MARKET UPDATE — Winter 2010

We would like to tell you everything is fine and there’s nothing to worry about. However, we must accept the present reality which is not all that pretty.The housing bubble, which was created by an incompetent government and fueled by Wall Street greed, has led to hundreds of bank failures, real unemployment near 17%, and many cities and states near bankruptcy.So, what now?We can continue to debate whether all the government involvement was prudent or even necessary (mostly not), but this will not help in positioning your portfolio to take advantage of what has been created.

Knowing how we got here, and what constitutes a bubble, is important in order to know what to look for to avoid getting caught in the next one.Most bubbles are associated with strong growth in money and credit, but this time the opposite is true.Bank lending continues to contract as banks are very happy to maintain large cash reserves. With near-zero interest rates, the government is forcing money out of safer investments paying near nothing into riskier investments.Why would they do this? Because when we collectively decide not to take risks the economy grin to a halt.Our government, through the Fed, has adopted a strategy of making it so uncomfortable to play it safe that investors will move into riskier assets in order to obtain the returns that they need.Unfortunately, by doing this they increase the risk of fueling speculation somewhere else and creating a new bubble – especially with the Fed making it clear that rates will stay down for “an extended period.”Ultimately, the piper will need to get paid—this will lead to much higher interest rates and a drastic reduction in value of US Treasuries somewhere down the line.

Worldwide, the extreme policy actions of the past couple of years are creating all kinds of distortions.These pressures could be alleviated by a tightening in monetary conditions in China and other growing economies that are coming out of the recession in better shape.However, they currently have very little incentive to back off the throttle on their growth engine as they attempt to provide their citizens a greater standard of living.The seeds of prosperity that used to be the domain of the USA now have a passport full of overseas destinations.

Going forward, we believe this recovery will be meek. The Fed will be tolerant of further gains in all asset prices as long as inflation expectations are calm and US economic growth remains near zero. With such a weak recovery, we do not expect the Fed to raise rates until 2011. Early last year we stated our preference of corporate bonds to stocks for 2009, and we weighted portfolios quite heavily that direction. Despite what turned out to be a decent year for the stock market, the bond positions did substantially better for the year, some even doubling the stock market. We continue to see value in corporate bonds, several foreign markets and technology stocks. While not as cheap as they were a year ago, they still offer good yields or the prospect of further growth during 2010. As always, we are monitoring the changing economic landscape and will strategically adjust your portfolio as warranted.

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