The Markets	9/30/09   Close	6/30/09      Close	3rd   Qtr.  Change	9/30/08    Close	12 Mo. Change	YTD       Change
Dow	9,712	8,447	+14.98%	10,851	-10.50%	+10.67%
NASDAQ	2,122	1,835	+15.64%	2,082	+1.92%	+34.56%
S&P  500	1,057	919	+15.02%	1,166	-9.35%	+17.05%
MSCI EAFE	1,553	1,307	+18.82%	1,553	0.00%	+25.49%
10-yr Treas. yield	3.31%	3.52%	-0.21%	3.83%	-0.52%	+1.07%
Fed funds rate	0 to.25%	0 to.25%	n/a	2.00%	-2.00%	n/a

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

The market summary is short and sweet – the Dow Industrial Average had its best quarter since 1998 and its best third quarter since 1939. And the other broad US indices performed even better, while international markets both recovered and benefited from a slightly weaker dollar. Despite the pain of the long market decline, year-to-date performance is nicely positive and the markets have nearly recovered to their levels of a year ago when the financial system unraveled.

On the economic front, things generally got “less bad” and in some cases actually got slightly better. While GDP fell in the second quarter for the fourth quarter in a row for the first time since 1947, it was later revised to a smaller decline of 0.7%. Fed chairman Bernanke, who was nominated for a second four-year term, declared that prospects for growth appear good and that the recession is “very likely over” on a technical basis but that pain will persist for individual workers. Despite somehow seeing signs that economic activity has picked up, the Fed left short-term interest rates unchanged at near zero.

Retail sales showed some resurgence by jumping the most in three and a half years, increasing 2.7% in August, but consumer confidence measures were mixed. A measure of leading economic indicators reached its highest level since January, 2008 and merger activity, with several large deals announced in September, hinted that optimism is returning to corporate buyers as well. August manufacturing grew for the first time in 19 months but orders for orders for durable goods which last more than three years were weak. Inventories of unsold homes continued to drop as sales picked up slightly, but 7.6% of mortgages are at least 30 days past due, leading to continued fears of another wave of foreclosures cause by job losses rather than by exotic loans. Homes sales were helped by first time buyers taking advantage of the $8,000 tax credit (30% of August sales) and resale of foreclosed properties (another 30% of sales).

The slowdown is not without some positive developments. Wholesale inventory levels fell for the 11th straight month, leading to expectations that restocking will contribute to increased business activity. The current account trade deficit, a broad measure of trade and capital flows, was the lowest in 10 years as compared to GDP (2.8%) due to significant drops in imports. And inflation remains benign, with the core Consumer Price Index (which excludes energy and food) up only 1.4% from a year prior.

Unemployment remains a major concern. July unemployment unexpectedly improved to 9.4%from 9.5% in June and jobs lost decreased for the first time in 15 months. The situation reversed in August, with unemployment reaching a 26-year high at 9.7% (and further inching upward for September, just after the end of the quarter, to 9.8%). August also saw 42 states lose jobs as compared to only 29 in July and estimates of total “underemployment” (workers without jobs or working well below their capacity) are well over 16%. For the fourth time since the recession began, Congress extended jobless benefits, this time for 13 additional weeks but only in states where unemployment exceeds 8.5%.

Looking Forward

As the Fed chairman noted, high unemployment will still cause pain even if the economy returns to consistent growth. Recovery often leads to job growth, but some economists conclude that increases in productivity or a structural change in the labor market as workers shift industries can lead to growth without higher employment. Productivity for the second quarter rose 6.6%, the most in six years, leading to a drop in labor costs of 5.9%. With the consensus view that unemployment will remain high for the foreseeable future, are we looking at a “jobless recovery”?

Research by economists at the Federal Reserve Bank of San Francisco indicates why this could happen again. In “normal” recessions there are increases in temporary layoffs in which workers can be quickly and easily recalled. Since December, 2007, though, the share of unemployed workers on temporary layoffs has actually decreased. Likewise, there is currently a very high level of workers employed part-time by necessity rather than by choice (5.8% of the workforce) and their hours can be increased without new hiring.

Real growth returned after World War II with the rebuilding of the world’s industrial base, ending the Great Depression. The malaise of the 1970’s was eventually replaced by the growth fueled by information technology. With the end of decades of consumer and debt-fueled growth, there will surely be some new wave to restore growth. Despite the promise and hype of “green” technology, it is still unclear when and what this new wave will turn out to be.

Our Portfolios

With the stock markets 50% off their March lows, how could there be any difficulty in managing portfolios? In practice that hindsight is greatly misleading and there always challenges in positioning a portfolio for the future. As we noted in our second quarter review, we are looking for the right opportunity to return to a “neutral” allocation for stocks and we have frankly been surprised that the rally has continued with barely a pause. That decision is a dynamic one and must consider the economy’s current prospects as it tries to turn the corner, but we continue to feel market levels have gotten ahead of economic strength.

This does not mean that we are not pleased to participate in the market’s improvement, and at the risk of being repetitive this is yet another example of the advantages of maintaining a balanced portfolio. The fact is that anticipating and acting on every market turn is simply impossible. So, while holding an equity allocation through the decline was painful, we have been rewarded for not panicking and reducing equities even further.

Crisis? What Crisis?

Just last year the bankruptcy of Lehman Brothers nearly pushed the global financial system over the brink. To prevent a total meltdown and try to restore some shred of confidence the government pushed through the $750 billion Troubled Asset Relief Program, increased FDIC coverage for bank deposits, established a backstop for money market mutual fund values and grew the balance sheet of the Federal Reserve by trillions. Since no crisis can pass without political knee-jerk reaction, a slew of direct and indirect government bailouts soon followed.

So, aside from avoiding total collapse, where do we stand a year later on some of these areas?

• The Federal Reserve has extended its program of buying mortgage securities into 2010, although the total amount of the program remains the same at a mere $1.45 trillion. While the housing market seems to have bottomed, home purchases have been pumped up by the $8,000 first time homebuyer’s credit. (Think government giveaways don’t stimulate demand? A month after the “cash for clunkers” program ended, U.S. auto sales fell 23%.)
• The FDIC has extended its increased deposit coverage of $250,000, originally scheduled to expire on December 31, 2009, to December 31, 2013. The FDIC has also extended unlimited coverage for non-interest bearing transaction accounts to June 30, 2010.
• The Treasury Department has ended its Guarantee Program for Money Market Funds, established after the Reserve Primary Fund became the first money market fund in 14 years to have its net asset value fall below $1 a share. While the program was funded with $50 billion from the Treasury, there were no losses under the program and the Treasury made $1.2 billion in participation fees.
• The burning need for reform of financial regulation has gone nowhere, with various government agencies lobbying to protect their own turf and politicians seemingly content to criticize executive bonuses but do little else.

But what about the unfettered risk-taking by banks that led to the crisis? Bank of America absorbed Countrywide and Merrill Lynch (albeit under some possible arm-twisting from the government in the Merrill case) and Wells Fargo took over Wachovia, while four times as many banks have failed thus far in 2009 as in all of 2008. Peter Solomon, a former Lehman vice chairman, was quoted in the Wall Street Journal that “There’s no fundamental change in the way banks are run or regulated. There’s just fewer of them.”

Banks no longer use off-balance sheet vehicles to hold risky assets and capital ratios have improved as banks reduce their use of borrowed money to make bets. Goldman Sachs and Morgan Stanley converted into bank holding companies to gain access to government funding, but short-term trading operations have returned to favor. The five top firms (Bank of America, Citigroup, Goldman Sachs, J.P. Morgan and Morgan Stanley) generated $56 billion in trading revenue in the first half of 2009 compared with $22 billion in 2008 and $58 billion at their peak. The Wall Street Journal examined regulatory filings and found that in the second quarter of 2009 the “value at risk”, or the daily amount the top five banks stood to lose if their bets went sour, rose to $1 billion from $0.87 billion in 2008 and $0.59 billion in 2007.

Exotic financial instruments have not gone away and are in some ways still thriving. The value of credit derivatives is only down 8% from prior periods and is still three times the level of three years ago. And in a classic Wall Street technique, banks are using collateralized debt obligations, which were supposed to lower the risk of packaged securities but instead lost trillions, to repackage the risky mortgage securities that blew up in the first place.

Regulators’ vague directions to avoid excessive risk are in conflict with a push to return banks to profitability. Even the attention paid to compensation has had little effect. The top five firms set aside $61 billion for compensation and benefits in the first half of 2009 compared to $65 billion in 2008 and $77 billion in 2007, but since the number of employees has been reduced the individual payouts could actually be higher. And restrictions on bonus payments have easily been avoided by simply paying larger salaries.

The net effect is decidedly mixed. Time has healed some wounds and an economic recovery will heal more, but the “too big to fail” mentality has ironically been strengthened in the aftermath of Lehman’s bankruptcy and that spells danger to some shareholders, at best, and the entire financial system at worst.