Let’s put 2010 into some measure of perspective. The unemployment rate at the start of the year was 9.7% and, by the end of the year, it had fallen to 9.4%. There were 1.05 million homes foreclosed in 2010, topping the previous record of 918,000 set in 2009 according to RealtyTrac, a real estate data firm. Long-term interest rates (as measured by 30-year Treasury bonds) started the year at 4.65%, but fell all the way down to 3.52% by the end of August before recovering to around 4.34% at the end of the year. Short-term interest rates, as measured by Treasury bills, were far worse at, essentially, nothing. The Dow Jones Industrial Average gained 11% while the S&P 500 Index was up 12.8% for the year, most of which came in the fourth quarter. Coming on top of a nearly 39% gain in the S&P 500 Index for 2009 we have had two really good years for stocks. However, stocks remain the “red-headed step child”. According to the Investment Company Institute, a trade group for mutual funds, through November 2010, investors have withdrawn a net $29.6 billion from equity mutual funds while these same investors have added a net $241.9 billion to bond mutual funds (http://www.ici.org/research/stats/trends/trends_11_10).

On the face of it, this seems to be really strange. Current bond yields are near all time lows. Meanwhile, many good stocks are paying great dividend yields. For example, among the stocks in many Aerie portfolios, ConocoPhillips currently pays a 3.2% dividend yield, Ennis, Inc, yields 3.6% and Oil-Dri Corp. yields 3% annually. Even better, we have a number of stocks in portfolios that pay better than most bonds. These include names such as Progress Energy, which pays 5.7%, Buckeye Pipelines which yields 5.8% and NuStar Energy which yields 6.3%. These yields are just the returns from dividends we collect and do not count any capital gains that we might earn.

The issue, though, is fear, not greed. Too many investors, burned by the crash of 2008, the high unemployment rate, massive home foreclosures and talk of a plunging dollar are afraid of the future. The continued cash flow into bonds is a rush to safety, which is perversely humorous. The reason this is humorous is all of the talk of the demise of the U.S. Many “gloom and doomsters” are decrying the huge budget deficit and the steadily declining dollar and arguing that one should invest in gold, silver, emerging stock markets, China, India, foreign currencies and just about anywhere besides the U.S. If things are so dire, then why does the rest of the world run to U.S. bonds in times of crisis? Could it be that we may be the last bastion of safety? Perhaps the reality is not as bad as the perception.

Be that as it may, though, the question comes back to whether bonds are the right investment at the moment. Actually, we’re more worried about a bond bubble. In fact, in recent weeks, we have trimmed client positions in some of the bond ETFs that we own. We didn’t sell all of our bond positions as we still believe that interest rates are not increasing in the very near future and we think many of our clients should have a well-balanced portfolio. That includes some exposure to fixed income securities. We did “take money off the table” so to speak and moved into an area we view as a bit of a safer haven – convertible bonds. Convertible bonds are sort of hybrid creatures – part bond and part stock. It is the ability to convert the bond into shares of the underlying company’s stock that can help support the price of the bond even in the face of increasing interest rates. With the proceeds from selling our bond positions, we purchased shares in the SPDR Barclay’s Convertible Bond ETF. We are also continuing to add to our position in TIPS – Treasury Inflation Protected securities. These are government bonds that will compensate an investor for inflation. While inflation is (officially, anyway) not an issue at the moment, we do agree that our country cannot continue to spend without some repercussions. Those repercussions are likely to include higher interest rates, higher inflation and reduced government spending at some point down the road.

The key point here is that the most certain thing about the current investing environment is that there are lots of uncertainties. Commodity prices are higher but inflation is, according to the government, a non-issue. Interest rates are low but home foreclosures continue and there is a large inventory of unsold homes. Unemployment is stubbornly sticky above 9% and there doesn’t seem to be any major catalyst, in spite of billions of government “pump priming”, to bring this down any time in the near future. This all sounds down right depressing, doesn’t it? Actually, we love it when things are in chaos.

You see, the more chaos there is, the more opportunity is created. To borrow a quote from Sir Winston Churchill, “The pessimist sees difficulty in every opportunity. The optimist sees opportunity in every difficulty.” Now, we’re not sanguine enough to see things as all rosy and bright. We do recognize there are many hazards ahead. This recovery – and we are in a recovery – is a very slow, torturous grind. Most recoveries in the past were fueled by consumer spending and that is not happening this time around because the consumer just is not there – yet. Government debt is ballooning. Oil is back over $90 per barrel and gas is over $3 per gallon. In spite of all of this negativity, we are still finding really good companies with great long-term prospects to purchase. We have a number of good names in our portfolios and we have several names on our radar. As we continue to focus on sound companies at a fair price, we continue to believe that, over time, we will be rewarded. We will continue to look for opportunities to take advantage of market crises and we will continue to use all tools that are available to make money for our clients.

Finally, we recognize that you have many choices for investments and we really appreciate your faith and trust in us for this portion of your assets. If you have any questions about your portfolio or any other financial planning issues, please feel free to give us a call!

Sincerely,

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
www.aeriecapitalmgmt.com