January 10, 2011

Presented below are statistics for the Dow Jones Industrial Average, the S&P 500 and the NASDAQ Composite Index.

  Dow Jones S&P 500 NASDAQ
Index at 12/31/09 10,428.05 1,115.10 2,269.15
Index at 09/30/10 10,788.05 1,141.20 2,368.62
Index at 12/31/10 11,577.51 1,257.64 2,652.87
Full year % change 11.03% 12.79% 16.91%
Fourth qtr. % change 7.32% 10.21% 12.0%

S&P 500 Index 1/1/10 – 12/31/10

DJIA 1/1/10 – 12/31/10

2010 was a pleasantly average—albeit a little bumpy—year. Ultimately the S&P 500 finished up for the year with a gain of 12.79%. Volatility accompanied the year’s gain and prudent diversification proved to be the keel in reducing overall portfolio volatility. The statistics and charts above illustrate that much of the year’s gain occurred in December—fueled in part by the tax deal reached in the 2010 Tax Relief Act (if you didn’t receive our overview of this Act please let us know and we will gladly forward one to you). By November the market had reclaimed its April highs. June and July saw the worst numbers of the year.

Looking back over 2010 it was a year filled with evocative headlines and sensationally unsure predictions from the mass of experts. In the end, after all was tallied, U.S. stocks and investment grade bonds produced a somewhat “average” year in relation to historical averages according to Fidelity and Ibbotson Associates. 2010’s “average” performance was a welcomed respite from the previous two years as we saw continued stabilization in the broad markets.

From 2009 into 2010 headlines continued to be captured by the Greek Credit Crisis. Greece’s economic problems struck fear in the hearts of investors worldwide. By the spring the European Union stepped in and provided a $140 billon bailout package as well as a $1 trillion rescue fund for future problems. The credit crisis headlines caused ripples in worldwide investor confidence but overall it seemed as investors “priced it in” to their expectations. According to the Council on Foreign Affairs, Greece is known to have had a spotty track record of fiscal management so it is possible it was “priced in.” After the bailout some stability returned to the markets for a short time.

What seemed to be stoking fear in investors was the possibility of the Greece’s problems spreading to other European counties. Later in the year this fear became a reality when Ireland, now in line for an $89 billion bailout, announced large budget deficits that could lead to default. The same patterns of warned credit downgrades, actual downgrades and budget deficits that occurred with Greece and Ireland appear to be happening again with Portugal and Spain. The Associated Financial Press reported in December that Spain had been put on warning for another potential downgrade after having already been downgraded a level back in September.

So what does all of this mean to us here? First, if you wanted to take a European vacation now is a good time while demand for tourism is high (and thus price competition is fierce). Second, the Euro has weakened against the dollar. This is likely to be attributable to the lack of confidence in the European nations at the moment. In light of all this we do continue to utilize investments in European countries and other foreign countries. At this time we still believe in gaining global exposure in a diversified portfolio. We continue to look at emerging markets in South America, Africa and Asia for opportunities in this sector and are watchful of our asset allocations to both Europe and other foreign countries.

During the 2nd quarter of 2010 we saw an 11.87% loss in the S&P Index from the first quarter’s highs. The aforementioned European debt issues helped contribute to the slide, as did China’s market slow down where the Shanghai Composite Index lost 23% from April to June. There was what has become known as the “Flash Crash” on May 6th. It was reported by The New York Times that regulators concluded a single mutual fund set off the chain of events causing this nearly 1,000 point drop in the Dow. The confluence of Europe’s woes and the “Flash Crash” likely led to the low consumer confidence in June, thereby causing the market selloff that then led to June and July lows in the markets.

China had a tumultuous year both at home and on the international front between their market volatility and foreign policy. China’s Shanghai Composite Index experienced a one month slide of 23%. The Wall Street Journal reported that their economy would close out the year with an estimated 10% growth rate even in light of the sizable slide. There are mixed feelings amongst analysts on the future of China but it is readily agreed that whatever hurdles are in front of China, it will continue to grow as a economic force. During 2010 China overtook Japan as the second largest economy after the U.S.—the speed at which its economy has accelerated is astonishing especially in such a short time.

China’s monetary policy has caused a lot of tension between the US and China. Reuters reports that the anticipated trade surplus for 2011 of $270 billion is the main source of friction between China and other world economies. The trade surplus as well as China’s opposition to allowing the Yuan to appreciate (China made small concessions here) has been a point of contention between the superpowers. This imbalance allows China to continue exporting inexpensive products in a favorable currency trade with the U.S. It is possible that that this could fuel U.S. inflation—which up to now has remained in check. Tension between two powerhouses like China and the U.S. is unsettling so we continue to watch this situation apprehensively while maintaining positions in investments that focus on China and Asia in some portfolios. Many of our portfolios have some emerging market exposure in addition to the developed foreign markets holdings.

The 3rd quarter was marked by rising and reeling markets. Part of the volatility stemmed from a lack of investor confidence in what would happen with the Bush-era tax cuts—they have been extended and if you would like a copy of our overview of the 2010 Tax Relief Act please let us know. This confounded proper realization of gains and losses with relation to long term tax efficiency planning. The tax cuts that provide for 15% capital gains rates and a 15% tax rate on qualified dividends, as well as favorable income tax rates, will be around for at least two more years. We are happy to have some clarity from lawmakers on the income tax rules and estate tax laws.

Throughout the year there was commentary about “bond bubbles” that continues into 2011. The so called “bubble” risk is linked in part to inflation which continues to be another oft mentioned subject. We have remained steadfast in the target allocations of fixed income in your portfolios. We maintain the belief that diversifying those holdings is of utmost importance. Where we have made some adjustment is to reduce duration on those fixed income holdings. We are more focused on short term and the lower end of intermediate duration investments. As was proven in the downturn, diversification is fundamental. We will maintain our allocations of fixed income in your portfolios with an eye on the proper duration to produce sufficient yield to meet your income needs.

At the close of 2010 the 10 year treasury yield, which is often thought of as the benchmark to which mortgage interest rates are most closely related, was 3.29%. The 10 year began 2010 at 3.77% which amounts to a half a percentage point decline. In April the yield rose just above 4% only to fall back down to 2.4% amidst the growing talk of bond bubbles. Then through December it rose again, sending bond prices down. For all of the movement of the 10-year treasury yield during 2010, which moves inversely to bond prices, bonds still enjoyed a solid year. The fixed income portions of our portfolios performed well during the year and we continue to recommend that anyone with a mortgage ask us to review the loan to see if a lower interest rate can be secured.

Inflationary pressures remain low through 2010 even with the Fed’s quantitative easing program. There was a lot of fear that the Fed’s intervention would accelerate inflation beyond control but having already lowered the fed funds rate to zero this was one of the few tools left to fuel growth. Through June of 2010 the Fed held $2.1 trillion of bank debt, mortgage backed securities, and treasury notes on its balance sheet, up from $800 billion in early 2008. During August 2010 the Fed stepped in with further quantitative easing as it decided the economy was not growing as robustly as hoped. In November of 2010 the Treasury announced that it would purchase $600 billion of treasury securities through the second quarter of 2011. It seems that the bond purchase program which started November of 2008 has been a success insofar as it was supposed to prop up the economy.

Of course the big question now is what happens when the Fed steps away and stops fanning the flames? The hope is that it has put enough cash back into the economy to drive spending, borrowing, lending and so on. U.S. Corporations are turning in high earnings for the year and many have sizable cash positions on their balances sheets, positioning them to invest money back into the business thereby helping stimulate growth. The Fed’s actions are unchartered territory for both our economy and the Fed itself. We remain watchful for indicators as to what direction these policies will take the economy.

For all of the sensational headlines during 2010 the year produced solid returns with much more gentle market swings (most days) than in the previous two years. There were certainly periods that looked dubious but as we saw historical correlations between assets returning and increasing overall stability we focused on our diversified portfolio strategies. We continue to utilize more exchange traded funds (ETFs) in our portfolios to increase diversification at low costs. We focus particularly on those ETFs that are highly liquid and have a low tracking error. We like these ETFs because we can direct investments to a specified mandate at extremely low cost relative to mutual funds and single equity investments.

If you would like to discuss the role of ETFs in your portfolios, review your portfolios or have us review any portfolios not under our management please contact us to schedule a time to meet. We would be delighted to meet with you or anyone you feel could benefit from our services. Happy New Year and best wishes for another happy, healthy and successful year.

Sean M. Dowling, CFP, EA
Joseph M. Dowling, CPA

Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.