"The pessimist sees difficulty in every opportunity. The optimist sees opportunity in every difficulty."                   

Sir Winston Churchill

As we approach the end of the year, it is useful to take a look at the stock market's performance in 2010. It was quite a roller coaster: the S&P 500 index was up 7% through April, then tumbled 13% and was down almost 7% by the end of June. It then proceeded to rise more than 21% and is up approximately 13% year-to-date as we write this email.

Throughout most of the year, the mood was of fear and pessimism, as many investors felt overwhelmed by problems in the US, led by high unemployment, government deficits, depressed housing prices and gridlock in Washington. Today, people are feeling somewhat better, and retail sales are back to where they were before the crisis, back in 2007.

Clearly there are substantial issues that have to be worked through. That said, throughout history Americans have regularly overcome problems of similar and bigger magnitude. This is the theme of a thought-provoking new book by leading science writer Matt Ridley - The Rational Optimist: How Prosperity Evolves.  In a review in the Wall Street journal[1], Microsoft's Bill Gates wrote: "there have been constant predictions of a bleak future throughout human history, but they haven't come true. Our lives have improved dramatically-in terms of lifespan, nutrition, literacy, wealth and other measures-and he (Mr. Ridley) believes that the trend will continue."

There are at least two reasons to remain optimistic-the role of innovation and some of the positive things that are happening in emerging economies in Asia, Latin America, Eastern Europe and even Africa.

With regard to innovation, in his review of Ridley's book, Bill Gates wrote: "Pessimism is so often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new developments and insights that might alter current trends."

The other big positive is what's happening in emerging economies. Many consider China, India, or Brazil and come away impressed by the drive, energy and ambition they see there. A new and growing middle class wants a better life and a whole new generation of young people is getting educated, applying a strong work ethic and making a huge impact as a result.

As for the argument that these emerging economies are going to win at our expense, this assumes that the size of the wealth pie we're dividing up is fixed. It's not - through trade and globalization, those emerging markets are going to dramatically increase the amount of wealth in the world.

Implications for Our Clients and Fellow Investors

What does it all mean for your portfolio? First, understand how much volatility you can tolerate. We guarantee you that markets will experience similar upheavals in the future. With every client, we work through how much short-term volatility and risk they can withstand. It is particularly important if you are already retired and making regular withdrawals.

Second, we continue to feel positive about the shares of high-quality companies, those with competitive advantages, competent management, and strong balance sheets. They will directly or indirectly benefit from increasing wealth around the world. The market rally of the last 18 months has seen these companies' stock underperform lower-quality companies - we don't think that will continue.

Finally, we need to take a "rationally optimistic" view of the future, walking the fine line between succumbing to dire pessimism on the one hand and blind optimism on the other. This will not necessarily pay off in the next six or even 12 months - but history tells us that we'll ultimately be very well rewarded for investing in the companies best positioned for the future.

Thank you for the opportunity to work together over the past year. Should you have any questions on anything in this email, please give us a call. Meanwhile, best wishes for a relaxing holiday season - we look forward to talking to you in 2011.