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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.

There has been much discussion over the past few months about the stock market and the economy and whether or not they are recovering or whether there are still dangers lurking. While both are still on shaky ground, it does appear that things are improving for our economy, although at a slow pace. We will likely continue to shed jobs and see the unemployment rate climb through the first stages of economic recovery. The stock market has also recovered over the past four months, although it remains well off of its highs.

We have often pointed out that during a recession the stock market normally bottoms out well before the economy does. As bad as the market was during the first quarter of this year, over the past sixteen weeks the S&P 500 has risen over 35%. To continue this momentum, we will need to see continued economic improvement over the remainder of this year. History suggests that this should be a good time to invest in equities. Since 1957, the S&P 500 has averaged a return of 35% in the first year following a bear market and 8% in the year following a down year for the index. As is the case with most bear markets, panic selling last fall has provided opportunities for long term investors to buy quality companies at reduced prices.

If you like volatile stock markets, the first quarter of 2009 was for you. The three month period we just finished saw a bear market and a bull market, all on its own. From its low point on March 9 th , the S&P 500 gained more than 20% over the next three weeks, including the fourth best one day return in the last fifty years. March ended the month as one of the best months for the stock market in the last twenty years after starting the month as one of the worst.

An obvious question to ask is whether we have seen the market bottom or is this just another bear market rally that will not hold. Consider that since the market reached an all time high in October of 2007, we have seen three different rallies of at least 15%, including the latest, which is the largest of the three. While short term market prediction is impossible, there are signs that the market is behaving in a more reasonable manner. We are also seeing better, although not great, economic data that suggests the economy is beginning to show some signs of life.

The unfortunate thing about the current financial crisis is that it did not have to happen. While our economy has always gone through cycles, a crisis like this one cannot happen without a lot of help from a lot of people. A tremendous lack of oversight allowed Wall Street firms to run wild and take enormous amounts of risk. These same firms cultivated a self serving culture, seemingly creating products that served no purpose other than to make themselves vast amounts of money. Government regulation not only allowed the emergence of an unregulated shadow banking industry, but required financial firms to make mortgages to borrowers that had little ability to repay. People cared little about what they paid for a house because they had the mistaken belief that home prices would never go down. Leverage can be a good thing, but too much can be devastating. This is true for individuals, businesses, and the economy as a whole.

The U.S. economy has been in a recession for twelve months, but the stunning events of September, October, and November surprised almost everyone. With the near collapse of the financial sector, consumers and businesses basically stopped spending money, causing further economic contraction. With consumer sentiment readings reaching all time lows, it is clear that people are bracing for the worst. At this point it is impossible to know when this recession will end, although it seems clear that we are not as of yet out of the woods. There are those that have stated that we are headed for another 1930’s like economic depression. It is important to keep in mind that there are major differences between today’s crisis and the depression:

A lot happened during the third quarter of this year, and almost none of it was good. To recap the events of the past few weeks: A segment of our financial sector has been nationalized; we suffered the largest one day drop in the stock market since the crash of 1987; the credit market completely seized up; and investments that were rock solid a month ago have suddenly become very shaky. The rapid worsening of the financial crisis has thrown all of the capital markets into disarray and threatened to spill over into all segments of the economy. We will discuss the scope of the problem and what we think should be done about it, as well as what we think investors should do and not do in response to these extraordinary events.

We have talked in past letters about the housing bubble and the subprime mortgage problems. It initially appeared that the problems were confined to the subprime market, but these problems quickly expanded into a full blown credit and liquidity crisis that has affected leveraged holders of all assets. This lack of liquidity and credit has led to rapid write downs in asset values and an inability to raise the necessary capital to make up the difference. This is how we can go from having well capitalized companies to bankrupt companies literally over night. We have been seeing a classic run on the bank as investors try to dump securities where there is no market, causing prices to tumble.

You need only look at two pieces of data to understand why the capital markets have struggled through the first half of this year; consumer confidence is at its lowest level since 1980; and only 17% of the American people are optimistic about the direction in which we are headed as a nation. This pessimism, driven by a number of factors, directly causes the economy to slow down and stocks to fall. The factors causing this pessimism include the following:

The price of oil and other commodities We have discussed the price of oil often over the past couple of years and it remains an issue. The high price of energy affects almost every segment of our economy in addition to making people feel poorer every time they fill up their car. Food prices and other basic materials are also rising rapidly. This type of inflation has always unnerved consumers and causes them to slow their spending in other areas. A worker making minimum wage spends almost 25% of their weekly earnings to buy one tank of gas for their car. Farmers earn more on their crops but spend huge amounts on fuel and chemicals. Nobody benefits from spiking commodity prices.