January, 2011
By Darren Nyce
Senior Research Analyst, Castle Investment Advisors®, LLC

The changing of a calendar year always leads one to take a look back over the previous year’s events as well as to look forward to what is to come. As investment advisors, it falls to us to survey the landscape as it currently exists and prepare portfolios for what is most likely to occur in the future. We are not much on making specific predictions, feeling a certain futility that exists in that exercise. After all, who would have predicted the following 5 years ago:

  • Chrysler & GM would file bankruptcy
  • General Electric would trade for a time under $6
  • Bear Stearns and Lehman Brothers would be virtually non-existent
  • High-end MBA’s would be nearly unemployable

The markets and our economy are far too complex to be predicted, at least with any consistency. And to make the forecasting game even more difficult, it is not enough to get an event right, it is important to have all of the associated consequences right as well.

And so while we do not predict, we do look forward, we pay attention to what is going on, we learn from history (both ours and others), we allocate portfolios in a way that emphasizes diversification and valuation, we seek to minimize taxes and expenses, and we maintain a long term horizon in the context of each client’s individual situation.

As we look back over the fourth quarter, we see an economy that continued to show slow and steady improvement leading to solid stock market gains as the following table shows.

Index Q4 2010 Full Year 2010
S & P 500 10.8% 15.1%
Dow Jones Industrial Average 8.0% 14.1%
NASDAQ 12.3% 18.2%
Russell 2000 (Smaller Companies) 16.3% 23.9%

Initial data for the fourth quarter projects that the year over year growth in the economy, as measured by the GDP (Gross Domestic Product), will come in at 2.6%; a bit below the historical average of 3.3% but at least there is growth and recovery from the recession is continuing.

As we all know, markets do not move from their levels at the beginning of a year to the end in a straight line, but experience many peaks and valleys along the way. Some of the major market moving events of the past year include:

  • Health Care Bill
  • European Sovereign Debt Crisis
  • Flash Crash
  • Gulf Oil Spill
  • Low Mortgage Rates
  • Credit Crunch Consequences
  • Quantitative Easing Round 2
  • Election Upheaval
  • Tax Cuts Extended

With each of these events, and many others, leaving their own unique footprint, we close the book on 2010 and look forward to 2011. While many things about the coming year are completely unpredictable, it is sure to contain a dose of excitement, opportunity, laughter, joy, as well as tragedy and heartache. Hopefully, we will all choose an attitude that helps us to make the best of whatever the future holds.

Last quarter, we wrote about the uncertainty of the tax code. Some of this uncertainty has been removed, or at least postponed, as Congress reached a compromise before the end of the year. Some of the provisions of the passed bill are:

  • The Bush tax cuts are extended for all income levels through year-end 2012.
    • This means that dividend and capital gains rates will remain at 15% until then.
  • The employee’s share of Social Security tax is reduced by two percentage points in 2011.
    • This translates to a savings of $2,120 for anyone making over $106,000.
  • Businesses may deduct immediately the full cost of capital assets acquired in 2011.
  • Investors may move up to $100,000 from an IRA to a charity in each of 2010 and 2011 to satisfy their RMD requirement without incurring tax.
  • The popular Build America Bond program was not extended and, thus, expired on December 31, 2010 unless Congress acts in 2011 to reinstate it.
  • A $5 million estate tax exemption and a 35% estate tax rate.
  • Reinstatement of stepped-up basis for assets at death.

These and other items in the bill create certain planning opportunities that may be of benefit to you and your family. You are encouraged to contact Gary or Mike for a discussion of your personal situation.

While we have been encouraged by the improvement that we have seen in the economy, there are several items that appear to be headwinds to above average growth.

  • Employment
    • With the jobless rate likely to stay above 9% for a while, it is hard to envision a significant increase in consumer spending, which accounts for about 2/3 of GDP
    • We are paying particular attention to the direction of the monthly revisions, we have seen 4 months of upward revisions, which is quite positive.
    • Something that is significantly less positive is the reality that we will need an additional 2.5 million jobs for each of the next 5-6 years in order to get back to a 5% unemployment rate. We have never before added that many new jobs even 2 years in a row.
  • Housing
    • Sales and housing prices remain weak with the threat of another wave of foreclosures adding to inventory in the near future.
  • QE2
    • It remains to be seen what impact the second round of quantitative easing will have. On the face of it, encouraging additional debt in a highly leveraged economy does not seem to be the road map for success, but we will see.
  • Local Governments
    • Perhaps you saw the 60 Minutes piece in December about the financial hardships that state and local governments are facing. We are not predicting massive municipal bond defaults but the challenges are real.
  • International Environment
    • Will worldwide conditions allow an environment that continues to demand increases in U.S. exports?

Though these drags are significant, we think that there is enough strength to sustain a recovery and avoid a double dip recession; keeping in mind that there remains a certain amount of vulnerability to occasional shocks.

On the list of things we are encouraged about there is:

  • Exceptional levels of productivity
  • Remarkably strong corporate earnings
  • Corporations have stronger balance sheets and significant cash reserves waiting to be deployed.
  • Low interest rates
  • Low inflation
    • We do expect both interest rates and inflation to remain low throughout the year, but do see the writing on the wall for increases down the road and continue to prepare portfolios accordingly.
    • Despite overall low inflation, energy costs have been increasing (particularly noticeable by the $3/gal that we are paying for gas in many parts of the country).
  • Opportunities in real estate, commodities, and on the international front.

On the bond side of things, performance for the quarter was generally negative despite the Fed’s attempt to lower long term rates. We believe in the importance of a certain fixed income allocation for most portfolios and are also aware of the negative impact a rising interest rate environment could have on these securities. We will continue to prudently rebalance where appropriate in order to navigate these waters.

Thank you for the opportunity to be a part of your financial lives. We appreciate the trust you have placed in our firm.

In our effort to provide you with more articles and information that can help keep you updated on the things going on in the markets, the economy, and with our firm, we encourage you to connect with us on LinkedIn and follow us on Twitter under the handle @CastleWealth. Here we will provide you with links to articles that we have read that you might find relevant, reports on economic data, maybe something that made us laugh, as well as other activities happening here at Castle.

As always, feel free to call us if you have any questions. Here’s to great 2011!

Castle Investment Advisors®, LLC Investment Team

Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.