The Markets	12/31/10    Close	9/30/10   Close	4th  Qtr.  Change	12/31/09              Close	12 Mo. Change	YTD       Change
Dow	11,578	10,788	+7.32%	10,428	+11.03%	+11.03%
NASDAQ	2,653	2,369	+11.99%	2,269	+16.92%	+16.92%
S&P 500	1,258	1,141	+10.25%	1,115	+12.83%	+12.83%
MSCI EAFE	1,650	1,561	+5.70%	1,581	+4.36%	+4.36%
10-yr Treas. yield	3.31%	2.52%	+0.79%	3.81%	-0.50%	-0.50%
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)

Unlike the third quarter, the stock market’s climb this quarter was fairly steady. The uncertainty of the November election was clearly resolved as the Democrats suffered significant losses, losing control of the House and nearly losing control of the Senate. Then the lame duck session of Congress turned in one of the most productive periods in recent memory. The tax impasse was resolved, extending the Bush tax cuts for two years and putting in place a $5 million threshold for estate taxes. Capital gains tax rates of 15% were extended, as were jobless benefits; the expiration of jobless benefits would have left millions of unemployed workers with no benefits whatsoever.

The consumer returned, to some degree. Holiday retail sales were up over 3% from 2009, although still below pre-recession levels for many goods. Increased spending outpaced income increases and came at the expense of savings, which slid a bit to a savings rate of 5.3%. Home sales ticked up but still remain at low levels, with prices barely above the April, 2009 lows and plenty of foreclosed homes still not on the market. Jobless claims went below the psychological 400,000 level and were the lowest since July, 2008, but total unemployment actually increased to 9.8%. Massive errors in documentation stalled foreclosures but consumer bankruptcies were over 1.5 million for 2010.

There were plenty of significant developments in international economies. Tensions between North and South Korea flared with the North launching an artillery barrage on a disputed island. Ireland was forced to accept a bailout package and the outlook for Spain was cut by the rating services (see Looking Forward below). While the US is trying to lower interest rates, Australia (due to commodities demand), China and India were all raising rates to try and slow their explosive growth. Tension grew between the US and China over currencies, with the US claiming that China’s currency should be much stronger (thus making Chinese exports more expensive) and China basically telling the US to mind its own business. Higher exports and lower imports meant the US trade deficit shrunk but there was a large increase in advanced technology imports, which have traditionally been a source of US exports rather than imports.

All the while there are signs of recovery, albeit in fits and starts. The Conference Board’s leading economic indicators increased for the fifth straight month and manufacturing has grown for 16 months in a row. Productivity was strong at an upwardly revised 2.3% while labor costs were basically flat. Both producer and consumer price indexes are increasing at just under 1% and reported job openings have increased 44% from July, 2009. General Motors had an initial public offering of new common stock and it was in high demand, reducing the government’s ownership dramatically, and the government also sold all its stock in Citigroup, netting a $12 billion profit on the $45 billion bailout. (The net cost of the entire TARP bailout program is now estimated at $25 billion, not counting the bloated Federal Reserve holdings of securities and Fannie Mae and Freddie Mac.) It all added up to a revised increase in third quarter GDP growth to 2.6% and a forecast of 2.8% growth.

Looking Forward

Interest rates have been a frequent element of Looking Forward, but now it is the impact of specific actions of the Fed that are uncertain. The Fed had been talking about a new round of “quantitative easing”, which basically means an increase in the money supply from the Fed buying bonds in the open market. (The Fed has already exhausted its ability to directly lower short-term interest rates, as they have been near zero for over two years.) The aim was that the market would lower long-term interest rates even further, at the same time making other investments such as stocks more attractive. And sure enough, the anticipation of the Fed program did push interest rates lower throughout the third quarter.

That trend reversed in the fourth quarter, and when the Fed formally announced their intention on November 3 to buy $600 billion of Treasury bonds by June, 2011, the rise in interest rates picked up steam. Still, the Fed has reiterated their commitment to the bond buyback, citing disappointingly slow progress in the economy. There is some question whether the Fed is willing to ignore their long-standing goal of keeping inflation below 2% in the interest of pumping the economy.

The US is not alone in making bold changes. After bailing out Greece in the spring, the European Union forced a bailout on Ireland in November. The EU then settled their differences on how to deal with struggling EU countries by establishing the European Stabilization Mechanism (ESM). The ESM is a significant departure from the original structure of the EU, which created a common currency but left each country fully responsible for its own fiscal policies and problems. The ESM now makes the deficits of each EU member the responsibility of all EU countries. Even at that, the Euro remained weak against the dollar.

Our Portfolios

The recent allegations that research organizations facilitated a version of insider trading should come as no surprise. It has been clear for a long time that innovation and communications technology will easily overwhelm trading rules, and there will always be those who are interested in manipulation or cheating for financial advantage.

So why the enduring fascination with individual stocks? Why would otherwise rational people willingly participate in the equivalent of a poker game with professional gamblers and a loaded deck? One simple reason is that’s where the money is made (by the professionals, not the novices) and the pitches are so compelling that they are impossible to resist. Hence the majority of media dedicated to this loser’s game, even though personal finance writers overwhelmingly preach the folly of the game.

This is yet another reason a portfolio that is part of a broader financial plan or perspective does not rely on the casino element of investing, which includes individual stocks, narrowly-focused funds and leveraged investments. We prefer to utilize well-diversified funds, including index funds, that have consistent performance rather than recent eye-catching numbers. We have also been confirming portfolio allocations and rebalancing the asset mix to target allocations as necessary.

As discussed above, there continues to be some uncertainty on interest rates, and we are taking a cautious approach with short and intermediate bonds. Municipal bonds have been reviewed to focus on quality and the strength of the issuer and the underlying projects.

The Numbers Trap Revisited

Remember when everyone was screaming that stocks had just had a “lost decade” with negative returns? It was blamed for everything from “forcing” people to speculate in real estate (no, that was greed and ignorance) to contributing to the dire circumstances for baby boomers approaching retirement (partly, but that is due far more to wasteful spending and a lack of disciplined saving).

The “lost decade” was true, as far as it goes. A lump sum invested in the Standard & Poor’s 500 at the start of 2000 would have actually declined in value over 9% in 10 years by the end of 2009. Even worse, a lump sum invested at the start of 1999 would have declined 13% in 10 years. Clearly, this is not what one expects when investing in stocks, which have long been touted as the best way to pursue growth that will outpace inflation.

But there are plenty of other ways to look at this period, as there are with any figures (my wife likes to say that figures lie and liars figure).

• The lost decade is most accurate if that lump sum was the only investment made and was liquidated at the worst possible. If that same lump sum from 2000 had been left invested in the S&P 500 for another year, its value would have increased 4% from the initial amount. Still basically flat, but far from a 9% loss. The 1999 lump sum would have recovered to a 10% gain in its eleventh year, and by now would have increased 26% from the original investment.
• A lump sum invested a year later at the start of 2001 and held for 10 years to right now would have increased over 15%. Even better, a lump sum invested in 1996 and held for 15 years would have increased 167%.
• But who invests lump sums and leaves it at that? Equal amounts invested at the start of each year beginning in 2001would have increased 22% by now.
• Likewise, who invests everything in stocks? If that lump sum in 2000 had been invested 60% in the S&P 500 and 40% in a bond index, it would have increased 28% in 10 years and over 42% if held for another year.
• If that annual investment had been split 60% stocks and 40% bonds each year and started in 2001, it would have also increased 28% above the total amount invested.
• Before 2008, there had only been two other instances of negative returns for full 10-year periods, in the periods ending in 1938 and 1939. (There were other quarter-end periods in which 10-year returns were negative, but those were fleeting.)

This could go on forever, but would just get increasingly confusing, and the point is not that negative returns should be dismissed and stocks are necessarily wonderful. Rather, it is to recognize that an isolated observation like a 10-year return is simply raw data. Data require context and some test of relevance or applicability to become useful information.

Avoid the natural impulse to overreact to scary data, which the media love to throw around. First, take a critical “so what?” approach. Then, take a step back, focus on your individual situation and goals, and use supporting data to create worthwhile information on which to make any decisions.