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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.

During the last week of June, the stock market posted its best weekly performance in almost two years. Prior to that, it had dropped in seven of the previous eight weeks. Such is the world of stock investing. Economic data that suggested the economy was slowing down was the cause of the sell off. Better than expected data late in the quarter calmed many of these fears. Manufacturing data that topped expectations, stable home prices, lower unemployment claims, and higher consumer confidence all combined to push stock prices higher. We also saw some resolution to the debt crises in Greece, which calmed some of the fears on the global economic front, at least for now. The whole European debt problem will likely continue to be a problem for the foreseeable future.

When we discuss the economy and how strong it is or isn’t, it is important to remember how bad things were three years ago and how far we have come since then. During the fall of 2008 and the spring of 2009 the U.S. economy was on the brink of falling not into a recession, but into an economic depression. While things might not be where we would like them to be, it is remarkable that we’ve gotten this far this fast.

Despite a few trouble spots around the world (Libya, Japan), U.S. capital markets continued their rise during the first quarter of the year as corporate earnings continue to impress. Stocks turned in volatile gains as good earnings trumped international events. Bonds were even for the quarter as interest rates continued creeping upward. Our economic recovery continues to gain strength, which should bode well for stocks going forward.

Since the stock market bottomed two years ago, the S&P 500 has nearly doubled. It is worth noting that during that time period, there have been six different pullbacks of at least 5%. Volatility is a normal part of a healthy stock market.

2010 was a good year for investors as both stocks and bonds turned in nice gains for the year. The stock market ended with a strong December, following up on strong gains during the third quarter. Bonds outperformed our expectations, even with a sell off late in the year. Stocks have benefited from improving economic conditions since the melt down two years ago and have regained most of what was lost during that time.

Since the bear market low set in March of 2009, the S&P 500 has gained over 93%, proving once again that buying stocks when things look bleak is the best way to create long term wealth. Additionally, if you were not invested for the three best days of 2010, you would have given up 78% of the year’s gains. As is almost always the case, being in the market during the best days is much more important than being out of the market during the worst days.

After the stock market dropped during the second quarter of this year, many anxious investors were concerned about the remainder of the year as disappointing economic news began piling up. As further proof that stock market rallies happen when they are least expected, stocks staged a steep rally during the third quarter. For those of you who keep track of such things, September experienced the best September stock performance since 1939, and was the third best month in the past ten years. This is particularly interesting given that August was a very poor month for stocks. Bonds continued their strength as interest rates stayed at historic lows.

It was announced this month that the recession of 2008-2009 officially ended in June of 2009. Recent polls indicate that most people believe we are still in a recession. The definition of an economic recession is when a nation’s gross domestic product (GDP) contracts for two consecutive quarters. In other words, the economy is shrinking rather than expanding. When they say the recession is over, it does not mean that the economy is good; it just means it is once again expanding, even if that growth is meager and uneven. There is no doubt that the recession ended. There is doubt that the recovery is sustainable.

After four straight quarters of stock market gains, the market sold off during the second quarter as economic data showing troubling signals from housing and jobs fueled fears that the economic recovery may be in jeopardy. An unexpected drop in consumer confidence also spooked the markets. Economic recoveries rarely happen in a straight line and slowdowns in growth during recoveries are not unusual. Whether this is a bump in the road to recovery or the end of the recovery itself remains to be seen.

Most of the disappointing economic news we have seen recently appears to show an economy struggling to sustain growth rather than one headed for a recession. While jobs growth has been weak, the economy is still adding jobs. The private sector is expected to add about 100,000 new jobs monthly going forward. Year over year growth in the automotive industry has shown strong growth, although it remains far below peak numbers. While these numbers need to show improvement, they do provide some positive news.

The stock market continued its rally during the first quarter of the year as improving economic conditions and better than expected corporate earnings fueled the advance. The rally continues to be broad based with almost all market sectors doing well. The S&P 500 experienced its best first quarter performance since 1998 and has now generated positive returns in the last four quarters. Before this, the S&P 500 had declined for six consecutive quarters; the first time that had happened since 1969-1970. The bond market appears to be running out of steam as higher yields are beginning to materialize, resulting in lower bond prices.

The economic data we are seeing suggests the economy is gaining momentum and growing at an increasing rate. Consumer spending is rising and consumer prices are flat. Consumer confidence numbers are also rising. The ISM manufacturing survey rose in March as the manufacturing sector is showing improvement at an accelerating rate, fueled in part by strong export demand. The U.S. economy added 162 thousand jobs in March with most being in the private sector, as initial unemployment claims fell. This was welcome news as the lack of job growth has been a drag on economic growth.

By any measure, 2009 was an amazing year for investors. The stock market, as measured by the S&P 500, gained 26% for the year. This was the second best year of the decade and the eleventh best year in the past fifty years. It is doubtful that many of you reading this would have predicted these results back in March, when we were at the depths of a very painful bear market. In fact, from the market lows in March, the stock market gained over 67% through the end of the year in what has been one of the steepest post bear market rallies in history.

As we have pointed out in the past, market rallies tend to mirror market declines. The intense sell off in the stock market late last year and early this year resulted from a classic run on the bank as panicked investors dumped everything without regard to long term value or realistic expectations. While it was definitely a scary time to be an investor, it is always important to remember that successful investors are those who keep a long term view of the world. Market decline happen, but it is important to be invested during these rallies. The one thing that always proves to be impossible is to try to own stocks when the market is going up and not own stocks when the market is going down.