Here we go again making another comparison to The Great Depression. Only this time, it’s a positive comparison.

For the five months ending last Friday, the S&P 500 had its best performance streak since The Great Depression year of 1938, according to Reuters. During these five months, the S&P 500 index rallied 34%. Yet, despite this tremendous rise, losses between January and early March of this year limited the S&P’s year-to-date gain to 9.3%, according to data from Yahoo! Finance.

Several factors helped propel this rally including a normal bounce back from a deep correction, better than expected quarterly earnings, and “less bad” economic news. Rallies like this also tend to feed on themselves as trend followers jump on board and help push prices higher.
Interestingly, corporate insiders have been big sellers during this rally.

According to Vickers Weekly Insider Report as reported by MarketWatch, the ratio of insider selling to insider buying over the past few weeks was at its highest level since the fall of 2007 - right before the bear market began. Although not foolproof, this suggests corporate insiders are less sanguine about the future of this rally.

Corporate insiders notwithstanding, this has been a powerful rally. Only time will tell if it continues into the fall or rolls over into a new leg down. Either way, we’re doing our best to help you preserve capital and generate profits as appropriate.

ARE WE HEADING TOWARD INFLATION OR DEFLATION over the next few years? The answer to this question may have significant portfolio implications.

With the economy having just completed four consecutive quarters of negative GDP growth, it’s hard to imagine that inflation could be a potential problem - but it is. Thanks to the government’s massive monetary and fiscal stimulus, all this money sloshing through our economy has the potential to juice it so much that we end up with double-digit inflation and a weak dollar.

Deflation, on the other hand, is possible, too. With unemployment near double-digits, consumer spending subdued, banks being tightfisted, and our industrial complex operating way below capacity, we could end up in a vicious circle of declining prices that overwhelms the government’s stimulus efforts.

From a portfolio standpoint, here’s the rub. Investments that have historically performed well in an inflationary environment may not necessarily do well in a deflationary environment and vice versa.

So, what’s an investor to do?
Ben Bernanke, Chairman of the Federal Reserve, is on the record as saying the government, “…would take whatever means necessary to prevent significant deflation in the United States.” From a political standpoint, some inflation is preferable because it allows the government to pay back its debts with cheaper dollars. Given the government’s comments and the political benefit to inflation, it’s reasonable to conclude that if the government errors, they are more likely to error on the side of inflation rather than deflation.

However, from an investment standpoint, putting all your eggs in an inflation-based portfolio would be risky. A more prudent strategy may be to include some asset classes that could benefit from inflation and some that could benefit from deflation and then monitor those assets closely to see which scenario unfolds.
Successful investing is never easy and it is issues like the inflation/deflation question that are especially vexing. While you may find this issue boring, it excites us and is an example of what you have hired us to help you navigate. Please be assured that we are doing all we can to find the smoothest route possible through this potential white water issue.

Weekly Focus - Think About It

“And now let’s go hand in hand, not one before another.”

– William Shakespeare, The Comedy of Errors

The second quarter earnings season started just like the Fourth of July - with a bang!
The hard-hit financial sector delivered some good news last week as companies such as Goldman Sachs and JP Morgan Chase announced earnings that pleased the market. In the tech sector, Intel and IBM provided support, too. On the other hand, widely watched General Electric came out with earnings and guidance last Friday that was disappointing and the stock dropped 6% by the end of the day. The good news was that the big drop in GE stock did not take the rest of the market with it - perhaps a sign that investors don’t view GE as the bellwether stock it once was.

By the end of the week, after all the news and noise, the S&P 500 index had surged 7% and had almost recaptured its recent June 12 high.
Going forward, investors will keep a close eye on the rest of the earnings reports looking for any sign that profits are being generated by revenue growth instead of relying on cost cutting. As you know, you can’t cost cut your way to 15% profit growth each year, so, eventually, we’ll need to see solid revenue growth before investors will feel confident that we’re out of the woods.

Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.
Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association.
Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not available.
AMERICANS SOCKED AWAY MONEY AT THE HIGHEST MONTHLY RATE IN 15 YEARS last month, according to the Department of Commerce, and that’s good news - mostly. The personal savings rate rose to 6.9% in June, which is well above the average savings rate over the past decade. The personal savings rate is the percentage of personal disposable income that is saved each month.
A higher savings rate may reduce our dependence on foreign countries financing our deficits - a good thing - but, paradoxically, it might lengthen our recession. If we collectively save “too much” it could stunt economic growth as consumption slows down and fewer goods and services are produced and delivered. This “paradox of thrift” may hurt the economy in the short-term, but could be very beneficial in the long run. A higher savings rate also helps cushion families against unforeseen financial setbacks like the loss of a job, so that’s good, too.

Source: U.S. Department of Commerce: Bureau of Economic Analysis
Notice that from the 1960s through the 1980s, the personal savings rate averaged a healthy 8.3% to 9.6%. During the 1990s, there was a noticeable decline in the savings rate as consumers started a nearly 20-year spending binge. As we started the new millennium and all the way up to September of last year, consumers were on a spending rampage as they not only burned through their income each month, but, in some cases, borrowed money to support their habits.
In August 2005, near the peak of the housing bubble, the personal savings rate was actually a negative 2.7%. This amazing financial alchemy was aided and abetted by consumers pulling out billions of dollars in home equity loans and using that money to finance an unsustainable lifestyle. Of course, this spending above our means also meant that the level of economic growth was unsustainable, too. This all abruptly shifted in August 2008 as the personal savings rate went from 0.8% that month to last month’s 6.9%.
Yes, it is generally a good thing that consumers are saving again. The big question is, have we learned our lesson? Is this new frugalness just temporary or is it the new normal? The answer to that question has major implications for the worldwide economy over the coming years.

Weekly Focus - Think About It
“Money often costs too much.”
– Ralph Waldo Emerson

Warren Buffett has said his favorite holding period is forever. Does he follow his own advice?

Buffett’s Berkshire Hathaway recently posted its worst quarterly loss in more than 20 years and a big chunk of that was due to what Buffett called a “major mistake.” Less than a year ago, with oil prices nearing their all-time high, Buffett dramatically upped his stake in oil giant ConocoPhillips and became its largest shareholder. Unfortunately, his timing was horrible. ConocoPhillips stock subsequently plunged along with the price of oil and as of last Friday, the stock was down about 50% from its high of last summer, according to Yahoo! Finance.

So, here’s your question: You’re Warren Buffett, your favorite holding period is forever, and a stock you recently paid billions of dollars for is now down by billions of dollars in just a few months, what do you do?

Well, Mr. Buffett hit the sell button. In the first quarter of this year, he sold 13.7 million shares of ConocoPhillips and took a $1.9 billion loss, according to Bloomberg. But, that may not be the end of his losses. As of March 31, Berkshire still held 71.2 million shares.

There are two good investing lessons here.

First, if you make an investment and the facts change, don’t be afraid to cut your losses and move on to a potentially more rewarding opportunity. Remember, you don’t have to recover your loss in the same way that you generated your loss.

Second, taking a capital loss may offer some tax benefits. In Buffett’s case, the $1.9 billion loss may allow Berkshire to recover as much as $690 million in previously paid capital gains, according to Berkshire’s quarterly report. Tax benefits shouldn’t be the only reason for selling an investment, but they can be part of the equation.

Oh, and by the way, Berkshire entered into long-term derivative contracts in recent years that are more than $13 billion in the hole as of March 31, 2009, according to Berkshire’s quarterly report. These contracts have expiration dates between 2019 and 2028 so there is time for them to recover, but $13 billion is a big hole to climb out of.

Yes, even the greatest investors make mistakes. However, one thing that makes them great is their willingness to embrace change, cut their losses, and move on.

ARE WOMEN BETTER INVESTORS THAN MEN? In a battle of the sexes, finance professors Brad Barber and Terrance Odean crunched the trading data on over 35,000 households from a large discount brokerage firm. They built upon psychological research, which indicates that in the area of finance, men tend to be more overconfident than women. Additional research shows that overconfident investors tend to trade more often than less confident investors. Armed with this data, Barber and Odean went to work.

They hypothesized that men traded more frequently than women and that this excessive trading hurt their performance more than it hurt the performance of women. Here’s what they found in a 2001 study published in The Quarterly Journal of Economics:

1. Men overall traded stocks 45% more frequently than women.
2. Single men traded stocks 67% more frequently than single women.
3. Women overall earned annual risk-adjusted returns that were 1.0% greater than men.
4. Single women earned annual risk-adjusted returns that were 1.4% greater than single men.

So yes, based on this study, women are more successful investors than men because they earn a higher annual return. An interesting sub-point from the study is that the out-performance by women was solely due to their lower trading frequency. Women were no better than men at security selection; instead, their advantage came from making fewer trades.

Let the bragging begin!

Weekly Focus - Think About It

“A man’s errors are his portals of discovery.”
–James Joyce

Despite another harrowing decline in the banking sector last week, the overall stock market has been holding up rather well, considering the circumstances.

Many analysts thought the worst of the banking crisis was behind us, but Citigroup and Bank of America reminded us last week that all is not well in the land of lending. Both firms reported earnings last week that were nothing short of ugly. This latest rupture in the banking sector has government officials looking at fresh approaches to contain the problem. One idea being floated around is to create a government bank to buy up bad assets. Officials think that ridding banks of bad assets will enable them to open the lending spigot again.

So, how can we say the overall market is holding up reasonably well? Two measures show some optimism. First, as of last Friday, the percentage of stocks in the S&P 500 index trading above their 50-day moving average was 40%, according to Bespoke Investment Group. By contrast, during the October and November lows in the market, this figure was near 0%. This suggests the recent new leg down in the market is not as broad-based as last quarter’s drop.

Second, during panic selling on October 10, 2008, more than 2,400 stocks on the New York Stock Exchange closed at new 52-week lows. By contrast, last Friday, less than 100 stocks closed at a new 52-week low price, according to StockCharts.com. Again, this suggests that even though the market averages are nearing the November price lows, the decline is not as broad-based as it was late last year.

In short, sellers appear to be a little more discriminating in what they’re selling. This may be an early sign of “reason” returning to the markets.

HOW WOULD YOU LIKE A GOVERNMENT GUARANTEED RETURN of 13.25% per year for 25 years? Sound too good to be true? In today’s environment, that’s absolutely too good to be true. However, if we turn the hands of time back about 25 years, that’s exactly what the U.S. government was offering.

On May 15, 1984, the Treasury department auctioned $5 billion of 30-year bonds (callable after 25 years) with a fixed coupon rate of 13.25%. This means you could have purchased bonds with the backing of the U.S. government and been guaranteed a double-digit return for a minimum of 25 years. In the context of today’s environment, with 30-year Treasury bonds yielding less than 3%, that is absolutely incredible.

Why were government bond yields so high back in May 1984? Well, if you recall, the memory of the 1970s energy crisis, double-digit inflation, stagflation, recessions, and a general malaise were part of the national psyche. That, coupled with the failure of Continental Illinois National Bank and Trust that same month, made people reluctant to lock up their money at a fixed rate. In order to entice money out of the mattress, the government had to offer a very high interest rate.

With the benefit of hindsight, buying and holding that 30-year government bond would have been a brilliant investment for many investors. Ironically, today, we face almost the exact opposite situation with the 30-year bond. The yield is below 3%, yet investors are clamoring to buy it. Are investors who buy 30-year bonds at today’s low yields making the same mistake as investors who were too scared to buy 30-year bonds at a 13.25% yield 25 years ago? In other words, are they doing the wrong thing at the wrong time?

As advisors, we find it instructive how times change and how fear plays a role in the value of investments. Back in 1984, people were fearful of locking their money up at an historically high interest rate with the memory of the previous decade’s bad news still fresh in their minds. Today, the fear of losing money has driven down the yields of 30-year bonds to near historic lows as investors seek out the safest investments.

All this leads us to the stock market. It’s possible that the declines we’ve seen in the stock market over the past year have led us to a situation similar to the May 1984 bond market. Specifically, fear and legitimate economic woes have caused the stock market to drop dramatically, but will we - perhaps 10 years from now - look back and say, “Oh my gosh, it would have been a brilliant investment to go long in the stock market back in 2009.”?

It may take years before we know the answer to that question, but at a minimum, it’s important to put the current maelstrom in historical context. As George Santayana said, “Those who cannot learn from history are doomed to repeat it.”

Weekly Focus - Think About It

“The ultimate measure of a man is not where he stands in moments of comfort, but where he stands at times of challenge and controversy.”
– Martin Luther King, Jr.

While stock markets are down, there may be one market where you can actually make some money.

Collapsing real estate prices helped lead us into the current recession and the government realizes that stabilizing real estate prices may be one key to pulling us out of the recession. Accordingly, the government is doing what it can to influence mortgage rates and help them move lower. Lower mortgage rates improve housing affordability and may lead to higher demand. Higher demand may help put a floor on housing prices and end the current downward spiral. That, of course, would be a good thing.

Lower mortgage rates also offer another potentially huge benefit for consumers and the economy. As rates drop, homeowners have an opportunity to refinance their mortgage and lower their monthly payment. Like the recent drop in gas prices, a lower mortgage payment puts more money in your pocket.

As of last Friday, some banks, such as U.S. Bank, were offering conventional 30-year fixed mortgages for less than 5% and that was with no discount points and no origination fee. So, while you can’t control what happens in the stock market, you can make some common sense moves such as refinancing a mortgage to take advantage of lower rates. Now may be a good time to look into it.

BAILOUTS AND STIMULUS PACKAGES have a long history in the United States. From Alexander Hamilton’s solution to the Panic of 1792, to the federal response to the Savings and Loan Crisis in the 1990s, when there’s a financial meltdown, Uncle Sam comes to the rescue. This time, the federal government is charged with creating a stimulus package of historic proportion to save an economy rocked by the ongoing effects of the subprime mortgage crisis, falling home prices, increasing unemployment, plummeting consumer confidence, and dismal stock market returns.

Next month, a record-breaking $800 billion to $1 trillion multi-year stimulus package may land on the President’s desk. Among other items, the package may include tax reductions for individuals and businesses, plus increased spending on infrastructure. Will it work?

Importantly, the package is being planned with an eye to the recent past. For example, because many taxpayers used recent tax rebates to pay down debt, thereby muting the positive impact of infusing new dollars into the economy, the new administration is considering tax cuts for businesses and individuals in the form of lower payroll taxes. While giving consumers a bit more cash in each paycheck will get money into the economy more slowly, it may be more effective than rebates in increasing consumer confidence and stimulating spending. Naturally, tax cuts for businesses will bolster the economy only if companies use the money they save to hire or invest in new technology. Conscious that falling demand for goods and services could cause companies to balk at expansion, President-elect Obama has proposed a $3,000 tax credit for each new hire.

The key to the success of increasing spending on infrastructure projects will be to ensure the unemployed are put to work. What’s more, state governments need to be cautious that the likely “use it or lose it” rule that will accompany infrastructure grants doesn’t prompt them to plan major projects hastily and fail to ensure that federal money, and that it doesn’t benefit those hardest hit by the recession. Of course, additional drops in interest rates, one of the most effective economic recovery levers the government can pull, will also be on the table. Here, the obvious beneficiaries are banks and major businesses that borrow large sums at or near the prime rate. Lower rates will also benefit consumers in the market for mortgages, as mentioned earlier, or car loans, and could result in companies being more likely to hire new workers.

The timing of a government stimulus package is also important. For example, some say federal intervention during the recessions of the 1960s and 1970s came too late and did more harm than good. It’s also imperative to realize that in our increasingly global economy, the federal government has little control over a number of factors that impact the domestic economy - from oil prices, to the value of the dollar, to world demand for American goods.

Finally, even if the spending plan pulls us out of recession, it’s important to understand that overspending contributed to this financial crisis and perhaps more saving is in order, too.

Weekly Focus - Word of the Week - “Frigorific”

Now that it’s freezing in some parts of the country, “frigorific” seems like an appropriate word for this week. It’s an adjective that means “causing cold” or “chilling.” It comes from the word, “frigus,” which is Latin for “cold” or “frost.” For example, “Without proper clothing, the frigorific blast of air would turn your skin purple in a heartbeat.” Just for fun, see if you can use “frigorific” in a sentence this week.

With 2008 in the history books, we’ll use this week’s commentary to review some of the key stories over the past year. As you well know, it was not one of the market’s finest performances.

STOCKS SUFFERED MIGHTILY
Global stock markets shed about $30 trillion dollars in market value over the past 12 months. Of that, about $7 trillion came from losses in the U.S. market, according to Bloomberg.com. In fact, the drop in the S&P 500 index was the worst annual loss since The Great Depression. Also according to Bloomberg.com, Tunisia was the only country out of 69 monitored by MSCI Inc. that saw a stock market gain in 2008. When it came to stocks, there was virtually no place to hide.

INTEREST RATES DIVERGED WILDLY
It was a tale of two markets when it came to interest rates. The flight to safety turned U.S. government securities into the investment of choice for many investors and the resulting demand sent yields plunging. The Federal Reserve helped lead the way by cutting its key interest rate seven times in 2008. The Fed Funds rate went from 4.25% at the start of the year to a target rate of 0% to 0.25% by the end of the year. Conversely, investors fled corporate bonds and municipals, which helped drive a spike in their yields, according to The Wall Street Journal.

THE COMMODITY BOOM WENT BUST
We’ve heard for years that countries such as Brazil, Russia, India, and China will drive worldwide growth and keep demand high for commodities such as oil, copper, and food staples. Well, it worked for a while. By mid 2008, commodity prices were flying high. But, then, sentiment changed and investors began to realize that economic growth was slowing and there may be a limit to the world’s demand for goods. Commodity prices quickly tumbled. Oil is a good example as it surged from around $100 per barrel at the start of 2008 to over $145 by July. It then plunged and ended the year near $45 per barrel, according to Bloomberg. And, you don’t need us to tell you about the dizzying trip of gasoline prices this past year.

HOUSING PRICES CONTINUED TO FALL
In hindsight, a crack in housing prices in late 2006 was one of the first signs that our economy was headed for trouble. Since its July 2006 peak, housing prices have fallen 23% through October 2008, according to the S&P/Case-Shiller Home Price index as reported by The Wall Street Journal. The decline in home prices removed one of the economy’s growth engines and, when that stalled, it helped take the rest of the economy with it. On the bright side, mortgage rates continue to drop. Thirty-year fixed rates are near record lows at 5%, according to the Mortgage Bankers Association. And, if the government gets its way, those rates should head toward 4.5%, according to The Wall Street Journal.

UNEMPLOYMENT CONTINUED TO RISE
Since this recession started in December 2007, the U.S. economy has added 2.7 million people to the unemployment rolls, according to the Labor Department. President-elect Obama has stated that he’d like to create 3 million new jobs as part of his administration’s plan to help the economy, according to MarketWatch. While that may seem like a big number, by the time his plans get rolling, we may have lost much more than 3 million jobs. That just gives you an idea of the magnitude of the problem we’re dealing with.

WHERE DO WE GO FROM HERE?
Our country is facing a near perfect storm of economic headwinds that most of us have not seen in our lifetime. Years of easy money and a conspicuous consumption lifestyle have finally caught up with us. In 2008, the financial markets woke up to the fact that we can’t indefinitely spend money we don’t have. Now that consumers and businesses are de-leveraging, the resulting effect on the economy can be summed up in one word: contraction. The government is trying to counteract this consumer and business freeze by spending money it doesn’t have. So far, the government is successfully walking a fine line between being the “spender of last resort” and being called out as the “wizard behind the curtain.” As evidenced by the decline in Treasury yields and the stable dollar, investors worldwide are putting their faith in that wizard. Don’t be surprised, though, if that faith is tested at some point in 2009.

Weekly Focus - A Thought for the New Year

“Year’s end is neither an end nor a beginning but a going on, with all the wisdom that experience can instill in us.”
– Hal Borland

It’s “Helicopter Ben” to the rescue.

For people who follow the financial markets, last Tuesday’s announcement by the Federal Reserve was a watershed event that historians, pundits, and investors will talk about for years to come. The Fed essentially opened the floodgates to help the economy and signaled more help is on the way. Here are the key points from the Fed’s announcement.

• It established a new target range for the federal funds rate of 0 to ¼%-effectively it’s as low as it can go.

• It expects to keep the federal funds rate at an exceptionally low rate, “for some time.”

• It will use, “All available tools to promote the resumption of sustainable economic growth and to preserve price stability.”

• It is evaluating the benefits of purchasing longer-term Treasury securities as a way to lower long-term interest rates.

• Going forward, it will, “Support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.”

Money manager Bill Fleckenstein summed it up nicely by saying, “The Fed went for it, corroborating the view that many of us have held for some time: that when push came to shove, the central bank would let nothing stand in the way of printing any amount of money, and monetizing anything required to fend off the ill effects of the collapsing bubble.”

Wall Street’s reaction to all this was mixed. On the day of the announcement, the Dow Jones Industrial Average soared 359 points. Over the next three days, though, it gave back most of those gains.

For homeowners, the Fed’s action was positive. Long-term interest dropped significantly after the announcement and that may translate into lower mortgage rates. If this causes the housing market to perk up, it may give the economy the jolt it needs to begin stabilizing.

You probably remember the old saying, “We’re from the government and we’re here to help.” No doubt about it, the Fed, the Treasury, the White House, and even Congress are now “here to help.” The question is, do they know what they’re doing?

As James Grant, editor of Grant’s Interest Rate Observer, so wryly pointed out in a recent Wall Street Journal essay, “Prescience is rare enough in the private sector. It is almost unheard of in Washington.” Despite this historical lack of foresight, we’re all putting faith in the government that they can correctly diagnose our current problems and prescribe the right dose of medicine to get the economy moving again. So far, the medicine may have moved us out of the emergency room, but we’re still in intensive care.

THE SPEED AT WHICH the economy and the financial markets have moved this year is astonishing. Here’s a brief look at some of the most amazing changes.

• The S&P 500 index dropped nearly 47% in just six months between May 20 and November 20, according to data from Yahoo! Finance. By contrast, during the severe 1973 - 1974 bear market, it took the S&P 500 more than one year and eight months to drop that amount (January 11, 1973 to September 27, 1974).

• Crude oil prices started the year at $95.98 a barrel and just over seven months later, it peaked at $145.29 per barrel on July 3-a 51% increase, according to data from MSN. This helped stoke fears of runaway inflation. But wait, crude prices then plunged 76% in less than six months between July 3 and December 19. Now the talk is about deflation. Vertigo, anyone?

• The yield on the 10-year Treasury bond dropped from 4.02% on October 14 to 2.07% on December 18, according to data from Yahoo! Finance. That’s a 48% decline and nearly two full percentage points in just over two months. By contrast, for the six years ending October 14, 2008, the yield on the 10-year bond changed by less than one quarter of one percent, according to Yahoo! Finance data.

• Nonfarm payroll employment rose by 94,000 in November 2007. Just a year later, in November 2008, nonfarm payroll employment fell by 533,000, according to the Department of Labor. And sadly, from December 2007-the start of this recession-to November 2008, the number of unemployed persons in the U.S. rose by 2.7 million.

• The auto industry, as we all know, is hurting. Parts supplier Johnson Controls issued an outlook on October 14 of this year and forecasted North American auto sales would reach 12.3 million units in 2009. Just two months later, on December 16, they revised their forecast downward to only 9.3 million units. Is it any surprise that two of the Big 3 auto manufacturers are on the brink of bankruptcy?

We’re not sharing this information to depress you. We’re simply pointing out that changes are happening with lightening speed. So far, many of these changes have been detrimental to people’s wealth. But, on the positive side, let’s keep in mind that if things turned this quickly on the downside, perhaps they could also turn that quickly on the upside. A return of confidence may be one key to making that happen.

WE WANT TO TAKE A MOMENT and comment on the Bernard Madoff scandal. As you probably know, Madoff allegedly engaged in a giant Ponzi scheme that bilked investors around the world out of $50 billion. In this industry and in human relation in general, trust is of utmost importance. When that trust is shattered, people are understandably enraged and dispirited. As it relates to Madoff, it’s doubly frustrating because we rely on government regulators, such as the Securities and Exchange Commission, to monitor money managers and brokerage firms and prevent this type of fraud. Clearly, the regulators failed us.

Madoff is the latest in a line of swindlers who put their own interests ahead of their clients. Yes, there are bad apples in the financial services industry just like there are bad apples in government or any other line of work. Yet we don’t want a small number of bad apples to deter investors from seeking investment counsel. We work extremely hard to earn your trust and we do all we can to ensure that your assets are invested wisely and housed with secure and trustworthy custodians. If you have any questions or concerns about this, please let us know.

Weekly Focus - Happy Holidays

As we wrap up one year and begin a new one, we wish you and your family peace, health and happiness. It’s our privilege to serve you and we look forward to working hard on your behalf in the years to come.

The following comment might shock you, so prepare yourself. Here it is… last Monday’s closing price on the S&P 500 index confirmed that we have been in a new bull market since November 20th.

Yes, it seems rather ludicrous to say we’re now in a bull market since the S&P 500 index is still down about 40% this year. But, according to the standard definition of a bull market as reported by Bloomberg, the bull is alive. The bull is here because the S&P 500 closed last Monday about 21% above its November 20th closing low of 752. That meets the definition of a bull market, which is a 20% rise from a previous 20% or greater decline. The bear market we just exited, which lasted from October 9, 2007 to November 20, 2008, drove the S&P 500 down 51.9%, which is its third worst decline on record without an intervening 20% increase, according to Bespoke Investment Group.

Semantics aside, we’re not kidding ourselves into thinking that all is now well in the financial markets. Statisticians and market technicians may have fun playing with these numbers, but in the real world of managing money, we know that bull and bear markets don’t neatly conform to standard definitions.

Clearly, even within the context of a negative market environment, we may see significant rallies. These rallies could simply be “head fakes,” or bull runs within an ongoing bear market. For example, during the Great Depression between 1929 and 1932, the Dow Jones Industrial Average experienced nine bear markets and eight bull markets, according to Bespoke Investment Group. Each one lasted an average of just 105 days. Even though there were eight bull markets during this period, overall, the Dow dropped dramatically between 1929 and 1932, so we shouldn’t necessarily get too comfortable with the current bull market.

The point of this history lesson is we may experience a series of bull and bear markets within the context of a longer-term “secular” bear market. When we see big rallies, pundits will be quick to say the worst is over and it’s time to get aggressive. At some point, they may be right. In the meantime, we want you to be aware that big rallies may be followed by big declines. This yo-yo action can be very frustrating, but it’s a plausible scenario as the market and economy painstakingly work through the challenges we face.

HOW MUCH IS ENOUGH? The new administration is reportedly considering a two-year fiscal stimulus package worth up to $1 trillion, according to The Wall Street Journal. They have to walk a fine line though, because just like households, the government cannot spend beyond its means or else it will face negative consequences.

Since households are not in the mood to spend money, the government is turning into the “spender of last resort.” Political leaders on both sides of the aisle are arguing that it’s the government’s role to step in and prop up the economy if consumers are tapped out. This is not new. Our country has a long history of federal stimulus packages including one earlier this year.

The plan now under consideration is massive in scope. According to the Journal, it may include, “Funds for roads, bridges, water systems, school repair, spreading broadband access, promoting health-care information technology, improving energy efficiency in buildings, renewable-energy projects, and assisting struggling state and local governments.” It sure sounds nice, but economically speaking, there’s no free lunch.

Spending of this size has the potential to be both wasteful and excessively inflationary. Imagine if we gave you a budget of $1 trillion. Do you think you could effectively and efficiently spend it within two years? Okay, it would be fun trying, right!

As it relates to supporting the economy, we don’t know whether $1 trillion is the right number or not. Keep in mind, the government has already provided hundreds of billions of dollars in various backstops, facilities, bailouts, and guarantees. Combined, we’re talking serious money. Ultimately, this intervention may pose substantial long-term risks to our economy if not handled properly.

• One long-term risk is the possibility of uncontrollable inflation. Currently, few people are worried about inflation because economic growth is weak and commodity prices are plunging. But, with all this stimulus, the possibility exists that the economy could inflate beyond the government’s ability to corral it.

• A second risk is the possibility of an extremely weak dollar. If we print too many dollars and nobody wants to own them, then the value goes down. This would make our exports more competitive (a good thing), but our imports more expensive (a bad thing). It could also lead to a rise in commodity prices, higher inflation, and higher interest rates.

• A third risk is how effective will the government be in extricating itself from the economy after it’s outlived its usefulness. Many people, including some diehard free marketers, are willing to accept some level of government intervention right now to help prevent a devastating economic collapse. However, if things turn around, will the government be able to exit the economy gracefully without causing a relapse?

When the government intervenes in our economy at a level that is way above historical norms, there may be unintended consequences. As an advisor, we can’t control what the government does with all of our tax dollars. However, we can monitor the government’s actions and do our best to try and benefit on your behalf from whatever unintended consequences may result.

Weekly Focus - Think About It

“Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And, if it stops moving, subsidize it.”
–Ronald Reagan

We typically think of stock market volatility as a “bad” thing, but last week, we saw the “upside” of volatility.

As the chart indicates below, the broad-based S&P 500 index rose a stunning 12% for the week. Barron’s said it was the largest one-week gain in that index since 1974. In the holiday-shortened week, the S&P 500 index rose all four days that the market was open for trading. So, yes, last week was volatile, but it was all “good” volatility. By contrast, Bespoke Investment Group said for the 50 trading days ending November 23, the S&P 500 averaged nearly a 4% daily move up or down - the majority of which were down (i.e., bad volatility). Bespoke says that was the most volatile period in the history of the S&P 500 index.

Thanks to last week, the S&P 500 has now risen 19% since its November 20 closing low, according to data from Yahoo! Finance. We’d call that a very powerful rally!

The ironic part of last week’s rally is that the economic news is still terrible. Data from the Commerce Department showed orders for U.S. made durable goods fell 6.2% in October, which was the largest decline in two years, according to MarketWatch. The Commerce Department also reported that consumer spending declined 1% in October, its largest decline since the September 2001 terrorist attacks. And, of course, housing is still in trouble. The Case-Shiller home price index published last week by Standard & Poor’s showed home prices in 20 major U.S. cities fell a record 17.4% on a year-over-year basis.

The fact that the market soared last week in spite of this weak economic news is a positive development. Remember, the stock market tends to turn around before the economy does, so perhaps investors are starting to see some light at the end of the tunnel. We’ll have to wait and see if that light gets any brighter over the next few weeks.

SOME WISDOM never goes out of style. Below are a few of the late Sir John Templeton’s 22 Principles for Successful Investing that we think are worth remembering in this volatile market environment:

1. Outperforming the majority of investors requires doing what they are not doing.
2. Buy when pessimism is at its maximum, sell when optimism is at its maximum.
3. Buying when others have despaired, and selling when they are full of hope, takes fortitude.
4. Bear markets aren’t forever. Prices usually turn up a year before the business cycle hits bottom.
5. Buy what other people buy and you will succeed or fail as other people do.
6. Invest worldwide.
7. When your method becomes popular, switch to an unpopular method.
8. Stay flexible. No asset or method is forever.
9. Stock market investing takes more skill than any other kind of investing.

Source: The Templeton Touch (1983), by William Proctor.

Templeton makes it sound simple, but we know from experience that successful investing is anything but simple!

Weekly Focus - Think Inspiration, Not Spending

After you cover your basic needs, you have a choice on what to do with your money. You can save it, spend it, or redirect it to higher purposes. Prudent planning suggests that you save a certain amount, but, after that, how do you determine how much to spend for your own gratification versus redirecting toward serving your highest commitments and deepest values? One of the best ways to answer that question is to ask yourself, “Whom do I want to become?” Once you know the answer to that question, the path you should follow will unfold… and it may surprise you.

“Hope springs eternal,” wrote Alexander Pope back in the 1700s and, after a rocky start, we ended last week on a hopeful note.

If you look at the numbers in the chart below, it was another disappointing week in the stock market. Last Wednesday and Thursday didn’t help matters as the Dow Jones Industrial Average posted back-to-back 400 point plus declines. That set the stage for another nail biter as markets opened on Friday morning. Fortunately, the markets opened steady and after see-sawing above and below the previous day’s close, the Dow soared more than 6% in the final hour as word leaked that President-elect Obama would nominate Timothy Geithner as Treasury Secretary, according to MSN Money.

Geithner is currently president of the Federal Reserve Bank of New York and has been deeply involved in all the recent machinations at the Fed and Treasury as they plotted to thwart a systemic failure of our financial system. While no one thinks Geithner will single-handedly solve all our problems, his potential appointment shed some clarity on this important position and offered a glimmer of hope, which helped Wall Street close the week on a positive note.

Being hopeful and optimistic are certainly desirable traits and studies show they are associated with good physical and mental health. Unfortunately, those studies don’t tell us anything about how to manage investments. Successful money management takes hard work and we’re doing all we can to try and help you reach your goals and objectives. And, while we remain hopeful and optimistic that we’ll be successful in the long term, we don’t simply rely on having a sunny outlook to get there.

JUST A FEW MONTHS AGO, inflation was a big concern.Back then, the price of a barrel of oil had skyrocketed to an all-time high of $147, gas prices were over $4 a gallon, and other basic commodities and foodstuffs were shooting higher, too. Today, the world economy is slowing down and few people are talking about short-term inflation; instead, we’re starting to hear talk about the dreaded “D” word - deflation.

Deflation is a persistent decline in the level of consumer prices that’s typically caused by a decline in demand or a restriction of credit, or both. On the surface, you might think it’s a good thing because we’d all like to pay less for something rather than more, right? That sounds good in theory, but, when spread throughout the economy, deflation is an insidious condition that could cause serious harm.

Here are three dangers of deflation as identified by Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business:

1. Falling prices may lead companies to cut production and employment levels because of reduced demand. With more people unemployed, it may exacerbate a vicious cycle of falling prices as fewer and fewer people have the money to buy goods and services.

2. Falling prices encourage consumers to hold off on purchases because they know they can buy the goods and services at a cheaper price in the future. This also feeds a vicious cycle of declining prices.

3. Falling prices increase the real rate of interest, which helps stunt future economic growth. For example, if consumer prices drop 2% in a year, the real interest rate is 2% even if the actual interest rate (nominal rate) is 0%.

Last week, the Labor Department said overall consumer prices in October declined at a seasonally adjusted rate of 1%, which was the largest amount since records began in 1947. This was the third month in a row that prices dropped. The core rate, which excludes food and energy, declined at a 0.1% rate - its first decline sine 1982.

While the headline number looks a little scary, some of the decline occurred because of a huge drop in gas prices, according to MarketWatch. Of course, we can’t count on gas prices dropping to zero, so we’d have to see other categories experience declines before we could say deflation has arrived.

The government does have some tools at its disposal to combat deflation should it occur. One of those tools is to spend massive amounts of money to re-inflate the economy. The government has started to do that and it may accelerate when the new administration takes office. The trick is to add enough liquidity to the system to keep it running well, but not too much that we end up with runaway inflation-a delicate balance to say the least.

Weekly Focus - Word of the Week

“Hypocorism.” It’s a noun that means a pet name or the practice of using a pet name. For example, “Mike started calling Peggy by her hypocorism, “Bubbles,” when they were sweethearts in high school.” Just for fun, see if you can use “hypocorism” in a sentence this week.