The Markets	9/30/10    Close	6/30/10   Close	3rd  Qtr.  Change	9/30/09 Close	12 Mo. Change	YTD       Change
Dow	10,788	9,774	+10.37%	9,712	+11.08%	+3.45%
NASDAQ	2,369	2,109	+12.33%	2,122	+11.64%	+4.41%
S&P 500	1,141	1,031	+10.67%	1,057	+7.95%	+2.33%
MSCI EAFE	1,561	1,348	+15.79%	1,553	+0.53%	-1.25%
10-yr Treas. yield	2.52%	2.95%	-0.43%	3.31%	-0.79%	-1.29%
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)
Well, what do you know, the recession ended while we weren’t looking – in June 2009, according to the National Bureau of Economic Research, which determines these things. Still, the slowdown that began in December 2007 is the longest since the Depression, lasting a full 18 months.

The markets had a very strong quarter, but the quarterly returns mask a lot of volatility. After bolting out of the gates for a 7% increase in July, the stock market drooped nearly 5% in August only to recover for its best September in 70 years with another 9% gain. International markets were strong, with the euro recovering to a five-month high against the dollar in September and emerging markets continuing to be the primary contributor to global growth.

The Federal Reserve continued its chorus that it will maintain low rates “for an extended period” but added more detail. First the Fed announced that as the mortgage bonds in its $1.5 trillion portfolio matured and paid back their principal, the proceeds would be used to buy other securities rather than to reduce the portfolio size. This will pump more money into the financial system at a time when rates can’t be lowered any further. Second, the Fed declared that it is prepared to provide more support if necessary to prevent the economy from sliding into recession again, although it did not specify exactly what those actions might be. Finally, Fed Chairman Bernanke acknowledged that the mentality of financial institutions being “too big to fail” must somehow end. Neither the Fed nor the broad financial regulation bill passed by Congress have plans to fully unwind the tangled relationships created by the financial bailout.

Weekly jobless claims (between 450 and 500 thousand) and unemployment (9.6%) seem to be stuck at current levels. Inflation is dormant, leading to renewed concern about deflation being the greater threat. General Motors filed for an initial public stock offering, which would partly repay its loans to the government, but an exact date and IPO price are undetermined. Drought in Russia pushed wheat prices higher while gold reached record prices above $1,300 an ounce. The results of “stress tests” on European banks were announced and only 7 banks were deemed to have capital shortfalls, leading to concerns that the tests were too lenient. Global bank regulators agreed to a gradual increase in capital requirements for banks, which was seen as a break for European banks that would struggle under tougher guidelines.

All the while the consumer managed to chug along. Consumer spending was cited as the reason second quarter GDP was revised to an increase of 1.7% from the prior 1.6%. Credit card debt is at its lowest level in 8 years and the savings rate is a healthy 5.8%. On the other hand, the poverty rate of 14% is the highest since 1995, foreclosures are running 25% above a year ago (although default notices, an early indicator of future foreclosures, are down 30%) and the slow real estate market has new home supply at a 42-year low.

Looking Forward

While there is always something going on politics, and it is generally a good idea not to mix politics with investing, the coming mid-term elections have many implications for investing and the economy. Beyond the obvious question of which party will fare better, Congress is letting many issues sit until after the election. Will the mess that is the estate tax (an estate tax threshold of $3.5 million in 2009, no estate tax in 2010 and a threshold of $1 million in 2011) finally be resolved? What will happen with the rest of the “Bush tax cuts” which are set to expire in 2011? What changes to various tax rates may be enacted to help address the growing deficit? Will capital gains tax rates be increased as has widely been assumed? What programs may be rolled out to help spur the economy and hopefully prevent any “double-dip” recession? If the Democrats lose control of Congress, what might a lame-duck Congress push through in November and December? And what if the elections result in no clear party advantage and there is gridlock in Washington?

The uncertainty surrounding taxes has been seen as a drag on investments, but ironically the growing likelihood of gridlock has contributed to the market’s rally in September. Gridlock is ultimately a bad thing, as vital issues linger without action, but for investors gridlock helps eliminate uncertainty. One rule of investing is that taxes should not be the driving factor in making decisions; there should be fundamental reasons for buying or selling, with taxes perhaps influencing timing or tactics. But with such a wide range of possible tax and policy changes, and despite the shortcomings of the current system, continuing with the status quo is reassuring in an uncertain world.

Our Portfolios

We do not make a practice of making economic forecasts, nor of timing markets, but it is hard to deny that there is still plenty of risk in the economy and the financial markets. Even if the political ramifications are discounted, nagging unemployment and continued housing problems make a full-blown recovery less likely. Times like these often lead to claims that “it’s a stock-picker’s market” and “the old techniques no longer apply”.

We disagree, and would further argue that times like these validate the “old techniques”. Risk management calls for spreading risk, which is a diversified portfolio, and for minimizing risk, which can be accomplished through cash or other low-risk options. Volatility requires either short-term trading or a longer-term perspective, and we prefer the latter. At the same time, volatility presents opportunities to create market exposure at favorable prices. Innovation creates new areas and vehicles for investment and a diversified portfolio allows for some exposure to these new areas (such as funds of master limited partnerships) without risking major loss. There will undoubtedly be anecdotes of big bets making big money and claims (in hindsight) of opportunities that should have been obvious. Hindsight is worthwhile as a learning tool, but we don’t rely on anecdotes or 20/20 hindsight and will stick with a disciplined, long-term diversified approach.

What Do You Think?

Not only does consumer spending make up the bulk of the US economy, but economists are notoriously inaccurate in predicting future economic activity. (A long-term study by the Federal Reserve Bank of Cleveland found that economists “have trouble producing forecasts that were superior to naïve predictions, and only a small proportion of forecasters were more accurate than the median forecast – and none statistically so”.) Since the average consumer’s opinion appears to be as valuable as any given economist’s, here is just a sample of recent efforts to determine what the consumer is thinking about both the economy and his finances.

The general view of the economy has been battered by ongoing worries about jobs and also reflects the “disconnect” between Wall Street, where stocks have rallied, and Main Street, which has grown suspicious of financial markets. The Conference Board, a business research group, conducts a random survey of 5,000 households to develop its Consumer Confidence Index. The index is based on how consumers feel now as well as their expectations for the next six months. For example, in September 46% of respondents felt jobs were “hard to get”, nearly 23% felt there would be even fewer jobs in the months ahead and only 15% expected more jobs.

A reading of 90 on the Consumer Confidence Index is considered to indicate a “healthy” economy – and the index has not been anywhere near that level since the recession began in December 2007. It plunged steadily to an all-time low of 25.3 in February 2009 and has been stuck in a range between the mid-40’s and high 50’s for the past year. This malaise creates a concern the consumer is unable or unwilling to fuel the pace of economic growth.

Despite the financial pain of the recession, consumers don’t seem to have taken financial literacy to heart. The 2009 Financial Literacy Survey by the National Foundation for Credit Counseling found little change in behavior from the prior two years. Less than half of adults keep close track of their spending and 7% don’t monitor overall spending. One-third of adults either have no savings or put no part of their annual income toward retirement, and 26% admit to not paying all of their bills on time. Of those with mortgages, 28% say that the terms of their mortgage somehow turned out to be different than they expected. Across the board, young adults and minorities are at greater financial risk. Over half of adults report spending less than a year ago, but half of them admit that if their financial situation were to improve they would resume their previous spending habits. (Maybe less spending is not the “new normal” as some suggest, and maybe the consumer will contribute to economic recovery, albeit at the expense of their own financial health.)

As is often the case, a similar audience can deliver different results (or at least a different interpretation). A recent study by the Certified Financial Planner Board of Standards found that 44% of Americans expect the US economy to improve in the next six months with 28% expecting things to get worse. Accordingly, 37% expect to see their personal finances improve in the next six months, with 46% holding onto what they currently have and 16% who expect to lose money. But when asked to describe the economy as an animal, most chose “slow, lumbering animals like sloths, bears, turtles and elephants; few chose the iconic symbol of confidence, the bull”. And in a contradiction of more specific financial questions, 64% said they are “very” or “somewhat” financially prepared for the future.

Of course, what we say and think can differ from actual behavior. David Laibson, a Harvard economics professor, paid workers $50 to attend an educational workshop which explained the glaring advantages of their employer’s retirement plan. With a separate group which did not receive payment to attend, many participants said they weren’t saving enough and intended to save more in the future. In both cases, there was barely any increase in saving activities, and Laibson concluded that education and financial incentives were ineffective in changing behavior. Laibson developed a model that our minds tend to discount future benefits by about half, while giving full value to immediate gratification or costs. The best way to encourage good behavior is to remove the effort of taking positive action and replace it with effort for not taking positive action – in other words, find ways to make positive action automatic.

All these points of view (to say nothing of the abstract forces influencing the markets) don’t mean you should just throw up your hands and do nothing. To the contrary, your opinion is probably as valid as any other. You should focus on what is most important to you and recognize what motivates you. You can then cut through the clutter and focus on the information and approach that best fit your circumstances and goals.