The fourth quarter was defined by two big political events.  First, the long-awaited November elections saw a shift in power. Republicans (with a push from the TEA Party) took control of the House of Representatives, while the Democrats held onto the Senate. Second, on December 23, Congress passed and President Obama signed into law H.R. 4853 extending the Bush-era tax rates through 2012. Additionally, it extended unemployment benefits, cut the employee-share of payroll taxes by 1/3 for 2011 and mercifully raised the estate tax exclusion to $5 million. Regardless of their position on taxes all sides understood that raising taxes in this economy was political suicide. 

The Republicans enter the 112th Congress vowing to repeal the Patient Protection & Affordable Care Act and reduce government spending as the nation’s debt surpasses $14 trillion (about 95% of U.S. GDP). With President Obama sporting a veto-proof Senate it looks like we may be facing two years of tug-of-war with the Democrats pulling one end of the rope and Republicans the other. It will be noteworthy to see who lets go first as the two sides attempt to sort out their differences. One clue will be the upcoming fight over raising the current $14.3 trillion debt ceiling. 

The stock market took it all in stride focusing instead on improving economic fundamentals and corporate earnings. The 4th quarter was a robust period for investors in American companies as double digit returns were posted for most U.S. indices. Bond investors did not fare as well as interest rates increased from record low levels resulting in lower bond prices. The Federal Reserve’s November 4th announcement to buy up to $600 billion in Government debt (dubbed QE2 for second quantitative easing) was designed to keep interest rates down to spur economic growth. So-far QE2 has had the opposite effect. It seems the bond market puts more emphasis on growing debt levels than FOMC decisions.   

Economic Summary 

Even with serious systemic problems the U.S. economy is definitely past its recession levels. Fourth quarter numbers are not released until late January but will certainly be positive meaning we have now had 6 quarters of economic growth following four quarters of negative growth. For 2010, GDP will likely average less than 3.0%, a low number at this stage of an economic recovery. 

Companies are now hiring but the pace is not enough to make a significant dent in the numbers of the unemployed. With 14.5 million Americans officially unemployed and 25.6 million either unemployed or under-employed it could take four to five years for labor markets to normalize according to many experts. The official unemployment rate dropped significantly last month from 9.8% to 9.4%. This was due to increased private sector hiring and a smaller denominator because many people have dropped out of the labor force. The long-term unemployed (the percent of unemployed out of work for 27 weeks or longer) jumped from 42.2% in November to 44.3% in December. Unemployment has now been at 9% or higher for 20 months, the longest such stretch since WWII. Our economy is growing, just not fast enough to soak up the huge numbers of people looking for work. 

The consumer has been spending as evidenced by a 5.5% jump in holiday sales, the best such performance since 2005. Since consumer spending comprises 70% of our GDP, consumer activity and sentiment is vitally important. Additionally, the manufacturing sector is still growing. The ISM survey was 57.0 in December compared to 56.6 in November and 56.9 in October. Anything above 50 is considered expansionary. 

Market Summary 

American corporations were able to leverage increased productivity into profits once again. Stocks ended the year with impressive gains in the fourth quarter.  Large companies (S&P 500) gained 10.76% in the quarter, medium sized companies (S&P 400) gained 13.5%, and smaller companies (S&P 600) trumped their larger brethren with gains of 16.24% during the period. Smaller companies should theoretically be able to grow faster than larger companies but at a greater level of risk due to increased competition and weaker balance sheets. For the year, American equity gains ranged from 15.06% (large companies) to 26.64% (mid-size companies). International markets’ gains were not quite as impressive as domestic but still very good. The MSCI EAFE (Europe, Australasia & Far East Index) gained 6.61% and 7.75% for the 4th quarter and 2010 respectively. Emerging markets were up 7.34% and 18.88% respectively for the 4th quarter and 2010. 

Interest rates rose during the 4th quarter resulting in sub-par bond returns. However, rates actually fell year-over-year which caused positive bond returns for the year. Short-term bonds (Barclays 1-5 Year Gov’t/Credit Index) lost -0.60% for the quarter, but gained 4.08% for the year. Long bonds as measured by the Barclays 20+ Year Treasury Bond Index dropped -9.32% for the quarter but had a solid year gaining 9.38%. Unfortunately, for bond investors, if interest rates move up from such a low point future gains are hard to imagine. Keep in mind the total return from a bond is the interest earned plus or minus the change in price of the bond during the period. When interest rates rise, bond prices fall and vice versa. 

Gold and other precious metals posted impressive gains as investors and speculators poured money into the physical bullion and into securities like ETFs which make it easier to add precious metals to portfolios. Gold was up 7.47% and 28.33% for the 4th quarter and year respectively. Demand is due to a combination of inflation hedges and safe-haven bets against the major currencies as governments struggle to get their debt-financed spending under control. 

What’s Next? 

2011 will be a tug-of-war between bulls who argue improving economic fundamentals will continue to favor equity investments and bears who think the unwillingness or inability of our elected officials to reduce deficit spending will lead to higher interest rates and a sell-off in stocks, bonds and the dollar. We certainly do not have a crystal ball and can make an argument for both scenarios.  However, we see little support for long term bonds and believe fixed-income allocations should be in short to intermediate maturities. 

One really good thing about economic downturns is that they enable companies to clean up their balance sheets and jettison less efficient operations.  Companies have been hoarding cash and will eventually put that cash back to work in the form of plants, equipment and people. If they can’t find anything else to do they will look for strategic acquisitions. At the end of the third quarter cash held by the 419 non financial companies in the S&P 500 was up 49% from three years earlier (before the start of the recession) while total debt was up only 14% according to the Wall Street Journal. 

Profits are higher too, as a result of cost saving measures. Total U.S corporate profits rose 26% in the third quarter from a year earlier to $1.64 trillion, the highest in four years. Fourth quarter profits are expected to rise by 9.8% compared to year-ago numbers. With large cash positions and increasing profits and confidence companies will be looking to expand.  Ironically, the great numbers posted in 2010 will make year over year profit-growth comparisons tougher in 2011 as will the increased investment in plants, equipment and workers. 

Regardless of the short-term direction of any asset class we believe prudence dictates a properly diversified, low cost portfolio structured to offer you a reasonably high probability of success without exposing you to unneeded risk. Add to that a written investment plan which you can monitor and adjust through time and throw in a little patience and a long-term focus. Then get on with the business of life knowing you’ve done about all you can do to prepare your finances for your future goals.