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Letter dated January 2010 reporting on the fourth quarter of 2009

Everybody wants to know whether 2010 will be as good in the financial markets as 2009.  After an earthquake, the seismograph tends to have smaller oscillations up and down.  A calmer market and regression toward more normal returns strikes me as the highest probability scenario in 2010.  But there are examples of consecutive years of 20%+ gains in the stock market.  It is certainly possible to have another year with more volatility than the norm.

Let’s toast a great 2009 before we look forward.  The S&P had a total return of 26.5% for the year.  We did considerably better, posting a total return of 33.3%.  You began the year with an account balance of $xx and ended it with a balance of $xx.  Details showing additions and withdrawals are appended.  We became a little more conservative in the fourth quarter as valuations seemed a bit stretched.  We wound up lagging the market slightly during the quarter, gaining 4.5% versus 6.0% for the S&P.  Our portfolio is less volatile than the overall market, so our returns remain very good on a risk-adjusted basis.*

It seemed prudent to be a bit more conservative for several reasons.  First, the rally has been led by low-quality stocks and that is not necessarily a solid foundation.  Second, we can get yields of 5%  on utilities that are also good candidates for modest capital appreciation.  There is nothing wrong with a 5% dividend and 5% appreciation – not a home run but still a double digit return.  Third, the market is no longer cheaply valued.  Fourth, there are question marks about the economy – particularly since the influence of federal stimulus money will probably wear off by the third quarter of 2010.

The stock market has discounted a moderate economic recovery.  Now GDP has to maintain a reasonable growth rate.  The most recent reading of 2.2% growth is less than half the average 6% rate of economic expansion historically seen in the year following a recession.  This modest bounce in GDP has been produced by government stimulus and a slowing rate of decline in business inventories.  Since these are temporary factors, the consumer is going to have to step it up.  If consumers get too conservative and save too much, they will not spend enough to help the economy grow.  If they spend too much, we’ll go right back into a state of excessive leverage which is what got us into this mess.  So the metaphor that comes to mind is Apollo 13.  On re-entry, if the angle of descent had been too shallow, the capsule would have bounced off the atmosphere back into outer space.  If the angle of descent had been too steep, the capsule would have burned in the atmosphere.  Consumer behavior has to be calibrated at just the right level for a healthy degree of economic growth.

It is hard to see consumer spending increasing much until unemployment and fears of it begin to recede.  Thus we are watching employment statistics more carefully than ever.  Our skepticism notwithstanding, consumer stocks have been leaders of the recent rally.  We were underweighted in them, which is a big part of the reason we lagged the market in the fourth quarter.  We may be wrong; year-over-year retail sales figures recently had their first positive measure in a year.  But our system projects an average annual return on consumer stocks of only 0.4%; this compares to a projection of 13.9% in June 2003 (when a sharp rally was in its early stages) and 5.5% in March 2004.

We did find some attractive opportunities during the quarter.  The healthcare sector seems relatively undervalued, and the major pharmaceutical companies have had a strong quarter and offer excellent dividend yields.  An aging population and an expanded share of GDP for healthcare are bound to be good for these companies.  Moreover, they are cheaper than they have been in some years.  For example, at the beginning of the decade, it took over ten years for Pfizer’s projected earnings stream to add up to the stock price.  Now Pfizer’s projected earnings pay back the stock price in under six years - a huge difference.  Pfizer returned 10.9% for the quarter, Merck gained 16.7%, and Bristol Myers Squibb posted a 13.5% total return.

The materials sector remains attractive.  The Chinese economy is still growing at over 8% annually and the demand for many raw materials remains high.  Copper producer Freeport McMoran trades at 15x current earnings and 8x peak earnings.  That is a reasonable value.  However, we limit our exposure to commodity producers because these stocks are very volatile, as are the underlying earnings estimates.  For instance, last April, the consensus among analysts was that Freeport McMoran would earn only $0.53 per share in 2009.  Nine months later, that projection is up to $5.24 – a tenfold increase in eight months.  In response, the stock has tripled this year.  But it can drop even faster; it fell from 125 to 17 between June and December 2008.

Energy stocks remain appealing.  Natural gas has been priced at one-third of its BTU equivalent relative to crude oil, and Exxon Mobil decided to spend ten percent of its market capitalization on a domestic natural gas provider, XTO Energy.  It is a long-term bet that cleaner fuel sources will increase in value due to environmental concerns or constraints.  In addition to our holdings in Exxon and other natural gas producers, we have added a position in Canadian Solar (CSIQ), another promising energy source where we bought in at a reasonable valuation.  At year-end, it was already up 51% from our purchase price.

Gold has not been a major position of ours at any time in the past decade, until recently.  But when governments print too much money, there is a risk that people lose confidence in so-called “fiat” currency and decide they want “hard” currency (ie, gold).  Thus gold rallied 24.6% in 2009.  The dollar has not lost much ground against the Euro because of debt troubles in countries like Greece and Spain, but it has fallen sharply against Asian and other currencies (eg, down 21% versus the Aussie dollar in 2009).  The US dollar could rally in a flight to quality scenario if there is a foreign debt crisis, but the fiat currency concern remains and justifies a core position in gold.  Some see the current gold price as yet another bubble, but others say that the amount of physical gold is at historic lows relative to paper currency in circulation.  A number of the hedge funds that profited during the 2008 sell-off in stocks are now bullish on gold.

Ironically, a rally in the dollar could be bad for stocks.  First, large speculators have borrowed dollars at very low rates and used that money to buy stocks in a so-called “carry trade”.  If the dollar rallies, these speculators will fear losing more on the borrowed dollars than they make on the leveraged stocks, and will likely unwind the speculation by selling stocks.  Second, US companies get about one-third of their sales abroad, and an appreciating dollar would make their goods less competitive.

The financial sector was a major contributor to our beating the market in 2009.  But most bank stocks lost momentum in the fourth quarter.  Credit is the lifeblood of the economy.  I regard it as unhealthy when the relationship between credit providers and the government is hostile, and we seem to be moving in that direction in both the US and the UK.  The President’s reference to “fat cat bankers” didn’t help and the British 50% tax on bonuses didn’t either; nor did the Goldman CEO’s comment that they are doing “God’s work”.  The government and private banks need to cooperate in order to get credit to flow, and both parties seem more interested in spiting each other and scoring political points than in repairing the system for the benefit of average Americans.  Our bank stocks were great in the spring and summer, but their recent weakness since is cause for concern.

Given these issues, some of the insurers seem better plays right now in the financial sector.  There is an interesting juxtaposition between two of them now.  Warren Buffet’s Berkshire Hathaway has actually been a disappointing stock in the past quarter even though it should have benefited from Buffet’s astute investments in Goldman Sachs and GE and his writing of put options near the market lows.  In contrast, there is an investor named David Einhorn who made a name for himself by shorting Lehman Brothers.  He is the controlling shareholder of Greenlight Reinsurance (GLRE) and seems to be trying to create the next Berkshire.  The stock is incredibly cheap relative to current and projected earnings, and we have invested in it accordingly.

There were disappointments beyond Berkshire.  We thought that the recent major bottom in housing stocks presented a rare opportunity, but they gave up most of what they had gained last quarter even though the inventory of unsold new homes is at a 17-year low.  Fortunately these situations were outweighed by other great positions.  Google returned 26% for the quarter and 101% for the year.  We recently bought Blackberry maker Research in Motion on a dip, and the stock rallied sharply on its recent 58% jump in quarterly earnings.  Kinder Morgan Pipeline provided a total return of 14.8% for the quarter and 42.5% for the year, and is yielding 6.9%.  We’ve done well in stocks as varied as Aflac, American Express, Apple, Priceline, and Disney.

Analysts are expecting S&P 500 earnings of about $76 in 2010.  That is about 24% higher than 2009.  At a PE ratio of 15, that implies an index level of 1140 (a 2.2% gain from 1115).  At a PE of 17, which is justifiable when interest rates are so low, the market would hit 1290 (a gain of over 15%).  So there is room for optimism.  (As a frame of reference, S&P peak earnings were about $88 in 2006).  Moreover, there is still ample cash on the sidelines, as measured by the ratio of money fund assets to the total capitalization of the S&P 500.  But as discussed earlier, there is also reason for caution.  That’s what makes the market interesting; reward comes with risk. We can either have a virtuous circle as a rise in stocks inspires enough confidence to lead to more activity in the underlying economy, or we can slide into a vicious cycle in which high (or higher) unemployment leads to further contraction of spending that would require more stimulus from a more constrained federal government.  A noted stock analyst, Lazlo Birinyi, points out that an article in the New York Times of October 1, 1982 noted a litany of economic problems, that the market was too far ahead of itself, and that there was a ceiling on prospective growth.  So the pessimists can be persuasive, and yet wrong.

Our job is to try to assess and balance risk and reward in an intelligent fashion in order to optimize returns for you.  I think we have done that well in 2009, and will do our best to continue in that vein in 2010.  We welcome questions, comments, discussions about asset allocation or Roth IRAs or anything else to do with your portfolio, or whatever else is on your mind.  Thanks for your continued confidence.

* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.  .