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2013 was a good year for stock investors and a bad year for bond investors.  Stocks had their best year since 1997, while bonds had their worst year since 1994.  Improving economic data pushed stocks higher while at the same time causing bonds to sell off as long term interest rates moved higher from their historic lows.

The stock market continued its climb during the third quarter, rising in July and September while declining slightly in August. Through September, stocks, as measured by the S&P 500, are up nearly 20% for the year. Bonds rallied during the quarter, reversing course after a big selloff during May and June. Even with this rally, most bond indices remain negative on a year to date basis. Stocks have probably gotten a little over extended at this point and a pullback would not be a surprise during the fourth quarter. Longer term, however, stocks continue to look good, especially relative to bonds.

Despite a late sell off by stocks, the second quarter of the year produced positive returns for the stock market.  The bond market, however, concerned that economic stimulus by the Federal Reserve may be coming to an end, sold off as interest rates jumped.

Many investors are concerned about seeing negative returns in their bond portfolios.  While we never like to see negative numbers on our performance reports, bonds fluctuate in value just like all other financial assets.  We have gotten very accustomed to seeing nothing but gains from the bond market over the years as interest rates have dropped to near zero.  As interest rates move back to a more normal level, bond prices will drop.  When prices drop by more than the bond’s interest rate, you get negative returns.

The stock market, as measured by the S&P 500 Index, had a very good year in 2012, finishing with a total return of 16%. An improving housing market, continued new job creation, improving consumer confidence, and strong corporate earnings combined to fuel the market gains. The bond market experienced an average year as interest rates remained largely unchanged throughout the year.

For the quarter just ended, the U.S. stock market experienced its second best first quarter return in the last fifteen years.  March was the fifth positive month for stocks in a row and the ninth positive month out of the last ten months.  Both the Dow Industrials and the S&P 500 are currently at all-time highs.  The bond market held its own the first quarter as interest rates stayed at historical lows.

Since June 4th of this year the stock market has risen almost 16% as the rally from the end of the second quarter has continued throughout the third quarter. This has occurred even as we have seen mixed economic data. Consumer sentiment has improved, as has the housing market. The employment situation has continued to be very uneven although the new jobs trend is upward. We are also seeing a spike in the negative to positive corporate earnings ratio which usually alerts us to a market selloff, at least in the short term. Bonds have held their gains for the year as interest rates have stayed at very low levels.

Like the past two years, this year started out with the promise of stronger economic growth only to see the economy begin to sputter as the summer months arrive. After a very strong first quarter for the equity markets, stocks sold off early in the second quarter as evidence of a weaker than expected economy began to emerge, then rallied late in the quarter. As we said in our last letter to you, the stock market was due for a pull back, so we were not been surprised by that. More alarming to us is the fact that the economy can’t sustain any momentum and is affected by several problems that have difficult solutions.

Since the last economic recession ended three years ago, the recovery has been very uneven and inconsistent. Of the twelve recessions we have had since 1940, this recovery has been ninth of the twelve in terms of new jobs created, adding 2.5 million. While all of us yearn for a return of the economic growth of the 1990’s, it is important to remember where we were in 2008 and how far we have come since then. Three years ago we were embroiled in the worst recession since the Great Depression. To expect a complete recovery this quickly is unrealistic. Our economy has been growing in the 2 - 2 1/2% range the past three years and that is expected to continue over the next year. The Fed would like to see that number closer to 3 - 3 1/2%.

The stock market just ended its best first quarter since 1998. This strong performance continued on the heels of a strong fourth quarter last year. The fuel for this rally has been economic improvement across the board in the U.S. as well as renewed hope for the economic situation in Europe. Corporate earnings remain strong and we are finally beginning to see meaningful improvement on the employment front. Consumer confidence and spending are rising and people are beginning to become more optimistic that the economic improvement is for real.

While we are generally optimistic for the markets this year, a pullback in stocks over the near term would not surprise us. Healthy markets occasionally pause to digest gains, and since the last six months have been straight up, we are probably due for some rest to catch our breath. Pullbacks of 3% to 5% in the stock market happen every two to three months on average. In fact, since the market low in early March of 2009, there have been 11 separate pullbacks of at least 5%. The average pullback has been 8.8% over an average of 18 days. The deepest pullback was 17.2% over 24 days last August. During those three years and eleven pullbacks, the stock market has more than doubled.

The stock market, as measured by the S&P 500, finished 2011 less than one point from where it started the year, the smallest change in history. With dividends factored in, the market showed a small gain for the year. At the high point for stocks, the market was up 8% for the year. At its low point, the market was down 12% for the year. If you missed out on the three best days of the year, your return went from a small gain to a 10% loss. It was, to say the least, a very volatile year for stocks, especially for international stocks. Bonds turned in another good year as interest rates stayed at historic lows throughout the year.

2011 was an eventful year. Some events were good, such as an improvement in the job situation in the U.S., and strong corporate earnings; and some events were bad, such as the debt crisis in Europe and the continuing mortgage problems in this country. The U.S. economy suffered during the middle of the year, but then showed signs of increasing strength during the fourth quarter.

Economic trouble in Europe and a slowing economy in the U.S. combined to give us the worst quarter for the capital markets since 2008. September marked the fifth consecutive negative month for stocks as investors tried to make sense of the outlook for economic growth. We have said for the past two years that this has been a sluggish expansion, which is why a slowdown is troubling. From this point it would not take much for our economy to fall back into another recession.

The problems in Europe stem from too much debt and the possibility of defaults in Greece. The fear is that a default by Greece would spread to other countries, resulting in massive bank failures. At this point we will need to see a resolution of some sort to this problem for the fear in the markets to subside. This resolution will certainly involve lenders agreeing to take losses of at least 50% with some estimates as high as 70%. In our opinion, the sooner this happens the better off we will be.