Following upon the success of our inaugural Investment Symposium last February, we ask that you mark your calendar for Tuesday, February 8, 2011 for the Second Annual Investment Symposium at the Chattanoogan Hotel.  At last year’s event, we acknowledged numerous and lingering uncertainties with regard to markets and economies.  In particular, we identified the PIIGS (Portugal; Italy; Ireland; Greece; Spain) as wildcards in developing an investment outlook.  We nevertheless felt confident that 2010 would witness a continuation of the market and economic recovery that began March 2009.  There were periods during 2010 that the markets became sensitive to concerns among investors regarding a “double dip” recession for the US.  Some of those concerns emanated from global volatility (associated with the PIIGS); some were “local” – e.g., the US housing market.

Despite many concerns, 2010 was quite a good year for investors, especially for those with exposure to the US stock market.  The bond markets delivered reasonably good total returns as well.  Market performance was not smooth; in fact, the markets were characterized, at times, by extreme volatility.  The May “Flash Crash”, for example, was a healthy reminder about the unstable nature of the markets. 

As we look forward, we would like to point out that the stock market has responded most directly and powerfully to policy measures undertaken by the Federal Reserve.  The Fed’s actions, in our view, were designed to encourage equity investing in order to generate a positive wealth effect, and in that regard, they have been qualified successes.  Long term inflation expectations have begun to normalize from the deflation scare of last summer, but they remain well within the range of the past decade.  Flows out of bond funds contributed to bond market weakness at the close of 2010, especially for long tax-free municipals.  To the extent the Fed can successfully balance stimulus measures while pre-empting damaging inflation, yields on long term bonds should not rise sharply in the near term. 

We should note that the most recent monetary stimulus program is supposed to terminate at the end of June 2011.  The Fed remains caught between doing what is best for our economy in the near term (i.e., monetary stimulus) and what is best for our economy over the long term (i.e., fiscal austerity and deficit reduction).  The Fed has made their intentions quite clear – i.e., policy rates should remain low for an extended period in an effort to assist the creation of jobs in our economy.

At present, we have a bifurcated global economy that should reward commodity producers at the expense of commodity consumers.  This will likely cause tension among trade partners, especially with respect to currency/monetary policies.  Many emerging market nations, for example, maintain some form of peg to the US Dollar.  As a result, it is quite arguable that Asia’s monetary policy, in particular, remains too loose.  Consequently, a hyperinflation problem is more likely in Asia than in the US.  Despite its growing importance, China is vulnerable to commodity price inflation, especially with respect to food, for which they could soon lose their self sufficiency.  This situation places the US in a powerfully competitive position as we offset dependence on crude oil imports with dominance in agriculture.

We believe that mergers and acquisitions will be another key theme in 2011.  If companies cannot organically grow their top line or improve operating leverage, they will seek synergies through acquisitions.  We remind investors that many companies utilized the Financial Crisis to cut costs and repair balance sheets.  On balance, companies emerged from the recession with much less leverage and in generally better condition than when they entered.  The consolidation trend could also include municipalities that seek to alleviate budget pressures through asset divestitures.  Such activity could include convention centers, sports arenas, libraries, toll roads, water and electric systems.

Finally, as we mentioned throughout last year, we believe investors should continue to be prepared for surprises.  While 2011 should be characterized by a very quiet legislative agenda, we are optimistic that opposing political forces will continue to make progress toward meaningful deficit reduction.  With nearly a trillion Euros worth of debt that needs to be refinanced during the first half of 2011, the fiscal issues in Europe remain far from resolved.  China’s monetary policy actions, much more so than those of the Fed, could greatly affect commodity prices and the performance of various markets in 2011.  If real interest rates rise significantly, we would expect gold to underperform.  We also believe that inflation hysteria related to debasement of the dollar is misdirected. 

Last year, we eventually became cautious toward the bond market as yields approached their natural limit (i.e., they cannot fall lower than zero).  However, we advise against abandoning this asset class.  We continue to believe that equities are relatively more attractive.  Further, we urge investors to consider equities as a source of current income.  The global economy is now entering a period during which new regulations will be drafted and implemented.  Long term, we contend the new regulations will promote stability.  In the near term, we anticipate spikes in volatility as the markets adjust to new paradigms.

Proponents of the “double dip” scenario correctly identify a formidable structural unemployment challenge in the US. Structural unemployment refers to jobs that were permanently destroyed during the recession. This negative factor is exacerbated by the contraction in available credit. The bear case basically concludes, therefore, that our economy will endure a lengthy period of consumer retrenchment. Until the economy can demonstrate sustainable growth without the need for fiscal or monetary stimulus, the bear case recommends caution, especially with respect to the outlook for financial assets. The headwinds are powerful as excess cash flow for onsumers will be devoted to debt reduction. This is a process known as de-leveraging, and its implications are quite deflationary.

The bear case also argues that monetary policy and currency devaluations will inevitably result in damaging inflation. We acknowledge the long term implications of these actions. However, given all the various considerations, we believe that, on balance, deflation is more powerful at present. Deflation is likely to prevail until the global credit system is either fully repaired or completely restructured. At a minimum, leverage will be considerably less in the future. That suggests that inflation is less of a concern today than it was in the 1970s.

Despite prospects for slower earnings growth, the bear case conveniently ignores the dramatic improvement in the corporate sector. Many companies utilized the Crisis to improve inefficient systems, eliminate redundancies, cut costs, repair balance sheets, and establish a more stable financial structure in anticipation of the recovery. On balance, companies emerged from the recession with much less leverage and in generally better condition than when they entered. In the murk of current sentiment, we contend there are numerous and exciting opportunities.

During the Second Quarter, we felt that the markets had grown too pessimistic. We also felt that markets were primarily responding to efforts by China to cool its overheating economy. Once China resumed its level of general economic activity, prices for various commodities responded to incremental demand. That, in our view, is precisely what occurred during the Third Quarter. At this juncture, we submit that the probability of a “double dip” in the economy is low. That said, we acknowledge the strong possibility that our economy exhibits sub-par growth for the next few years, but we remain excited about the strength in emerging markets.

On a year to date basis, long treasury bonds remain the best performing asset class, but their relative outperformance is likely unsustainable. Therefore, we are becoming increasingly cautious toward the bond market as yields approach their natural limit (i.e., they cannot fall lower than zero). We consider equities to be relatively more attractive. Further, we urge investors to consider equities as a source of current income. The global economy is now entering a period during which new regulations will be drafted and implemented. Long term, we contend the new regulations will promote stability. In the near term, we anticipate a continuation of elevated volatility as the markets adjust to a new paradigm.

Inflation – Should We Be Concerned?

By Ray Ryan, CFA

“Here we go again!” one might say, dreadfully, with regard to the prospect of runaway inflation in the near future. The Consumer Price Index (CPI) rose 12.2 percent in 1974; in August 1975, annualized inflation in Great Britain nearly reached a staggering 27 percent. During the miserable economic decade of the 1970s, unemployment was high, and economists crafted what came to be known as the “Misery Index.”

Given the policy responses to the economic crisis that began in October 2007, many experts have concluded that the multitude of fiscal programs will generate damaging inflation over the next few years. The money supply has exploded in size, and budget deficits are now projected to approach $1.8 trillion as soon as 2010. As inflation is often described as the condition that exists when “far too much money chases after far too few goods,” it is understandable why many people fear 1970s redux.

Yet, as ESPN commentator Lee Corso likes to say, “Not so fast, my friend.”

It is not a foregone conclusion that inflation wili be the unavoidable by-product of monetary and fiscal policy measures designed to deal with the crisis. There are several possible outcomes, not the least of which is that our nation could suffer a similar fate as that of Japan — a “lost decade” characterized by deflation, not inflation. Another quite probable outcome is the restoration of confidence in global financial markets that establishes a foundation for many decades of prosperity. In order to develop both sides of the debate, it is instructive to examine the causes of inflation and, more specifically, the factors behind inflation in the 1970s.

Inflation is an economic phenomenon that reflects the immutable laws of supply and demand. Generally, when demand for a good or service exceeds supply, prices adjust upward to arrive at equilibrium between those two forces. Conversely, if supply of a good or service is abundant, prices fall in order to stimulate demand. That is known as deflation.

Inflation tends to accelerate economic activity; deflation tends to defer economic activity If one is convinced that the price of a good will be higher tomorrow than it is today, one will accelerate the purchase decision. As others fear further price increases, they, too, accelerate their purchases; that action, in turn, drives prices ever higher. Some might even resort to hoarding.

We have had recent, yet temporary or unsustainable, bouts of inflation: energy prices in 2005 following Hurricane Katrina and again in 2008; housing prices from 2003 through 2007; food prices in 2008. For the most part, however, constant, sustainable cost inflation has been relatively remote. Whether it is flat panel televisions, personal computers, iPhones or apparel, consumers are aware that most prices tend to fall eventually. Americans are shrewd when it comes to bargain shopping. The notable exceptions have been health care and education costs.

Inflation also relates to the purchasing power of a nation’s currency. The impact of currency movements is most directly felt in trade. In that regard, a period of protracted weakness in the dollar is quite concerning.

There are numerous causes of the inflationary 1970s. Decisions by policymakers to remove fixed exchange rates and abandon the gold standard unleashed a wave of global credit. The abundance of credit contributed to inflationary developments. Perhaps the best-known cause was the Arab Oil Embargo, a “supply shock” of our nation’s most crucial imported natural resource. That period exposed our nation’s key vulnerability – our dependence on energy resources developed in the Middle East.

There were other, less prominent factors that one should also consider, and these are unlikely to repeat. In the 1970s, the first wave of the Baby Boom Generation was reaching its prime earning years. Our nation’s GDP remains quite dependent upon consumption, and the largest demographic force in modern history was boosting consumption as it established households and enjoyed rising standards of living. Today, as everyone is well aware, the Baby Boom Generation is approaching retirement. Capital preservation is more important than spending to enhance one’s lifestyle.

In the 1970s, the labor force participation rate of women began an upward trend that lasted nearly three decades. The entrance of women into the workforce resulted in the proliferation of two-income families. Many families discovered the need for two vehicles. Two wage earners required clothes and other necessities for their profession or career. Suddenly, there was a need for industries that did not exist prior to this period, such as professional child care services. Today, it appears that the labor force participation rate of women has peaked.

In the 1970s, unionized workforces were prevalent, representing approximately 40 percent of all those employed. Organized labor negotiated contracts with employers, known as collective bargaining agreements. Those agreements contained Cost of Living Adjustments (COLAs) that required annual wage adjustments pegged to some measure of inflation, such as the CPI.As prices rose, generally, producers were forced to raise wages. In order to maintain margins, companies would raise prices of their goods and services to consumers. Today, the percentage of labor that belongs to a union of some type is approximately half that of the 1970s. Whereas union participation among service workers is rising, the pressures faced by the domestic automakers – in addition to several other manufacturing sectors suggest minimal impact from this factor over the next few years.

The U.S. and many other countries currently suffer from excess capacity. Supply, in other words, currently exceeds demand for many goods and services. Unemployment continues to rise, which is another indication that inflation should remain muted.

What, then, is the concern about? Monetarists are economists that adhere to the belief that inflation is a function of the money supply i.e., if the money supply expands too far, inflation will be created. The monetary base of the U.S. has exploded in size since the economic crisis began. Additionally, burgeoning budget deficits will necessitate the issuance of mountains of public debt. Both factors contribute to a rather cautious outlook for financial assets – principally stocks and bonds. Similar to the 1970s, in which “hard” assets such as real estate and commodities outperformed, many experts are predicting difficult years ahead for both the stock and bond markets. Yet, in terms of both public sector debt and budget deficits, the Japanese have maintained proportions much larger than the U.S., and Japan has been fighting a long-term battle with deflation ever since its property market bubble burst in 1989.

Indeed, the growth of the money sup ply is alarming. Inflation, however, requires both the growth of the money supply and a corresponding increase in the velocity of money. The velocity of money has collapsed. Therefore, current concerns over inflation could be misplaced. From 1933 through 1936, the U.S. economy was recovering from the worst stage of the Great Depression. Then, in late 1936, policymakers grew concerned about inflation and responded with both tax increases and interest rate hikes. The U.S. economy promptly slid into a “double dip” recession in 1937, from which it did not recover until World War II.

Various economic indicators support the notion that our economy is stabilizing and beginning to recover. Could the growing paranoia over inflation prompt a premature policy move that nips the recovery in the bud? That, perhaps, should be the proper focus of people’s concerns.

At a minimum, prices should rise from depressed levels. Those price increases could serve as a manifestation of economic recovery. So, in a certain sense, a little inflation at this juncture might not be such a bad thing. Global economies experienced a shock like never before, and policy responses needed to be aggressive and massive. To the extent these measures prove to be inflationary, one could invest in some hedges – e.g., allocate some percentage of portfolios to gold, precious metals, commodities and Treasury Inflation Protected Securities (TIPS). An excessive allocation, however, might prove costly.

Europe will likely resort to more bureaucratic, stop gap measures that buy the region more time to address structural problems. While the markets remain pre-occupied with handicapping a collapse in the currency, the fundamental impact of the region’s austerity measures is more pertinent. There is a rising probability that the Euro Zone slips back into recession. In this event, it is likely that China will experience continued pressure. Since Europe is China’s most important destination for exports, it would not be a surprise if the Chinese government injects more stimulus into their economic system should growth slow much further.

Interestingly, some view the sovereign debt crisis in Europe as a precursor to a similar, yet much larger bond market rout (i.e., sharply rising yields and falling prices) in the US in a few years. It remains our contention that unless the US Dollar loses its primary reserve status, such an outcome is unlikely. Moreover, currency crises resulting from excessive sovereign debt tend to be deflationary. It that regard, we believe the markets have already begun to price in an increased probability of deflation. This trend is best captured in the difference in yield between Treasury notes and Treasury Inflation Protected Securities (“TIPS”), known as the break-even yield. Break-even yields have declined substantially since the correction began.

In the US, structural and long term unemployment represent deflationary head winds. In this environment, it is difficult to envision robust economic growth. Nevertheless, corporate fundamentals are significantly improved, and for the fist time in many years, our companies are under-levereged. So, a natural tension will surface in the economy between those sectors dependent upon the discretionary income of an underemployed, low earning consumer and a healthy corporate sector with ample cash flow and a desire to expand. The stock market must also contend with a tension between generally improving fundamentals and negative technical forces.

On a relative basis, the US stock markets outperformed most other major markets during the Second Quarter for the first time in at least five years. Long treasury bonds are the best performing asset class on a year to date basis, followed closely by gold. Most industry sectors in the S&P 500 posted declines in the Second Quarter. With relative outperformance by staples, telecom and utilities, the market seems to be rotating into higher quality, somewhat more defensive issues. As we enter the Third Quarter, there should be better visibility with regard to financial regulatory remorm. This should facilitate security and sector selection. Overall, we believe the ongoing stock market correction represents a long term buying opportunity for high quality assets. However, we acknowledge the numerous macroeconomic resks as manifested in heightened volatility. We remain fascinated with how the global economy will perform in an environment of considerably less leverage and substantially more regulation. While this prospect might seem discouraging, it does suggest a world of more sustainable, higher quality economic growth.

Financial Market Reform

by Ray Ryan, CFA

The 1930s witnessed the enactment of landmark pieces of securities legislation, many of which were directed toward preventing a recurrence of the factors that either caused or contributed to the Great Depression. At the time, one of the purported causes of the Crash of 1929 and its aftermath was identified as excessive speculation in capital markets by ostensibly unregulated banking institutions using depositor funds. Eighty years later, we are faced with an almost “déjà vu” as financial market reform occupies the center stage of public debate. The rhetoric today is eerily reminiscent of the rhetoric of yesteryear.

The new administration has “imitated the intellectual and vocal techniques of typical European revolution,” in which the “first demands were powers of dictation over industry and agriculture and finance and labor.”1 These words were delivered in a speech by Herbert Hoover on March 7, 1936. Hoover had lost the 1932 presidential election to then-Governor Franklin D. Roosevelt (FDR) of New York, and this comment referred to aspects of FDR’s New Deal legislation, including financial market reform.

Hoover was a free market advocate and feared the impact of a strict regulatory framework on commerce. In that speech, Hoover went on to say that “a great area of business will regulate its own prices and profits through competition. Competition is the restless pillow of progress.”2 He equated the New Deal to European collectivism and implied that FDR’s ambitious policies would derail American liberty.

Notwithstanding the resistance of Hoover and other free market ideologues, Congress passed the Securities Acts of 1933 and 1934 and the Glass-Steagall Act in 1933 to address some of these issues. Many commentators believed those acts to be either unnecessary or excessively severe. The Glass-Steagall Act, in particular, met with strong opposition.

Contrary to those concerns, however, 1930s financial reform helped establish a foundation of trust in the markets that arguably fostered decades of economic growth and prosperity. Ironically, Hoover acknowledged this fact, despite his general resistance to regulation. “Banking, finances, public markets and other functions of trust must be regulated to prevent abuse and misuse of trust,”3 Hoover said.

While our Congress debates and, ultimately, passes some form of financial market reform legislation, the clear division between free market purists and those who champion greater regulation to promote public welfare is apparent again. So, I suppose the conclusion that one could draw is that not much changes over time. That is also the conclusion of Kenneth Rogoff and Carmen Reinhart’s ironically titled book, This Time is Different, an excellent study of financial crises throughout history. This book effectively demonstrates that financial crises reflect repeated mistakes in terms of contributing factors and policy responses.

The benefits of a market-based economic system are most profound. Unconstrained by the shackles of an oppressive regulatory structure, markets have a remarkable ability to efficiently allocate capital to society’s most productive uses. Granted, the market did not create Google, but it facilitated its growth as it forged a marriage between entrepreneurs and investors that identified its growth potential. Just as the market determined Henry Ford’s Model T was superior to the horse and buggy, the market might determine someday that all newspaper and magazine content will be more efficiently delivered over Apple’s new iPad platform.

Society advances under the banner of progress as economist Joseph Schumpeter’s concept of “creative destruction” takes root. It is arguable that a central planning-based economic system would never have invested the capital to develop a product such as the iPad. Only markets facilitate the allocation of capital to new technologies from investors willing to assume the risk of an uncertain outcome. Ultimately, the markets reward those with vision as it provides the means by which that vision can be realized.

“The Securities Act proceeds on the theory that the United States government will not undertake to tell a man what risk he shall take with his money. It will, however, to the extent indicated, require that he be fully informed as to the facts.”4 That quote is from an article written in 1933 by professor A. A. Berle Jr., responding to criticisms that the Securities Act of 1933 was unnecessary and severe. This quote reflects the core ingredient of any market-based system – i.e., the trust that is required among all participants in order for a market to function properly. If trust is breached, the market will ultimately cease to function and collapse under its own weight.

The financial crisis of 2007-2009 uncovered numerous breaches of trust. All bear markets have the effect of exposing artifices of greed. Madoff, Stanford, Galleon, and a host of other fraudulent or illegal schemes have undermined the foundation of our capital markets.

The recent case filed by the Securities and Exchange Commission (SEC) against the investment bank Goldman Sachs is less clear from a legal standpoint, but it supports the notion that general business practices on Wall Street adhered, perhaps, to the letter of the law, but not its spirit. The SEC alleges that Goldman withheld material information from investors in a complex derivatives transaction. The information related to a third party that sought to capitalize from the collapse in value of those same derivatives.

When asked about the Goldman case, I acknowledge there is a balance between caveat emptor on the part of investors and disclosure requirements on the parts of underwriters and issuers. The case is complex, both in terms of the legal issues and the structure of the actual transaction. What seems pretty clear from publicly available information is that the transaction was designed to facilitate speculation in a certain market.

This is far removed from the 1930s version of investment banking in which firms such as Goldman would act as simple intermediaries between those with capital and those that needed capital. Using synthetic securities and derivatives, Goldman constructed a vehicle that would mimic the direction of a particular asset class and then found investors on both sides of the trade. Further, it is alleged that Goldman actively bet against certain clients on transactions the firm underwrote. Should such modern day practices be outlawed? That is the relevant question as the Goldman case becomes the focal point of broader financial market regulation.

With respect to the long-term impact of financial market reform, I worry that innovation and capital formation could be stifled. I worry that our markets could become less competitive. However, I recognize that the authors of the landmark securities legislation of the 1930s could never have anticipated the creation of collateralized debt obligations (CDOs), credit default swaps (CDSs), and other wizardry of Wall Street financial engineers.

I believe, therefore, the recent SEC securities fraud case against Goldman Sachs is likely to spur on new regulations that will modify the manner in which large financial institutions conduct their practices. I anticipate that legislative reform will focus on stricter capital controls, less leverage, and greater transparency. I further anticipate that a coordinated global effort at financial market reform will shrink profit margins for many of the large global banks.

While there is risk of “over-regulation,” I remain encouraged that much-needed regulatory reform will re-establish trust in the capital markets long term. While this also implies less available capital for small and large businesses alike, the system should be more stable. Moreover, it is likely that new financial intermediaries will emerge to serve neglected areas of the market, albeit at higher costs.

Reform today, as it was in the 1930s, does not imply an abandonment of free market principles. It is a necessary refinement, and I anticipate innovations will appear that facilitate the ongoing marriages of investors with entrepreneurs.

Ray Ryan is a Principal and Portfolio Manager of Patten and Patten, an investment management firm and Registered Investment Advisor in Chattanooga. Ray is a CFA Charter Holder, a member of the Advisory Board for UTC’s College of Business, and an Adjunct Professor of Finance at UTC. He is a graduate of Princeton University, where he had the privilege of taking a course taught by current Fed Chairman Ben Bernanke.

Not surprisingly, the market was greeted by negative developments in Greece during the First Quarter. While it appears some form of rescue plan will eventually be assembled by the European authorities, the fundamentals for the region remain clouded by the uncertainty. Moreover, investors worry that Greece is just the first in a line of EuroZone dominoes that could topple. While we remain optimistic that policy makers are “ahead of the curve,” we acknowledge that developments in Europe could have a large influence over returns this year.

While the markets will be affected by conditions across the Atlantic, we note that the US economy continues to make steady fundamental progress. Partly in recognition of this trend, the stock market has returned nearly to the levels that existed before the collapse of Lehman Brothers in September 2008, a linchpin of the crisis. We now state with confidence that the crisis among the major financial institutions in the US is over. In our view, investment strategies should account for generally improving corporate fundamentals but hedge against deteriorating fiscal conditions in various governments.

In contrast to the PIIGS, the BRICs (i.e., Brazil; Russia; India; China) and other natural resource heavy economies (e.g., Canada; Australia) continue to lead the global economic recovery. While these faster growing nations will not be immune from global credit disruptions, they are each characterized by powerful fundamentals, and we believe they benefit from secular tailwinds. The developed nations, on the other hand, are responding to positive cyclical forces, but their secular outlooks are less favorable.

We, therefore, recommend gradual increases in exposure to these faster growing regions of the world. Given the strength of the market’s rally over the past year, we acknowledge the rising probability of a correction of some magnitude given the rapidly evolving dynamics of the global economy. We urge investors to use the market’s recovery as an opportunity to diversify and broaden exposures. While the stock market continues to climb a “wall of worry,” a further advance will likely require validation of continued economic growth, most notably in the form of job creation. We are also of the view that resolution of an ambitious legislative agenda is imminent. While many might decry the outcome of these efforts, we are encouraged by the market’s initial reaction. Further, we believe legislative resolutions will afford investors greater clarity with respect to analyzing investment opportunities in certain sectors.

The stock market has been led by low quality, higher risk issues – i.e., those that benefit the greatest from a large injection of liquidity. As the Fed and other central banks begin the process of removing liquidity from the system, we believe the markets will gravitate back toward investments of considerably higher quality. In that regard, certain companies and assets remain quite attractively valued. Nevertheless, we advise investors remain diversified and protected against negative surprises. We remain fascinated with how the global economy will perform in an environment of considerably less leverage and substantially more regulation. While this prospect might seem discouraging, it does suggest a world of more sustainable, higher quality economic growth.

PowerPoint Slides

Introduction – Cartter Patten

http://www.patteninc.com/wp-content/uploads/2010/02/CartterPatten_Introduction.mp3

Part 1 – Ray Ryan

http://www.patteninc.com/wp-content/uploads/2010/02/RayRyan_Part1.mp3

Part 2 – Mark Fleck

http://www.patteninc.com/wp-content/uploads/2010/02/MarkFleck_Part2.mp3

Part 3 – Ashlee Patten

http://www.patteninc.com/wp-content/uploads/2010/02/AshleePatten_Part3.mp3

Part 4 – Ray Ryan

http://www.patteninc.com/wp-content/uploads/2010/02/RayRyan_Part4.mp3

Just as the markets have swung from one extreme to the other over the past two years, prognostications for the future likewise gravitate to one of the poles. On one hand, there are those who argue the US faces a “lost decade” characterized by deflation and neglibible growth – similar to that experienced in Japan. Along that line, a term formerly used to describe Europe is now being applied to our future – “euro sclerosis,” defined as chronically high unemployment with moderate economic growth. On the other hand, there is growing belief that the other extreme is more probable – high inflation resulting from massive budget deficits, a weak Dollar, and a burgeoning money supply. For those in this camp, there is fear of a decade similar to the 1970s – characterized by double digit inflation and poor performance for financial assets.

It is our contention that the most probable scenario lies somewhere well between these extremes. We understand the arguements for both cases, but we find less than compelling evidence in support of either outlook. In fact, we would look forward to sharing our analyses of both scenarios. In our view, any forecast for next year’s market must address actions by the Federal Reserve and other central banks. The pace and magnitude of actions by the central banks to remove excess liquidity will determine the relative performance of numerous asset classes. Those authorities are attempting to nurture a nascent global economic recovery to the point of self-sustainability. The key element to a sustainable recovery, at least in the US, is job creation. A secondary objective is to preserve long-term price stability. This is an extremely delicate balancing act, and the market will render its verdict quickly and forcefully as to whether the Fed is succeeding in this regard. Our confidence lies with the Federal Reserve at this point.

We have strong conviction that the markets will seek to upgrade quality next year. In 2009, lower quality, higher risk sectors of the market provided leadership. As an example, the best performing asset class was high yield (i.e., “junk”) bonds. High yield bonds appreciated 55%, their best annual returns ever. We doubt those types of returns will be achievable in 2010. Instead, we believe the markets will renew their focus on solid fundamentals and stable income. Given the resolution of numerous legislative and regulatory uncertainties, we further believe investors will be afforded greater clarity in 2010.

Finally, we believe investors should be prepared for surprises. Some of the surprises could relate to the exhaustion of certain technical forces that drove the markets the past two years. For instance, investors might be surprised to discover a strengthening Dollar in 2010. A stronger Dollar should result in stabilizing prices for commodities, and unlike many predictions, we believe the Dollar could strengthen coincident with a rising stock market. A stronger Dollar could also quell inflationary pressures and help preserve low interest rates.

Nevertheless, we acknowledge the numerous and lingering uncertainties with regard to markets and economies. For that reason, we advise investors to remain diversified and protected against negative surprises. We remain fascinated with how the global economy will perform in an environment of considerably less leverage and substantially more regulation. While this prospect might seem discouraging, it does suggest a world of more sustainable, higher quality economic growth. We look forward to presenting our outlook at our first annual Investment Outlook symposium in Chattanooga on February 2, 2010.

We have also maintained that the stock market was vulnerable to a correction.  We continue to believe that remains a possibility in the near future, but we would consider a retracement to be a long term buying opportunity.  Low quality rallies have never proven sustainable or long term.  We, therefore, believe this is an opportune time to upgrade the quality of portfolios as the economy enters the next phase of recovery – i.e., reducing dependence on government support while transitioning to a self-sustaining model.

With regard to the economy, we believe the crisis/stabilization phase is over.  However, it is difficult to unconditionally accept the view that all aspects of the economy will quickly return to normal when nearly 6 million people lost their jobs over the past year.  We, therefore, anticipate that the transition phase will be neither smooth nor easy.  Nevertheless, we believe the markets have normalized and the economy has advanced toward recovery.

Yields on short-term US Treasuries are now the lowest in the developed world – i.e., lower even than comparable Japanese government bonds.  This has facilitated massive, leveraged
speculation using the Dollar as a key funding source.  The implications for the long term value of the Dollar are worrisome.  Moreover, it presents problems with regard to the management of cash.  While we acknowledge the frustration associated with paltry money market yields, we urge investors not to lower credit standards or to increase risk tolerance for the sake of yield.  Many unresolved issues suggest this is not an environment for such strategies.  We are exploring methods of increasing the yields for cash reserves, but we continue to advocate that maintaining or upgrading quality should be of paramount importance.

From a long term perspective, we remain fascinated with how the global economy will perform in an environment of considerably less leverage and substantially more regulation.  While this prospect might discourage many investors, we look forward to a world of more sustainable, higher quality economic growth.  Heading into 2010, we recommend that investors remain well diversified, and we look forward to sharing our outlook for the markets.