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Quarterly Letter to Clients

January, 2011

Indices at year-end (December 31, 2010):

Dow Jones Industrials: 11,577.51 4Q'10 +7.32% YTD +11.10%

Standard & Poor's 500: 1,257.64 4Q'10 +10.20% YTD +12.78%

Near the middle of the quarter I opened one of the many missives that I receive from various brokerage firms, and I was struck by a headline that read "A Bumpy Road Ahead for Investors". Now, once in a while I get stuck on a particular phrase or statement, and I got stuck on this one. I began to wonder: was there ever not a bumpy road ahead for investors? In fact, in 40-plus years in this business I can never recall any piece of investment advice that said "smooth sailing from here on". Sure, there were puff pieces on individual stocks, but relating to the market as a whole? Most prognostications are more along the lines of "pavement ends".

Quarter-by-quarter this past year, the Dow Jones has been plus 4%, minus 10%, plus 10% and plus 7%. The S&P followed the same pattern, with slightly higher numbers in both directions.

While you might call that a bumpy road for investors, the end result (a double-digit gain) is not unappealing at all. Going forward there are many positive signs in the economy, and I am a "glass-half-full" kind of guy. So with corporate earnings pretty strong, housing sales perking up, and even employment, the final piece of the puzzle, showing a little life, you would think that the road ahead might be freshly paved and the gas tank full. Keep in mind, though, that we have just finished two consecutive years of double-digit gains. You should not expect to see a third year gaining that much. Check your shock absorbers and watch out for potholes.

In last quarter's letter I commented more than usual about bonds. I said that I had been trying to insulate our accounts by moving to shorter-term bonds: it is an action I had begun a couple of years ago, in anticipation of a turn up in rates. Today we are witnessing just how quickly interest rates can move. Over the last eight weeks or so, rates have risen by a full percentage point.

After a year in which stocks and bonds both gained smartly, you may shrug off such a move--after all, what is one measly percentage point? But let me define the potential change in bond prices as rates rise:

In approximate numbers, a one percent (100 basis points) rise in interest rates would mean that a 30-year bond would lose around 12% of its market value; a 10-year bond would lose 7%; a 5-year bond would lose 3%; and a 2-year bond would lose about 1%. The evidence of this has already shown up in my bond accounts.

But you can see that the shorter maturities do offer some protection. The trade-off--and there is always a trade-off--is a lower yield on the shorter paper. On the bright side, as rates rise we should be able to reinvest in higher-yielding bonds. With fully half of all of our bond holdings maturing in from one to eight years, our account yields can be expected to rise over that term. Hopefully, any hit to our market value will be minimal. Still, in fixed-income securities, the year ahead is likely to be difficult; at the moment I have a "glass-half-empty" feeling about the bond market.

The past year has been good to us. And the new year looks to be starting on a more robust economic note. While 2011 may well prove to be more of a challenge than the year just past, I still have positive, albeit muted, expectations.

Jim Pappas