March 18, 2010


Market Commentary

The Year Was Good, But Not Remarkable By Historical Standards
The history books will show that 2009 was above average but an unremarkable year for stock market performance. The S&P 500 returns exceeded 26% for the calendar year, which barely qualifies as top-quartile performance as 19 of the previous 80 calendar year periods saw higher returns. Of course this calendar year comparison ignores the 25% falloff in the first three months and the subsequent dramatic recovery. So, for those of us who have lived through the past two years, it will be a time to remember.

Benefit of Diversification On DisplayMarket Diversification
Diversification among equity markets was helpful in 2009 as virtually every other segment of the equity markets exceeded returns for the large-cap domestic market represented by the S&P 500. The chart at right shows that this diversification has also been helpful over the past ten years, as small-cap and international stocks have provided positive returns.

Over the past ten years investors have not been rewarded for taking the additional risk that comes with owning stocks, as bonds have generally provided better returns. However, diversified portfolios have provided positive returns as illustrated by the benchmark portfolio returns shown below, and the twenty-year results begin to reflect the expected risk-return relationship, where higher risk generates greater return.

Bond Returns Reflect Easing of Credit Crisis
The broad bond market provided a return of about 6% for the year. The ten-year Treasury rate increased during the year from a level near 2% in January to almost 3.8% by the end of the year. Because bond prices fall when interest rates rise, returns on Treasury securities were meager in 2009 as rates rose. On the other hand, interest rates on risky bonds fell dramatically during the year, as a collapse in capital markets began to appear less likely, so the value of corporate bonds and junk bonds jumped dramatically, reversing the losses they incurred in 2008. For bond fund investors, results varied significantly depending on the types of bonds held in the portfolio. Government bond returns were barely above breakeven while high yield (junk) bond returns were near 40%!

Where Do We Go From Here?
Much uncertainty remains in the markets and no one seems to be forecasting a rapid economic recovery, so, as always, surprising good news could lead to favorable jumps in market prices. Negative surprises will depress stock prices, but considerable pessimism, including slow growth and high unemployment, is already priced in.

Stock prices seem reasonable by some measures; they are still well below the peak reached in 2007 or even the level attained in March 2000. So a long-term expectation of returns 6%-8% above inflation still seems like a reasonable level for expected returns on stocks.

TIPS Are Now Included in Many Portfolios
Inflation is a particular risk for people on fixed incomes, people who own fixed-rate annuities, and owners of long-term bonds. Treasury Inflation Protected Securities (TIPS) offer a way to hedge against an unexpected jump in inflation.

Inflation is often expected to follow a rapid expansion of the money supply or a period of stimulatory monetary policy, which is not reversed or withdrawn quickly enough to prevent inflation. As a result of the recent credit crisis, the Federal Reserve has flooded banks with reserves and remains committed to keeping short-term rates near zero for an extended period.

Despite these events, and the growing trend in owning gold and real property, the market and many economists insist that inflation risk is low, particularly in the near term. The argument is that excess capacity and excess labor will keep in check any upward pressure on prices as the economy recovers.

The market for TIPS is also predicting modest inflation with a breakeven inflation rate hovering around 2% over the next ten years (see below).

Our investment philosophy is based on the assumption that markets work, so our best prediction of future inflation would be consistent with the market expectation of about 2% over the next ten years. Nonetheless, we are adding TIPS to many client portfolios, not because we think inflation will rise, but because they offer a way to diversify and reduce risk.

Treasury Inflation Protected Securities or TIPS are sold by the US Government, and have the full backing of the Government, just like other Treasury securities. The difference is in the way investors are paid.

Nominal Treasury securities pay a regular coupon or interest payment and return the face value of the bond at maturity. TIPS also pay a regular interest payment, but each year the principal or face value increases (or decreases) at the rate of inflation, based on the increase (or decrease) in the Consumer Price Index (CPI). Subsequent interest payments are calculated on this growing principal amount and the “inflated value” is returned to the investor at maturity.

The spread between the coupon on TIPS and nominal Treasury bonds represents the breakeven inflation rate. Currently the spread for ten-year securities is about 2%, so if inflation averages 2% over the next ten years, an investor would be indifferent about owning TIPS or nominal Treasuries. If inflation is greater than 2%, the TIPS owner will realize a higher return, but if inflation is less than 2%, the owner of nominal Treasury bonds will be better off.

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