The Markets	12/31/11    Close	9/30/11   Close	4th   Qtr.  Change	12/31/10    Close	12 Mo. Change	YTD       Change
Dow	12,218	10,913	+11.96%	11,578	+5.53%	+5.53%
NASDAQ	2,605	2,415	+7.87%	2,653	-1.81%	-1.81%
S&P 500	1,258	1,131	+11.23%	1,258	0.00%	0.00%
MSCI EAFE	1,413	1,373	+2.91%	1,650	-14.36%	-14.36%
10-yr Treas. yield	1.87%	1.92%	-0.05%	3.31%	-1.44%	-1.44%
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)

The fourth quarter was almost a mirror image of the third quarter, with a sharp recovery in October , a moderate decline in November and a jittery move up to close the period. The strong gain in the broad US market was a welcome close to a year which saw 11 swings in the Dow of 6% or more. Even smoothing out the intermediate market changes, the Dow was up 10% early in the year, dropped 17% by early October and the n rallied 15% by year-end, up 5.53% for the full year before dividends. The broader S&P 500 was flat for the year before dividends, and international stocks suffered as both emerging markets and Europe were down significantly.

Jobs are still the economic focus, and it is nice to be able to report positive news on that front. Weekly first-time jobless claims drifted pretty steadily lower and closed the quarter at the lowest level since April, 2008. More important, the four-week average hit 375k, the level below which lower jobless claims will start to reduce unemployment. An average 157k jobs were added monthly from September through December making 1.6 million jobs added for all of 2011 compared to 940k in 2010 and a loss of 5 million in 2009. The forecast for 2012 is 2.1 million jobs added, but at this point we are still 6 million jobs below the 2007 peak. The overall unemployment rate dipped to 8.5% and the number of workers who were part-time but preferred full-time work dropped by 1.2 million over the quarter.

The Euro crisis played out in a series of summit meetings, with each failing to deliver comprehensive results. Things began to improve, however, in mid-October when all the euro countries agreed that recapitalization was necessary, after Slovakia was the last holdout. The Greek announced that the Greek public should vote on any plan, which strained the connection between EU countries. Greece later cancelled the public referendum as that was the only way they would be allowed to stay in the euro zone long-term. Italian bond prices hit crisis levels, Italian prime minister Berlusconi resigned and the European central banks finally made $600 billion in three-year loans to 523 banks to increase short-term liquidity. The current state of the drama is that there will be great unity between the EU countries, except for Great Britain, who declined to participate because they feared damage to their financial sector’s autonomy. That unity includes central oversight of national budgets, constitutional amendments and sanctions for deficits, but the plan is far from implementation. Brazil became the sixth largest economy, easing past Great Britain.

In the US, Social Security recipients received their first benefit increase in 2012, the first increase in three years, but the overall poverty rate increased to 16%. Though overall inflation remains tame, the cost of a traditional Thanksgiving dinner increased 13% from 2010.There were a number of notable bankruptcies: American Airlines (the only major airline that had not already gone through bankruptcy); Jefferson County, Alabama (done in by a corrupt sewer project, and casting some concern on other municipalities), and MF Global (a futures broker which placed big bets on European bonds and which was unable to account for $1.2 billion in customer funds). The Fed held steady but noted that “downside risks remain” and an initial strong holiday retail season fizzled a bit but still finished around 3.8% over last year.

The Congressional “supercommittee” proved to be anything but and failed miserably at budget compromise, which means that there will be across-the-board budget cuts. The 2% payroll tax break was extended but only for two months and third quarter GDP, after revisions, increased 1.8%, a bit of a disappointment. Overall housing prices were down 3.4% year-over-year through October but several housing measures showed some signs of stabilizing and mortgage rates hit record lows yet again. Durable goods orders, consumer confidence and leading indicators all ended the year on an uptick.

Looking Forward

With economic news improving from the mid-year swoon and some progress being made in Europe, the big question is whether we will continue in a positive direction or will this all prove to just be a calm before the massive problems overwhelm us again. In other words, will we leave the “vicious cycle” where job losses led to retrenchment and further job losses and enter a “virtuous cycle” where new hiring boosts confidence and leads to new hiring. The virtuous cycle could even lead to some stability in the real estate market, the first step to a full recovery.

The irony is that if the economy recovers, government revenues will increase and the pressure to fix long-term problems will diminish. An example is bank failures; there were 92 failures in 2011, down from 157 in 2010 and 140 in 2010. This would seem like good news, but there are still 844 banks on the problem-bank list. An analysis by the Wall Street Journal indicated that failing banks are in worse shape when they fail, and stay alive longer, than in the past. It is certainly fair to allow a potentially viable bank the chance to save itself, but in most cases the failure is simply postponed. And a recovery still does not resolve the problem of some banks being “too big to fail”; without a structural resolution to that problem a recovery would likely just mean that banks would return to taking risks for which taxpayers would remain on the hook.

We will refrain from including the ongoing presidential race as a significant factor for the time being. While the rhetoric and drama may make for an entertaining diversion, and the election is fundamental to our democratic process, there is no need to be concerned until the winner is declared, and concrete plans are announced. And there is still the prospect of continued gridlock.

Our Portfolios

Last quarter we discussed the temptation to participate in short-term market volatility and our conclusion that this is fraught with peril and not in our clients’ best interest. Another debate that is taking place among financial planners is whether to abandon strategic asset allocation – creating an initial allocation based on client goals and long-term returns, and rebalancing to that initial allocation – in favor of tactical asset allocation – adjusting a portfolio to take advantage of perceived market anomalies or strong sectors. Once the hoped-for positive effects of tactical moves have been realized, the portfolio often reverts to its original strategic allocation.

In practice, this distinction is not necessarily “either-or”, and both approaches can actually work together. For example, the strategic allocation may determine overall fixed income exposure, but the tactical allocation will determine how that exposure is implemented. In this area, we have long emphasized high-quality, short and intermediate bonds. Another example is international stocks, and in some instances we have reduced direct exposure to emerging markets because of concerns over China. (China remains one of those areas that is so compelling because of its growth but is still so opaque in its political and business practices that caution is warranted.) We have maintained overall international exposure and indirect exposure to emerging markets through developed companies that operate there.

Besides, we remain committed to the idea that a portfolio is the product of an overall plan and tolerance for risk rather than the driving consideration. Diversification, patience, discipline and a long-term perspective will yield better results than any particular technique.

Caveat Investor – Round 2

We last visited regulatory enforcement way back in May, 2004. Back then we looked at NASD (now FINRA) actions against brokers and brokerage firms, and the common transgressions included unauthorized transactions, forged documents and signatures, misleading sales tactics and selling “investments” that had no legitimate investment purpose.

Investment advisers, who are regulated by either the SEC or their state of residence, are held to a higher standard than brokers. Investment advisers must adhere to a fiduciary standard – act in the client’s best interest – rather than the brokers’ suitability standard -an investment or financial product must be “suitable” for the client. The suitability standard leaves plenty of room for proprietary and higher fee products that may be more in the seller’s interest than the investor’s.

This does not mean that investment advisers are completely without fault. For the fiscal year ended in September, 2011, the SEC took 146 enforcement actions against investment advisers, a 30% increase over 2010. Some of the more notable actions were against Charles Schwab, for making misleading statements to investors regarding a mutual fund heavily invested in mortgage-backed and other risky securities, and against AXA Rosenberg Group, for concealing a significant error in the computer code of the quantitative investment model used to manage client assets. In the aftermath of the Madoff scandal, the SEC has reorganized to improve the way it handles tips and complaints, created a program to encourage cooperation in investigations and created specialized units in five priority risk areas.

And it was not just big firms that were involved. There was a $230 million fraudulent scheme targeting the elderly and another scheme targeting the deaf community. In fact, it is very common for fraudsters to gain trust in a specific community or interest group and then broaden the fraud through referral. The Arizona Securities Division brought 16 actions in 2011, mostly for misuse of client funds and fraudulent investments. (It’s sometimes tricky to comply with all the rules, but trust me, none of these actions were for minor procedural issues. They were all pretty bold-faced and make for some fascinating reading at the Arizona Corporation Commission website.)

What has not changed is how to protect yourself when working with any financial professional. Do a critical background check, including any disciplinary history. Understand exactly how the relationship is to work, particularly how the financial professional gets paid. Be sure to receive independent statements that do not go through the professional’s office, and be sure to review the statements. Be leery of special deals that seem too good to be true, or are far better than other investments. And most important, ask questions about anything you don’t understand or that seems out of whack – no reputable professional will object.