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