Market Commentary - Fourth Quarter 2011

The year 2011 turned out to be an extremely volatile year for the markets. Interestingly, even with all the up-and downswings during the year, the S&P 500 ended the year about where it started. However, small-cap and mid-cap stocks ended the year down, and the continued European crisis dragged down foreign stocks. Overall, well-diversified portfolios were hurt by small/mid and international exposure. That being said, after the dismal third quarter we saw a very good bounce back in the fourth quarter, which was a very nice way to end the year.

The Economy

The fourth quarter of 2011 was one in which economic data showed that the domestic economy has proved surprisingly resilient. However, the global economy continued to move in fits and starts, as the ongoing euro-zone debt crisis at certain times seemed to be on the verge of resolution and at other times at the point of complete meltdown. Economic data released during the quarter pointed to a thawing in the employment situation, signs of a potential bottoming in certain segments of the housing market, and generally improving economic activity.

Nevertheless, the situation in Europe continues to serve as a cloud overhanging the markets, with investors unwilling to commit to risky assets until euro-zone leaders have developed a sustainable solution. Throughout the quarter several attempts were made at ensuring the region would not devolve into financial chaos, with each effort being met with a rally from the equity markets. However, once the initial euphoria wore off, and investors became aware of the difficulties of achieving a lasting resolution, the markets once again sold off.

One of the most emblematic and dramatic situations in the quarter involved Greece, whose financial straits necessitated a debt deal with the European Union that required the country to hand over its fiscal sovereignty to Brussels in return for a halving of Greece's debt burden. Global markets cheered the arrangement, but Greek citizens viewed the deal warily, believing that true relief would be years away, and in the meantime fiscal austerity would constrain prospects for growth. As a result of this internal unrest Greek Prime Minister Papandreou called for a national referendum on accepting the deal, throwing the negotiated arrangement into a state of chaos and causing investors to once again favor safe-haven investments at the expense of risk assets. However, bowing to international pressure, Papandreou canceled the referendum and agreed to step down as Prime Minister.

Domestically, markets appeared to be looking for clarity from the economy, which in turn was looking for guidance from policymakers in Washington. Unfortunately, leadership in Washington was scarce, and the fiscal issues that dominated the headlines in the third quarter went unresolved in the fourth. Politicians seemed content to make the fiscal differences between the parties' election issues in 2012. However, by not tackling the problems immediately the authorities prolong the market's volatility and lack of direction.

For its part the Federal Reserve's Open Market Committee (FOMC) continued its policy of maintaining a low-interest-rate regime in the fourth quarter and is likely to do so for at least the next 18 months. Speculation increased during the quarter that the Fed would undertake another round of quantitative easing ("QE3") in order to mitigate against the U.S. economy being dragged down by Europe and to foster prospects for economic growth.

Highlights

GPD

The Bureau of Economic Analysis released the third estimate of third quarter 2011 GDP, a downward-revised 1.8%, down from the prior estimate of 2.0% and somewhat below the level economists had expected. However, economists note that most of the components of the number generally show positive trends, and they are encouraged by the uptick in growth experienced in the fourth quarter, which has been primarily a result of inventory accumulation. In addition, many of the headwinds that negatively impacted the economy in the second and third quarters, such as the aftereffects of the Japan earthquake and tsunami, have now dissipated. Economists point out that the primary downside risk to the economy is a deep recession in Europe and the spread to the United States of the fiscal crisis the euro-zone is experiencing. The reduction in the size of government and related spending is expected to be somewhat of a drag on the economy in 2012.

HOUSING

The housing market continued to show signs of bottoming in the fourth quarter, with several indicators providing a ray of hope. As with the third quarter, existing-home sales again exceeded expectations, with the most recent monthly data from November showing a 4% rise to an annualized 4.42 million units. The sales rate is now well above the six-month moving average, however, median sales prices are down about 3.5% from year-ago levels. Sales of new homes also crept up in the quarter, with November results showing a 1.6% month-over month gain from October to an annualized rate of 315,000 units. On a year-over-year basis sales are up 9.8%, and month's supply of existing home inventory is now down to six. On the downside, new-home prices were down 2.5% on a year-over-year basis.

While many hedge funds have now established positions betting on a housing recovery, economists and housing analysts continue to be cautious, saying that there is still a risk of an economic downturn as well as the potential for the euro-zone's fiscal issues to manifest themselves domestically.

EMPLOYMENT

The employment situation was mixed in the fourth quarter, with jobless claims data showing improvement but payroll data being less promising. The November payroll report, the latest available, showed a gain of 120,000 jobs, resulting in a decline in the unemployment rate to 8.6% from 9%. The decline in the rate is encouraging on its face but resulted from a shrinking in the labor force, which is not a good sign. A drag on payrolls in the fourth quarter was a reduction in government staffing, which accounted for a loss of 20,000 jobs. Many analysts believe that hiring will not pick up much in 2012-perhaps to only about 120,000 jobs per month, far below the 200,000 level needed for meaningful growth-due to the headwinds of government staffing reductions, the loss of stimulus spending, and continued weakness in Europe.

FED POLICY

The Federal Open Market Committee (FOMC) announced at its most recent meeting in December that it would leave monetary policy unchanged. As part of its policy it will continue to reinvest the proceeds of maturing short-term securities in longer-term issues in an effort to keep long-term interest rates low, a process dubbed as "Operation Twist." In addition, the FOMC left the target fed funds rate unchanged at 0% to 0.25%, the level it said it expects to maintain at least until mid-2013. While the economy has made improvements in the past quarter, the FOMC cited continued sluggish growth, a sub-optimal rate of hiring, and expected low inflation as rationales for leaving its policy unchanged. The FOMC also must do what it can to achieve its dual mandate of promoting full employment and stable prices, and with inflation expected to continue to be moderate the FOMC is able to maintain a low-interest-rate policy. Some analysts believe that inflation will slow enough in the early part of 2012 that it will spark fears of deflation. According to Fed watchers, in order to counter such a possibility, the Fed is likely to embark on another round of quantitative easing in early 2012 by purchasing more mortgage-backed securities.

Interest Rates

During the fourth quarter the fixed income market reacted on almost a daily basis to the news emanating from Europe, and it is fair to say that the quarter was basically trendless as far as interest rates were concerned. With the market correctly expecting the Fed's low interest rate policy to remain unchanged during the quarter, the market was riveted by the drama unfolding in the euro-zone, which at times resembled a car crash occurring in slow motion. On days when it appeared that the European Union might break apart and the euro currency dissolve due to the ongoing fiscal crisis strangling the region, investors flocked to the safe-haven status of U.S. Treasury securities, sending prices higher. When progress seemed to be made toward crafting a lasting resolution to the problems, the Treasury market fell and yields rose. Such so-called "risk-on/risk-off" activity was emblematic of the quarter, as it had been for the previous two quarters.

The U.S. economy proved more resilient than many analysts had expected, posting moderate GDP growth and modest improvements in employment and housing. Nevertheless, with the possibility that the European crisis may result in a deep recession on that continent and eventually might migrate towards the U.S., traders bid up the price of Treasury securities in anticipation of further quantitative easing by the Fed. With inflation benign and job creation still not at a level that would sustain growth, many investors expect the Fed will take action early in 2012.

Even with a great deal of volatility during the quarter, the yields on Treasury securities were little changed at quarter's end. The credit segment of the fixed income market saw longer-term yields falling more than yields on the short end of the curve during the quarter. The high-yield segment of the market experienced the largest rise in price and decline in yields, reversing some of the losses from the third quarter.

Equity Markets

After suffering a beating in the third quarter stocks did an about-face in October, as economic data was more resilient than first believed and investors seeking values looked for opportunities. With progress seemingly being made towards resolving the euro-zone financial crisis investors adopted a "risk-on" posture, reducing exposure to safe-haven investments in favor of riskier assets. The outlook turned cloudier in November, with European news gyrating markets on almost a daily basis. December brought a more favorable landscape with slow but steady progress being made in the euro-zone and investors speculating that the Fed would be likely to begin a third round of quantitative easing to support the economy early in 2012. While investors were primarily focused on macro-level issues, underlying fundamentals of the equity markets remained fairly strong during the quarter, with corporations continuing to generate profits in a trying environment.

For the quarter the Russell 1000 Index of large capitalization stocks posted a total return of +11.84%. For the year the Russell 1000 posted a total return of +1.50%. Small-capitalization stocks, as represented by the Russell 2000 Index, advanced strongly during the quarter, ending with a total return of +15.47%. However, the solid fourth quarter performance was not enough to lift the Russell 2000's year-to-date return into positive territory; the index declined -4.18% for the year. Value stocks outperformed growth-oriented issues in each of the market capitalization segments, generally a sign that undervalued cyclical companies are now beginning to show market leadership. The Dow Jones Industrial Average gained +12.78% during the quarter and +8.38% for the year. The S&P 500 gained +11.82% for the quarter and posted a modest advance of +2.11% for the year.

Like the third quarter, international stocks generally underperformed U.S. equities during the fourth. The MSCI EAFE index of developed markets stocks gained +3.38% during the three months ended December 31st, however, for the year the EAFE declined -11.73%. Emerging market stocks fared slightly better than developed markets issues during the quarter, with the MSCI Emerging Markets Index posting an advance of +4.45%. On the year the Emerging Markets Index declined -18.17%.

Looking Forward

Heading into 2012 the outlook for stocks is still rather unsettled, largely due to the euro-zone situation. In addition, the domestic fiscal situation, with rising levels of debt and seemingly no political will in Washington to make meaningful strides to solve the problems, also overhangs the market. Compounding what is likely to be another volatile year is the fact that Congress and the Obama administration have postponed working on most of the economic issues that have weighed on the market the past three years, preferring to allow the 2012 elections to serve as a referendum of sorts on the size of government and the tradeoffs between spending cuts and additional taxes to close the deficit. One would expect the market to react very favorably to a meaningful resolution to the euro-zone issues as well as any progress made toward restoring fiscal order on the domestic front. The market may also see a short-term boost from the liquidity provided through an additional round of quantitative easing, should the Fed decide to undertake such a move.

Although exposure to small/mid and international stocks hurt overall portfolio performance in 2011, we still strongly believe some exposure is an important part of a portfolio. In fact, going forward we are not likely to see strong economic growth in the U.S., but rather we may well see it in emerging markets. We feel exposure to many areas of the market, both domestically and internationally, are important both for long-term growth and to help mitigate risk.

Please be sure to let us know if you have any questions or concerns regarding your portfolio or if you feel your current allocation is no longer appropriate for you.

Karen recently celebrated her birthday with good friends and family. The one thing she asked from them was a copy of their favorite quote. We would like to share with you the quote from her youngest daughter.

And in the end, it's not the years in your life that count. It's the life in your years.
-Abraham Lincoln.

Wise advice from a 15-year-old (and a President)…here's to putting a lot of "life" in 2012.