Third Quarter 2010 Investment Thoughts

The stock market continued its roller coaster ride in the 3^rd quarter. The major stock indices rose in July, dropped in August, and finished the quarter up strongly in September. Even with all the volatility, the equity markets ended up with a strong quarter. The S&P 500 index was up over 11% for the quarter as was the Russell 2000, although the latter’s stronger performance earlier in the year helped them to lead large caps year to date. International stock markets also had a strong quarter and developed markets trail emerging markets year to date. Bonds were up slightly in the quarter (Barclays Aggregate Index was up 2.5%) and have shown strong performance for the year.

While we are seeing signs of growth in the economy, it is slower than what we typically see after a recession. We expect to see GDP growth of just over 2% for the 3^rd quarter and in the same range for the 4^th quarter. CPI has been increasing at around 1% year over year recently, and there does not seem to be much concern about deflation. Consumers continue to improve their financial situation as they deleverage, but consumer spending is not rising. The bigger concern is still the financial situation of the US Government as the growing national debt raises concerns for the economy going forward. The Fed continues to talk about quantitative easing but economists don’t expect them to take any action until sometime in 2011.

We still believe strongly that diversification is the key in environments like this. This doesn’t mean just your allocation between stocks and bonds.  You also must make sure your portfolio is well diversified within the various asset classes that are available. Making sure you have exposure to a variety of fixed income areas, diversification within US equity classes, and between developed and emerging markets on the international side are all an important part of a sound investment strategy. We could very well be in for continuing volatile and sub-par equity returns and in all likelihood, the tailwind of declining interest rates that have propelled the bond markets is over.

In light of potentially lower than historical average returns, reassessing your retirement/asset sufficiency planning might be more important than ever. It is also critical to make sure that you understand how much risk you are taking in your portfolio and to make sure you are investing according to your time horizon. Quite simply, the longer your time horizon, the less you are impacted by volatility. To do this, it might be helpful to think of your portfolio in different “baskets” based on the purpose that you plan for the specific funds. Integrating all of these ideas is the best way to build and manage your investment portfolio to meet your long term goals.