Other Updates

The Economic Environment

The economic rebound continues, with third-quarter gross domestic product (GDP) growth reported at a better than expected rate of 2.6 percent. The U.S. economy gained momentum in November and December, creating increased fourth-quarter growth of 3.2 percent.

Several factors contributed to the improved economic outlook, including the following:

• Mid-term election results reduced political uncertainty.
• The Bush tax cuts were extended for two years for all taxpayers, and additional tax relief was passed.
• The Federal Reserve (the Fed) began implementation of “Quantitative Easing 2 (QE2),” intended to stimulate the economy by keeping interest rates low.
• Consumer demand was stronger than expected over the holiday shopping season.

Despite an unemployment rate that remained close to 10 percent for all of 2010, retail sales rose nearly 6 percent during the holiday shopping period, the largest increase in several years. Coming out of the recession, consumer demand has been a drag on the economy due to lack of job growth and the focus on debt reduction in most households. But even consumers who remained employed and are able to spend have chosen to postpone purchases over the past two years, creating pent-up demand that may have been unleashed to some extent this year. The savings rate stabilized at just below 6 percent in recent months, meaning consumers are no longer increasing savings at the expense of spending, as was the case when the savings rate was rising. The extension of unemployment benefits also helped to boost spending during this period.

Although job growth was disappointing in 2010, there are indications this key area will make better progress in 2011. In our view, political uncertainty was a major factor keeping companies from hiring or expanding in 2010. With decreased uncertainty, employment trends should begin to improve. Corporate profits—typically a reliable indicator of future hiring activity—are re-approaching all-time highs. This also bodes well for the job market in the new year. However, job gains are typically more gradual than job losses, so an unemployment rate of 9 percent or lower by year's end would represent good progress.

Considering the recent momentum in the economy, most growth estimates for 2011 have been raised north of 3 percent. Although the economic rebound has found firmer footing, there are still issues to be resolved both here and abroad as developed countries wrestle with historically large deficits. Recent economic improvements offer some breathing room to make a concerted effort to balance inflows and outflows at the federal and state levels. But if borrowing rates continue to rise, increased debt service could create new budgetary pressures for the affected entities, potentially stalling the recovery.

The Stock Market

Stocks maintained the positive momentum that began in early September, posting strong results during the final quarter of 2010. Here are the index returns for the quarter and for the full year of 2010:

Index	4Q2010	2010 YTD
S&P 500	10.76%	15.06%
S&P Mid-Cap 400	13.50%	26.64%
Russell 2000	16.25%	26.85%
MSCI EAFE	6.61%	7.75%
MSCI Emerging Markets	7.05%	16.36%
Sources: Standard & Poor's, Morningstar, Inc.

U.S. mid-cap and small-cap stocks led the way during the quarter, as improvement in economic data allayed fears of a “double-dip” recession. The improved growth outlook caused investors to shift focus toward upside participation rather than protecting against downside risk. Midsize and small companies tend to provide the greatest return potential in a less risk-averse investment environment.

Consistent with the aforementioned increase in consumer spending, the top performing sector in the S&P 500 index during 2010 was Consumer Discretionary, whose component companies build and sell homes, cars, appliances and other big-ticket items. This sector returned nearly 26 percent in 2010. These companies tend to be very cyclical, and after experiencing such a large retrenchment in 2008–09, even moderate improvement in business translates into significant increases in share price.

Although international stocks posted results generally below U.S. market returns for the year, they rebounded significantly from mid-year lows. Returns for 2010 were reasonably good considering the continued debt concerns in Europe. Emerging market stocks extended their run of outperforming the shares of developed countries. Emerging market countries now contribute nearly half of world economic output and the majority of world GDP growth at the margin.

Last year marked the second year in a row of robust stock market returns, despite several periods of downside movement and volatility during the year. Importantly, these gains were well-supported by increases in corporate earnings, with S&P 500 profits growing at roughly twice the pace of stock prices during the year. The result was a market valuation of less than 15 times earnings for most of the year. This represents slight undervaluation by historical standards, given current interest rates and inflation levels.

The Bond Market

The goal behind the Fed’s QE2 program (in which the Fed intends to buy $600 billion of government bonds between now and June 2011) is to keep interest rates low to promote economic activity. However, Treasury yields did not cooperate, with the benchmark 10-year note rising from 2.5 percent to 3.3 percent during the fourth quarter. Given the inverse relationship between yield movements and bond prices, this quick rise in rates caused most segments of the bond market to post negative total returns during the fourth quarter.

Declines were limited in the taxable bond area, with the BarCap Aggregate index posting a -1.3 percent return for the quarter. Gains achieved earlier in the year, particularly in the corporate bond segment, cushioned the impact of rising rates, allowing the index to post a solid 6.54 percent gain for the full year. Taxable “satellite” and global bond components performed even better.

Municipal bonds faced a more difficult environment, as rising interest rates represented just one of several headwinds. Other factors contributing to inferior returns for the quarter included:

• Expiration of the Build America Bond (BABs) program, which is expected to create additional tax-free supply in 2011
• Extension of the Bush tax cuts, which reduced the stampede of demand toward tax-free investments
• Shift in investor money flow from bonds toward stocks as that market improved
• Concern over the financial health of some state and local municipalities

These factors were the cause of a fairly tough quarter for municipal bonds, with the BarCap Municipal index returning -4.17 percent. For the full year, the tax-free index gained 2.38 percent. Some analysts suggest default risk is rising rapidly in the municipal area. Although additional municipal defaults are likely in 2011, we continue to believe these occurrences will be limited in scope and issue-specific and will not represent a systemic problem for investors.

As we transition from a 30-year period of declining interest rates toward a period of rising rates, bond total return expectations must be lowered. The years of stellar (sometimes double-digit) bond returns are behind us. This dynamic is at the center of our recent decision to reverse the bond overweight implemented across most of our allocation models in late 2009. Although future bond returns are likely to average in the mid-single digits, this asset class still plays an important role in portfolios in terms of risk management and income production.

The Investment Outlook

After enduring a couple of very grueling years, the economy has returned to pre-recession levels of output, and corporate profits are close to all-time highs. Importantly, most investors with balanced portfolios who stayed invested throughout this period have recouped nearly all of the losses of 2008 and early 2009, even though the stock market is still nearly 20 percent below its October 2007 peak. Considering the magnitude of the downturn (the worst in 70 years), a recovery of value in less than two years is an unexpected and positive surprise.

Although the environment has clearly improved, uncertainty remains regarding what 2011 holds for investors. Solace might be taken in the fact that the stock market traditionally performs better during the third year, i.e., 2011 of a presidential cycle than any other, producing positive returns in every third year since 1943. The average return of these third years also is impressive at more than 21 percent!

But drawing conclusions or expectations from such simple analysis can be misleading, as evidenced by the extremely strong market performance in September and October of this year (up 8.92 percent and 3.8 percent respectively). Historically, these are the two worst months of the year for stocks. Had an investor made portfolio decisions based on this single fact alone, the opportunity cost could have been great!

A more prudent approach to anticipating market results is to consider certain fundamental factors in place for 2011. Several of these factors suggest the environment will be conducive to further gains in the new year, including:

• Low inflation levels and interest rates
• Easy fiscal policy
• Dissipating political uncertainty
• Strong corporate profits and balance sheets
• Reasonable stock market valuation, at under 15 times earnings
• Improving momentum in both the economy and stock market
• Return of retail fund flows toward stocks

However, as witnessed on several occasions during 2010, the market remains susceptible to sudden changes in sentiment and corresponding volatility in stock prices. Given the uninterrupted rise in stocks since early September, a pause or modest decline in the first few months of 2011 would not be particularly surprising.

The new year offers an opportunity to transition from economic rebound to economic expansion. For this to occur, job growth is essential, as the private sector must prove its ability to move the economy forward with far less government assistance. Maintaining a global presence also is important to reach consumers in economies growing faster than ours. While there is no sure thing in today’s environment, we are optimistic regarding the prospects for investors in 2011.

Thank you for the confidence you have placed in BKD Wealth Advisors and best wishes for a prosperous new year!

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¹ Source: Standard and Poor’s

² Source: Artio Global Management

³ Source: Ibbotson

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor for a personal consultation.