Quarterly Investment Commentary
When the dust settled on one of the most eventful and upended
years in memory, investors had generous gains in stocks and certain
segments of the bond market to salve the wounds of a disastrous
2008 and first quarter of 2009. Stocks finished the year
strongly, continuing their powerful run that began in early March.
Large-cap stocks, based on the Vanguard 500 Index Fund, gained
about 6% in the final quarter, and finished 2009 with a 26.5% gain.
In both the quarter and the full year, growth sharply outpaced value,
but between larger-caps and smaller-caps, returns were pretty
similar. Mid-caps were a different story; while the iShares Russell
Midcap ETF posted fourth-quarter returns in line with the overall
market, full-year returns were just north of 40%.
On the domestic fixed-income side, returns varied widely in 2009.
The Vanguard Total Bond Market Index Fund gained 5.9% for the
year, but the iShares Barclays 7-10 Year Treasury ETF was down
6.4% and the iShares Barclays Credit Bond ETF gained more than
14%. High-yield bonds, which normally exhibit hybrid characteristics
of stocks and bonds, instead crushed both, with Merrill Lynch
U.S. High-Yield Cash Pay Index gaining 56% for the year.
Heading overseas, the story was emerging markets. Both equity
and debt of emerging-markets countries left their developedmarket
counterparts in their dust. Vanguard’s Emerging Market
Stock Index Fund tacked on 8.2% in the fourth quarter to bring its
full-year gain to 76%, versus a gain for the predominately developed
market Vanguard Total International Stock Index of 3.2% for
the quarter and a still impressive 37% for the year. For bonds the
pattern was tighter but the same: Emerging-markets bonds
(JPMorgan GBI-EM Global Diversified Index) gained 2.8% and
22% for the quarter and year, while developed-nation sovereign
bonds (Citigroup World Government Bond Index) lost 1.9% in the
fourth quarter and gained only 2.6% for the year.
As we’ll note below, we aren’t overly enthusiastic about the multiyear
return potential from either stocks or bonds at current valuations,
but are optimistic that periodic dysfunction in the markets
will allow our mutual fund managers to continue to find opportunities
as well as allow us to take advantage of opportunities. The incremental
value of these opportunities may be much lower than it was this past year, where absolute returns
were unusually high, but in a low-return environment
they can make a material difference.
As we look ahead over the next several years,
we continue to believe that the weight of the
evidence makes a strong case for a tough road
for the economy and the financial markets, despite
the beginnings of an economic recovery—
which at this point have been mostly
government supported.
Debt, Debt, and More Debt
We continue to believe that we are in the
midst of a major debt-driven transition in the
economy that will keep risks elevated, result
in continued economic headwinds, and have
longer-term consequences due to the acceleration
of the buildup of our public (government)
debt.
Consumer Spending Headwinds:
Because
consumer spending is 70% of the economy it
is hugely important to overall economic
growth. The desire among households to rebuild
balance sheets, along with high unemployment
and low perceived job security,
makes it very likely that consumption growth
will be subpar compared to what we’ve been
used to.
U.S. Government Debt Explosion:
The U.S.
Government’s actions in aggregate probably
saved us from a 1930s-type depression. However,
the resulting leap in the government
deficit comes at a terrible time. This increase,
coupled with a coming explosion of Social
Security, Medicare, and Medicaid benefits to
retiring baby boomers, means that the U.S.
faces challenging times in the coming years.
As debt continues to grow, at some point it
will become difficult to get investors to lend
to a fiscally challenged U.S. in the amounts
needed without paying a significantly higher
interest rate. Though some increase in borrowing
costs is likely soon, the risk of a sharp increase
in rates is not imminent if the recovery
is subpar (as seems very likely). But looking
out over the next 10 years and beyond, the
math is impossible to ignore. There is little
question that taxes will have to increase and
spending will have to decrease. If this doesn’t
happen in a significant way, and maybe even
if it does, there is a great risk of both a dollar
and an interest-rate crisis that could be extremely
painful for the U.S. and global economies.
There are still many variables in play that relate
to these concerns, including a slower than
anticipated recovery for the labor market; the
wave of upcoming foreclosures and continued
high unemployment; small businesses suffering
from weak demand and a larger decline in
profits than bigger firms; states and municipalities
suffering from the steepest decline in
tax revenue on record; and loan delinquency
rates continuing to increase.
Given the challenges, there is risk of policy
mistakes as the Fed and the Treasury attempt
to maneuver through the next few years. Unwinding
of the stimulus at the right time and
in the right way will be one of the big challenges.
At what point the economy can stand
on its own remains an open question, not just
in the United States but in most of Europe and
Japan as well.
There are some positives, however. This is the
largest global stimulus ever to occur in peace
time. Strong emerging-markets economies are
feeding back into the global economy, which
is a positive for exports and manufacturing.
Corporate balance sheets, outside of financials,
are in good shape with the best liquidity
in 50 years. Inventories are low and a rebuilding
cycle is beginning, which will support
growth. And, the severity of the economic
contraction and corporate cost cutting may
mean that businesses overreacted and will
need to aggressively increase investment and
hiring (not likely in our view).
We don’t dismiss the positives as they explain
why some recovery is likely to be sustained.
However, we continue to believe that the
weight of the evidence makes a strong case for
a sustainable but subpar economic recovery,
with a risk of falling back into recession at
some point in the next two years as the stimulus
is unwound.
Return Expectations
Corporate and high-yield bonds are not overvalued
but they are no longer cheap. U.S. government
bonds are priced to deliver poor returns
over five years, barring a severe deflationary
world. With historically low dividend
yields of less than 4%, REITs are also overvalued.
Only emerging-markets local-currency
(non-dollar) bonds look reasonably attractive
in most scenarios but even they are subject to
a fairly high level of short-term risk stemming
from currency fluctuations. In short, no asset
class appears priced to generate fabulous returns—
though some asset classes will do better
than others and there are specific investments
that look somewhat attractive.
Getting Paid to Wait
As discussed above, we don’t believe stocks
are cheap. Moreover, we are headed into a period
of increased regulation and taxation
which will add to growth headwinds. With respect
to bonds, while it is true that rates are
low and this will limit returns, much of the
non-government bond market (corporate and
agency mortgages), while no longer cheap, is
priced to deliver mid-single-digit returns over
the next few years with far less risk than equities.
We should note that we are cognizant of inflation
risk, which would be bad news for bonds,
though we don’t see that risk as imminent.
Looking out over our five-year window, if we
simply invested in equities and bonds and held
them without making any tactical moves, we
would expect returns to be in the low singledigit
range. However, we expect some of the
bond niches we have access to will add incremental
value. There is also potential added
value from active management in equity and
fixed-income funds. These factors could raise
expected returns into the mid-single-digit
range (depending on the risk level of the strategy).
Looking forward over the next five years we
believe higher returns can be captured by patiently
waiting for compelling opportunities
and then making specific moves when they
appear. We seek to do well when judged over
the entire race, not just any particular mile.
We’re investing with that in mind, and as always
appreciate your confidence and trust.
WFA Welcomes Our Newest Employee
Kristy Larm joins WFA’s staff in 2010 as our
new paraplanner. Kristy will assist with client
relations, reporting and other back office duties.
Kristy holds a bachelor’s degree in finance
from the University of Utah and has
spent time working in the finance office of the
United States Air Force. We are excited to
have Kristy join our team and look forward to
her contributions to our firm.

We remain strongly committed to focusing everything we do on rewarding you for your confidence. –Your Firm Research Team (8/1/2009) Thomas Fritz, Kent Wilson, Carol Wilson, Nick Cosky
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