The global economy has finally moved from the intensive care unit into the recovery room. This has important implications for investors in matters related to both risk and return across multiple asset classes. Will stocks continue their upward trajectory? Has the real estate market bottomed? Is there value in bonds, given historically low rates? Will money market returns continue to be at historically low levels? These are important issues that will drive how we manage your portfolios, seek return and manage risk.

Our research indicates that the global economy is in recovery mode and though it is not yet back to normal, it has finally stopped getting worse. Keep in mind that, over the next few quarters, economic statistics may be far from stellar and that unemployment may remain at high levels. However, the worst is now behind us and that by year’s end, the engine of global economic growth may be humming along once again. Our leading economic indicators, which began to turn upward in early spring, continue to show signs that better days are ahead.

Global stock prices have advanced significantly from their low point of early March. We believe that this is only the beginning of a multi-year advance, which will take indexes back to their old highs. Thankfully, after a long period of maintaining larger than normal money market balances, we purchased stock throughout the past nine months and have participated during this initial recovery period. Though many market participants and pundits believe that the recent rally is “as good as it gets”, our research - and history - suggest otherwise. In almost every bear market in the last 100 years, stocks have regained all of their losses within a two year period. Only in periods when stocks were wildly overvalued before they declined did recoveries take longer than usual. Though housing markets may have been wildly overvalued at the beginning of this stock market slide, stock prices, by most measures, were fairly valued. This fact, coupled with the unprecedented level of government support through fiscal and monetary policy, should allow the global economy and global stock markets to continue their recovery at a robust pace. Keep in mind that we are still 40% below the stock market highs of late 2007. Of course there will be pauses and corrections along the way (perhaps we are overdue for one currently). However, the next few years will likely be a period when stocks outperform real estate, bonds and money market funds. Though we are increasingly confident in our research and view, we also know that sometimes the best laid plans can go awry. Therefore, we continue to manage potential downside risk through your portfolio’s allocation to stocks versus bonds, sector exposure, and the use of actively managed stop loss orders. These tools do not remove risk, but should mitigate potential downside.

Residential real estate is close to - and in some areas has reached - a bottom. This not only affects the value of our homes, but more importantly allows the economy to recover in a healthier fashion. It was the real estate market, after all, that got us into this mess. Firmer housing prices will allow credit markets to return to norm and slow the number of bank failures. Commercial real estate may take more time to bottom but is getting closer. At some point, depending on your personal circumstances, we will be adding Real Estate Investment Trusts (REITs) to your portfolio to take advantage of the values that are being created in this asset class. Keep in mind that, unlike stock markets that have a history of recovering quickly, real estate markets can often bottom for a long time and rise at a slow pace.

Economic recoveries lead to higher interest rates and we do not think that this period will be any exception. In fact, interest rates on a five year treasury have already tripled since March. Therefore, over the next few quarters, expect that money market yields will begin to rise from their currently dreadful levels. In addition, we will continue to invest in individual stocks and bonds as markets provide opportunity, further reducing these balances. From our research, the future for buying bonds looks bright. As you know, we have kept our bond maturities short and credit quality high (thank goodness!). As interest rates rise, this will have little negative impact on your bonds given their short maturities. However, this upcoming environment will allow us to buy even higher yielding, high quality bonds, enhancing your portfolio’s overall return.

We look forward to this upcoming, more constructive environment. Keep in mind that if our increasing - yet cautious - optimism turns out to be misguided, we have our risk management tools in place to help mitigate potential downside.
We hope you are doing well. Please let us know if you have any questions or would like to get together.

Sincerely,

James E. Demmert
Managing Partner