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Market Commentary

May 2010

The markets are in for a period of volatility. We wanted to share some thoughts with you.
  • First, the stock markets "fear gauge"--The Vix or Volatility Index, soared 80% this week.
  • Strong investment performance continued in the first quarter. However, we expect slower than normal economic growth in the U.S. as the unwinding of the debt bubble forces lower spending.
  • Stimulus and entitlement spending are contributing to ballooning federal deficits, which will eventually pose a major challenge and threat to the economy.
  • Recent economic positives stem mostly from temporary factors of stimulus spending and inventory rebuilding.
  • The job market - which is key - remains weak.
  • We recommend underweight to equities as stocks are not cheap enough to compensate for the macro risks.
  • Given our conservative positioning, we may underperform benchmarks if equity markets continue rising in the near term.
The Economy Will Continue to Face Serious Challenges in the Years Ahead
  • Over the last year, the debt binge fueled a lot of spending. Reducing debt necessitates less spending, which suggests a sluggish economy in coming years.
  • Stimulus spending revived the economy but added to the ballooning public debt problem that will be difficult to fix without causing more damage.
  • In addition to stimulus spending, the economy has been helped by inventory rebuilding. Neither can be sustained.
  • Jobs are key, and despite slow improvement the job market remains poor.
  • There are more problems, including:
    • Huge amounts of commercial real estate debt coming due.
    • Continued strains in the housing market.
    • Possible high inflation down the road from deficit spending.
    • Stressed state and local government finances.
There are Several Positives that Could Contribute to a Better Outcome
  • Continued strength from emerging economies would provide an important source of demand.
  • Domestically, we could see stimulus spending, low rates, and inventory rebuilding create a strong business cycle.
  • This may involve businesses with strong balance sheets adding jobs, and consumer and business confidence building and feeding on itself.

Stocks Are Not Priced to Deliver Strong Returns
  • After their powerful recent run, strong multi-year returns from stocks would require a level of earnings growth we consider unlikely.
  • We believe mid-single-digit returns or worse are more likely for stocks than higher returns over the next five year.
    • Our outlook for developed market foreign equities is similar.
  • We believe risks are relatively high, but if rates stay low and there is no negative catalyst, we could see low double-digit returns in 2010.

Closing Thoughts

  • The picture we paint is not the most uplifting, but we must make decisions based on what our analysis tells us.
  • We could be wrong in the short term and investors need to recognize that it is the willingness to be wrong in the short term that enables us to outperform over the more important longer spans.
  • There are a number of reasons to be optimistic about the longer-term returns we can deliver even in a challenged environment.
  • Doing so will require us to be patient and highly selective in the decisions we make.

The Government is Walking a Tightrope Between Stimulus and Deficits
  • As stimulus spending winds down it's possible the economy could tip back into recession.
  • More spending and less tax revenue is creating a spike in public debt.
  • Demand for Treasuries had been strong, but is showing signs of weakening, which would raise the cost of funding the debt.
  • High levels of borrowing could put upward pressure on rates in the next few years.
  • Longer-term, the deficit problem is about entitlement spending on behalf of retiring baby boomers which will massively increase the debt unless taxes are increased and benefit spending is cut.

Views on U.S. Equities
  • Our base-case scenario is slow economic recovery accompanied by private-sector (primarily household) deleveraging.
  • At current valuations, equities do not offer attractive potential returns in our base case or in other more pessimistic scenarios.

Views on Investment Grade Bonds

  • Potential returns for plain-vanilla investment grade bonds (Aggregate-type exposure) are low across all of our scenarios.
  • Rising interest rates pose a risk as we look forward.
Please advise us promptly if there are ever any changes in your financial situation or investment objectives.

Feel free to give us a call if you want to discuss anything further.
Paula SignatureMike & Jenn married
Paula and Bill Harris, CFP
WH Cornerstone Investments