4th Qtr Portfolio & Market Observations 2011

After a lackluster stock market last year, the first quarter of 2012 has started off with a whopping +4.48% return for the month of January. Although the U.S. economy and other developed countries are slow to have a meaningful recovery, the U.S. stock market has been performing quite well. The current rally started in October of 2011 with the S&P 500 advancing +11.82% for the quarter. As we write this letter the market is up +17.89% since September 30, 2011.

Many investors are scratching their heads asking, with negative economic news far outweighing the positive, why is the market going up and not going down? Many “so called” experts will give you many different answers. Our take is that there is nowhere else to go to get meaningful returns. Safe and secure bonds yield almost nothing for short term maturities – less than 1.0% for five year maturities, and 1.9% for ten year maturities. In order to get yields approaching 3.0% you have to buy maturities longer than 25 years. A diversified stock portfolio will yield 2.0% to 3.0% at today’s valuation. We feel that now is not the time to increase our allocation of high quality bonds. Given the present environment, stocks are attractive for both income and growth.

Market Commentary

While stocks were on a roller coaster ride for much of the year, the market produced unimpressive returns for 2011. In the fourth quarter, the broader equity markets were strong, with the S&P 500 rising 11.82%. Most of the gains came in October, with November and December being essentially flat. For the full year 2011, the S&P 500, including dividends, was up 2.1%. While not particularly impressive, it is interesting to note that the U.S. market was the best performing developed market for the year and one of the best performing in the world.

Europe’s debt problems pushed many of the world’s stock markets into or close to bear market territory in 2011. The complex sovereign debt issues and the policymakers’ confusing and disappointing efforts towards a solution hobbled the world markets. Every time the debt issue from a European country flared up, the markets got nervous and retreated. These higher fluctuations or “volatility” have challenged investors’ patience and long-term convictions.

For the year 2011, the major foreign markets were down between 15% and 20%. In spite of growing economies in the emerging countries, most of their equity markets fell: China’s SSE Composite was down -21.7%, India’s Sensex was down -24.6%, and Brazil’s Bovespa was down -18.1%. The European quagmire is a toxic combination of banking system crisis and sovereign debt crisis and is not expected to be resolved soon. To ease the funding situation in Europe, six central banks from around the world cut overnight borrowing rates so European banks would have access to overnight funding.

Here in the U.S., budget deficits have been a drag on the stock market with political squabbling ending in the failure of the Congressional “super committee” to agree on necessary cuts. This element of political uncertainty is going to continue with the upcoming Presidential election and is contributing to the current economic climate. On a cautionary note, given the mutually dependent relationship between the U.S. and European economies, any recession in Europe will have a dampening effect on the U.S. economy.

Despite these negatives, the U.S. economic recovery is turning positive. We have experienced upward growth in GDP, a decline in bond defaults, and balance sheet deleveraging. Unemployment, though high, has started to decline. We also believe the housing and financial sectors of the economy are nearing a trough and could soon possibly start contributing to growth.

Our Outlook

We continue to be optimistic about the long-term prospects for the stock market. With interest rates at record low levels, there is nowhere to invest money and get a respectable return without taking risk. Presently, stocks in general, are yielding more than 10 year Treasuries. Five year Treasuries yield less than 1.0%, and ten year Treasuries yield less than 2.0%. Historically, when stock yields are competitive with bond yields the stock market has presented a great long-term buying opportunity. Short-term, for the next 12 months, we expect the market to continue to be volatile reflecting the day-to-day financial news. We firmly believe the long-term returns will more than compensate investors for the short-term volatility.

Dumont & Blake Investment Advisors, LLC
December 31, 2011

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