First Quarter Letter To Clients {Part I}

Note this letter can also be summarized by reading our green highlights!

Stocks turned in one of their best years ever in 2009. Markets are currently showing signs of a change in trend.

Market Recap

Despite their gains, 2009 proved to be one of the most volatile investment years ever recorded. Stock prices collapsed nearly 30% through early March as fears of a global financial meltdown gripped investors. Stocks found their footing, stabilized and began a furious rally that saw share prices rise close to 40% from their lows.

From there shares languished until mid-July when another rally commenced that took equities in stair step fashion to their year-end gains. For the record the S&P 500 finished 2010 with a total return of 26.5%. The average pension plan returned 19.6%. Barron’s reports that a well noted hedge fund composite returned 20.12%.

We could spend pages discussing what went on last year. We believe our clients are more interested in what we think about the future. You can read our thoughts about last year by going to our archives at our blog: http://lumencapital.blogspot.com/

Looking Forward

Here are some of our bigger picture 2010 thoughts.

Stocks came back from the brink in 2009. Equities collapsed in 2008 on fears of systemic failure throughout the international financial system. One of the prime reasons for their recovery was the extraordinary efforts by world governments to avoid a repeat of the Great Depression. The rebound accelerated on evidence that these efforts were taking hold and of renewed signs of world-wide economic growth. We see no current evidence that these same governments are relaxing their vigilance on the system. Central banks have gone out of their way to continuously provide liquidity to the world banking system. Based on current policies we do not believe there will be a repeat of those events. Thus we think investors will continue to focus on the global economic environment and fears of systemic financial failure will continue to decline.

US Gross Domestic Product {GDP} surged in last year’s 4th quarter to a 5.7% advance. Traditionally, back-to-back quarters of GDP growth have marked a recession’s end. However, our economy faces many headwinds. Future economic growth will likely be less than what has traditionally been experienced at the end of a recession.

The economy is going through a massive deleveraging cycle. This is especially true for American consumers where the credit spigot has been turned off. They are also challenged by the depression in residential real estate. Governments at every level are broke. They are being forced into a combination of service cuts and raising taxes. They also have to cope with the staggering amounts of debt they have been forced to take on in order to mitigate the current economic crisis. Unemployment levels currently remain above 10% and will likely only slowly decline. Finally the Federal Government is not currently promoting policies that are pro economic growth.

We expect the economy to grow this year but that growth will be lower than historically experienced. The economy came to a standstill in 2008 and early 2009. The length of this recession leads us to believe that a combination of inventory rebuilds, replacement cycles in equipment-particularly as related to technology plus a slight pick-up in other economic activity will give us another year of economic growth. We believe these factors will be enough to grow the immediate post recession economy 3-6% in 2010. This is low by historical standards given the issues we highlighted earlier. Given the tepid nature of this recovery, the possibility of a shallow recovery or a double dip recession in 2011 cannot be ruled out.

3-6% economic growth, should it occur, would suggest possible S&P 500 valuation between 1,250 and 1,350 by year end. Current economic conditions would seem to favor the lower end of this range. That implies a possible total return for stocks of 10-15% based on closing values on December 31st. This return could be closer to 16-20% based on January’s decline. We base this analysis on what current data tells us. Events as they unfold could prove this either optimistic or pessimistic. We stand ready to change this thesis as events warrant.

We currently think that energy, technology, finance and certain health care sectors should outperform this year. We are also looking to find ways to up our client’s exposure to international markets. Our investment vehicle of choice is exchange traded funds {ETFs}. We continue to be interested in certain yield oriented securities and strategies. As of this writing it is still possible to find some ETFs that yield in excess of 4% with decent long term growth characteristics.

{Part II Tomorrow}

*Long ETFs related to the S&P 500 in client accounts.