubble to keep growing until it collapsed under its own weight.

Rather than restoring the proper element of risk in financial markets, policy makers have been focused on outcomes and practices. We are no closer to recognizing and managing the idea of firms that are “too big to fail”, and have made the problem worse by encouraging mergers that made firms even bigger. There was an opportunity to make changes when the government was the effective owner of financial firms through the TARP program; that opportunity has been lost as many firms have repaid the funds, leaving Citigroup and midsize banks on the hook.

Executive compensation is another area where the debate is off-point. Special taxes on bonuses or outright compensation limits are ineffective; creative minds will simply find ways around them. And long-term executives who earned stock options over time or deferred much of their compensation are probably entitled to large sums when they leave their posts. The problem is that there seem to be few consequences to poor performance or failure, and boards of directors, acting on behalf of the owners (shareholders) need to take the lead in enforcing realistic limits on compensation.

We have forgotten that taking big risks, when successfully navigated, can be legitimately rewarded with big returns. In our anger, all big returns somehow seem unfair or ill-begotten. But the chance at those rewards is one of the motivations for entrepreneurs to create new technologies, industries and jobs. (Even financial engineers who add little economic value will respond quickly if they are convinced that risk is real, because they understand it better than anyone else.) The greater risk to the overall economy is that those incentives are reduced by misguided efforts to mandate returns. Encourage them to try, and let ’em fail. The rest will take care of itself.