The first quarter of 2010 portfolio performance was very good, with U.S. stocks enjoying healthy gains.
We’ve had a great run over the past five quarters, and investors looking back on strong returns deserve to feel good, especially given the level of nerve that was required to earn them in the aftermath of a very difficult period. Looking back helps us understand how our economy got to the place it is today. But making good investment decisions requires us to look forward and understand how things are likely to unfold in the years ahead. This is the object of our research and analysis.
The big-picture view is especially important right now because a few key issues will determine what the years ahead bring. We’ve seen massive growth in debt throughout the economy, reaching binge levels in the last decade. All that debt could be thought of as a form of borrowing against future consumption now we must pay it back in the form of less spending. This expectation for lower spending suggests we could see a slower than normal growth in the economy for a number of years to come.
Meanwhile, government spending has jolted the economy back to life, but at a longer-term cost to the budget deficit. Further, entitlement spending (for Medicare and Social Security in particular) is projected to grow by huge amounts in the years and decades ahead. The deficit will be difficult to fix without causing more damage including the possibility that shifting gears to cut budget deficits too early could throw the economy into another recession.
A key factor to the continued and sustainable improvement of the economy is jobs, and data suggests the job market remains generally quite weak and there is little basis to think this will change quickly or dramatically. The best outcome would be one where stimulus spending, low interest rates, and inventory rebuilding together create a virtuous circle in which businesses with strong balance sheets add jobs and consumer and business confidence builds and feeds on itself. While we acknowledge the possibility that the economy could overcome the headwinds, we think the odds are greater that we will see a less favorable environment in the years ahead.
Therefore, our investment view remains cautious, balanced and flexible. Recent signs of economic strength are encouraging but mostly stem from temporary factors like stimulus spending and inventory rebuilding. Based on current valuations, it is likely that stock returns will trend below average in the next five years. Even in our less likely optimistic scenario, annualized equity returns barely reach double digits. This goes for stocks of both domestic and foreign developed markets.
The potential that we may see a number of years in which the economy remains weaker than normal as we go through the process of reducing debt is not very uplifting. But as always, we are committed to working hard to understanding the reality we live in and its impact on financial markets, and make investment decisions accordingly. In looking ahead, we do see positives as we consider the ways we can generate returns that are better than what the markets give us.
The kind of volatile, challenging environment that we think is probable plays to our strengths. We think over the next decade our research and analysis will help us reduce risk when it doesn’t make sense to take it, and take advantage of tactical asset allocation opportunities when they are presented. If we can do this successfully, then our own outlook is decidedly better than the mediocre outlook suggested by the big picture and current valuations.
Below are the returns of the major indices during the past quarter and the last 12 months.
Major Market Indexes
|Index||1st Quarter 2010||12-Mo. Return|
|Dow Jones Industrial Average||4.82%||46.93%|
|S&P 500 Index||5.39%||49.77%|
|MSCI EAFE GR (International equities)||0.94%||55.20%|
|Russell 2000 Index||8.85%||62.76%|
|Barclay’s Aggregate Bond Index||1.78%||7.69%|
|Barclay’s Municipal Bond Index||1.25%||9.69%|
|Taxable Money Market||0.00%||0.08%|
Looking forward over the next three to five years we believe higher returns can be captured by having a risk adjusted, flexible, globally balanced portfolio, which is rebalanced while patiently waiting for compelling opportunities to appear. When those opportunities appear, we will have the liquidity and flexibility to make tactical moves and capitalize on those opportunities.
Our portfolio strategy for the near future is to manage risk first and return second. We continue to remain cautiously optimistic, taking a balanced and flexible, middle of the road approach. This allows us to remain liquid and nimble, so we can seize opportunities as they present themselves. We have been adding new funds to our approved list. Most of these funds have the maximum flexibility to invest in all areas of the market. Since no one area offers exceptional returns at this point, it is important to give our managers the ability to exploit short term anomalies in the market.
On behalf of the entire staff, we thank you for the confidence you have placed in us and the patience you have graciously demonstrated over the years.