Bull Market in Stocks Back On Track

In recent weeks, our leading indicators of global economic growth have turned upward signaling that the global economy is unlikely to fall back into recession over the next year. As you may recall, in recent quarters, we had taken the position that the recent slowdown in the economy was most likely a temporary pause that would be followed by continued growth. In that vein we kept your exposure to equities at optimal levels. This view was not shared by the majority of investors who were busy making the term "double dip recession" a popular theme. Our research suggests that the global economy should continue to grow in 2011 and most likely pick up its pace as the year unfolds. This has important implications for investors.

The most recent advance in stock prices is a sign that the stock market is beginning to discount that the global economic and corporate profit cycle is alive and reviving. The continuation of economic growth should allow stock prices to continue to rise and perform better than bonds and money market funds. Our research suggests that certain sectors of the economy, such as technology, energy, industrials and materials, should provide higher relative profits during this period. We will continue to focus your portfolio on companies that are involved in these areas. Given the recent, somewhat magnified advance in stock prices, it would not be surprising to see stock prices temporarily pull back or correct from current levels. We would suggest that any pullback in stock indexes would provide an excellent opportunity for those investors who need to increase their stock exposure to optimal levels. Aside from the recent better economic fundamentals, stock prices are attractive based on 2011 earnings, and there is still $4 trillion of cash in money market funds that is supposed to eventually find its way back into the stock market. All of these characteristics are very positive for equities — so what's the risk?

There is still risk in today's global financial markets. The biggest risk is the failure of global economies to grow, which would cause a continuation of very high unemployment in the developed world along with the continued decline in the housing market. There are also a number of other risks including those associated with geo-politics, currency devaluation and inflation. However, at this time, these risks have been somewhat subdued, particularly the risk of recession. That said, we still believe that managing risk should be our top priority. Therefore, we continue to manage your risk through your portfolio's asset allocation, sector exposure and the use of carefully placed stop loss orders on companies that are very economically sensitive.

The result of better global economic growth should push stock markets higher but will likely cause interest rates to rise in tandem. This is particularly important for bond market investors. Rising interest rates can cause significant declines in bond prices, particularly bond funds or those bonds with long maturities. For this reason, we continue to keep your bond maturities short and of high quality. Keep in mind that in mid 2009, when the economy was on stronger footing, interest rates tripled from less than 1% to 3% on a five year treasury note. This proved to be temporary as economic growth sputtered late in the year and rates fell back to their old lows. However, our research suggests that this time may be very different and that interest rates are likely to rise significantly from current levels for an extended period of time (years). This will eventually provide a more normalized environment for bond investors providing yields of 4-6% for high quality, intermediate maturity bonds — something we haven't seen in years and that we will welcome.

In summary, we appear to be entering a period of better fundamentals for the global economy and financial markets. We will be watching the economic fundamentals closely for confirmation and will be willing to change our outlook and strategy if such confirmation fails to materialize.

Now that we are settled into our new office in Sausalito, we invite you to stop by for a visit. We hope you are doing well and wish you and your family a very safe and happy Thanksgiving.

Sincerely,

James E. Demmert
Managing Partner