Third Quarter 2010 Market Review & Outlook

We are pleased with our performance for the third quarter 2010. Both stocks and bonds enjoyed gains during the quarter.  Our portfolios participated nicely in these gains but with much less risk than the overall market. Stocks had such a great third quarter that they are largely responsible for the progress our portfolios have made this year.

While economic and political signals remained mixed for much of the third quarter, investors decided to see the glass as half full rather than half empty, fueling a broad-based rally that largely erased the losses of the previous quarter.

Positive momentum was in part fueled by an ebbing of concerns over Europe’s sovereign debt woes and the possibility of a “double-dip” recession. In fact, the National Bureau of Economic Research (NBER), the government arbiter tasked with defining the beginning and end of recessions, officially declared that the close of the latest recessionary interlude took place in June 2009. Officially lasting 18 months, it’s the longest recession since the end of World War II. Inflation has remained muted.

Yet the good news seemed longer on form than substance. Yes, the nation’s GDP expanded for four consecutive periods through the second quarter, but at a decelerating rate. The unsettling oil spill in the Gulf of Mexico was finally capped and corporate profits, though softening, continued to hold up. But it was difficult to look past persistent weakness in such areas as employment, consumer spending and the housing market, all key components in previous recoveries. Nevertheless, sentiment was sufficiently optimistic to propel September, traditionally a precarious month for investors to its best showing in 71 years.

Stocks

Bouncing back from a woeful second quarter, markets posted strong returns across the board as the benchmark S&P 500 Index chalked up a solid 11.3% gain, which was matched by the Russell 2000 Index of small-cap stocks. But the quarter’s best performance belonged to foreign equities, and particularly emerging markets, with the MSCI EAFE Index of developed market stocks rising 16.5%. Returns for U.S. investors in international securities were further enhanced by a weakening dollar (In the case of EAFE-related stocks, the declining dollar accounted for more than 9% of returns).

All 10 major industry sectors of the S&P 500 registered positive returns for the quarter, led by telecom, materials (especially precious metals) and consumer discretionary, which is the best performing sector year-to-date. Financials, which had played a significant role in the recovery since mid-2009, underperformed as concerns and uncertainty related to financial reform measures passed by Congress over the summer weighed on the sector. From a style perspective, growth predominated over value while mid-caps edged out large- and small-caps.

Bonds

The fixed-income market benefited as interest rates continued their downward drift, reflecting the renewed interest of small investors in bonds, slowing economic growth and anticipation of quantitative easing by the Federal Reserve. Yields on U.S. Treasuries maintained their steady decline resulting in robust price gains, especially for longer maturities. Low yields on the bellwether 10-year Treasury note contributed directly to historically low mortgage rates, helping to stimulate refinancing activity. The short end of the curve, including money-market instruments, remained moribund as the yield on two-year Treasury notes hit a record low towards the end of the quarter before bouncing back slightly.

Meanwhile, strong corporate balance sheets and yield-hungry investors helped corporate investment-grade and high-yield bonds achieve even better returns. Corporations have responded accordingly, pushing issuance of new bonds to record levels to capitalize on low interest rates. The municipal market, though facing serious and continuing challenges, remained resilient and also generated a robust return. Again, reflecting a flagging dollar and the very strong performance of emerging markets, foreign bonds outperformed domestic bonds for the period. For the quarter, the Barclays Capital U.S. Aggregate Bond Index returned 2.5% while the Barclays Capital Municipal Bond Index posted a 3.4% gain.

Major Market Indexes

Outlook

Despite positive market performance, global economic activity has begun to cool as the impact of rebuilding inventories begins to taper off, the amount of direct government intervention wanes and consumer demand has yet to increase again. But the rebuilding of a firm foundation for recovery appears to be gradually taking shape.

True, corporate hiring remains anemic, but one of the significant sources of market support in the third quarter was the increasing level of share buybacks, dividend payouts, capital expenditures and M&A activity (over the first nine months of 2010, there was a 21% increase over last year). This is a direct consequence of the nearly $2 trillion in cash and liquid assets sitting on company balance sheets, by one relative measure at its highest level since1968.

While these developments are encouraging, broader economic signals remain ambiguous and, as such, we continue to be vigilant regarding our exposure to risk.

We have trimmed our small-cap exposure while overweighting our exposure to large-cap stocks, although we believe equities are fully valued at this point, making bargains harder to find. Our portfolios remain defensively oriented to dampen volatility even as we employ flexible and asset-allocation funds to take advantage of shifting opportunities.

We hope the aftermath of the November elections will clarify some of the uncertainty surrounding tax policy (particularly regarding dividends, buybacks and capital gains) and financial regulation and the new health care laws.  That may help in boost both consumer and business confidence to stimulate growth the economy by accelerating corporate expenditures, bank lending, consumer spending and job creation.