The global economic recovery that began in the second half of 2009 is now in full swing. Corporate profits have advanced significantly from the depths of the great recession and economies around the world are once again growing, some – such as China and Brazil – at a breakneck pace. How long can this expansion last? What are the risks to the recovery getting derailed? How might this next economic expansion be different? These are the questions investors should be considering carefully.

If we have learned anything from a quarter of a century of managing domestic and international stocks, it is that the BIG risk in the stock market is not the temporary 7-10% corrections that are common in bull markets. The BIG risk is the 30, 40 and 50% declines that stock markets experience during economic recessions. Therefore, the timing of the business cycle is crucial to our investment thesis. The Great Recession of 2007-2009 is history and a new expansion has begun. Typical economic expansions last between 7 and 9 years. It would be nice to imagine that the current expansion can last that long, but we see potential headwinds – including future higher tax rates, historically high unemployment and our forecast of substantially higher interest rates in coming years – that may make it shorter than usual. Make no mistake – this expansion will last years – just maybe not 7-9 as is typical.

There are risks to the current economic and stock market recovery. These include the usual suspects: continued high unemployment, an implosion in commercial real estate, a double dip recession, the Federal Reserve mismanaging interest rates, to name a few, to say nothing about the ever complicated geopolitical environment that we now find ourselves in today. So far this expansion has primarily been a business-to-business expansion, while the man and woman on the street have not participated to any significant extent. This should improve in 2011. If the current expansion does not get derailed by this laundry list of risks, we forecast that stock prices could return to their old highs over the next 18 months. That would be an index return of about 40% – we think there is an 85% chance that this may come to fruition. However, if the expansion does get derailed, we would expect a decline back to the lows of March 2009 – not a pretty picture – though we believe there is only a 15% chance of such an occurrence. Given this tenuous set of forecasts, we continue to employ our Active Risk Management through your allocation to stocks versus bonds, sector management and the use of carefully placed stop loss orders.

This expansion is already proving to be different than those in past cycles. We are seeing the best profit growth from business-to-business. We are also seeing foreign economies, particularly those in the developing nations such as China, Brazil and India, growing much faster than our US economy. We are also facing a very different political environment which is focused on regulation and the potential for much higher tax rates. We are considering all of these themes as we manage your assets. For example, we have underweighted companies that are dependent on discretionary consumer spending, as well as banks that have significant commercial real estate exposure. We are overweight the sectors that thrive in a global business-to-business expansion – including the industrial, technology, energy, telecom and healthcare sectors – particularly those companies that do a significant amount of their business in the faster growing parts of the world. Lastly, we continue to forecast a future of much higher interest rates and we are recently beginning to see rates trending higher. We want you to keep your fixed income allocations in short maturity, high quality bonds to mitigate the risk of an abrupt rise in interest rates.

We are optimistic about the current economic and stock market recovery and we are monitoring potential risk closely. If for any reason you feel that your exposure to the market is less or more than you feel comfortable with, please let us know – we welcome the opportunity to discuss and make changes.

We hope that you and your family are doing well. If you would like to discuss and review your portfolio, please let us know at your earliest convenience.

Sincerely,

James E. Demmert
Managing Partner