The stock market continued its rally in the fourth quarter, with the S&P 500 stock index closing at 1115, a gain of 5.5% for the quarter and 23.5% for the year. Government bond prices fell, with the yield on the benchmark ten year Treasury rising to 3.84% from 3.31% at the end of September. The ten year note began the year yielding 2.24%. Gold prices increased to $1,097 per ounce from $1,009 in September and $884 at the beginning of the year. For the quarter and the year, markets were largely driven by extraordinary government monetary and fiscal support, and relief that that the American and global economies did not slide into the abyss. Gold and stocks both benefitted from a move out of the safe havens of the Treasuries and the dollar, leading to losses for Treasury holders.

Over the course of the next year, we expect the financial markets to generally continue the dominant trends of 2009. By year end, we look for higher stock prices, higher commodity prices, and higher bond yields. We base this forecast on the belief that the fundamentals behind these trends will remain largely intact throughout 2010. Of these fundamental factors, the two most powerful and persistent are the extraordinary monetary and fiscal policies adopted by the federal government. The Federal Reserve has made it clear that overnight rates will be kept at “exceptionally low levels… for an extended period.” This is generally interpreted as the current 0-0.25% target on overnight rates remaining in place for at least the next six months, and probably longer. Short-term rates at these levels are supportive of both economic and speculative activity by suppressing interest rates on almost all interest bearing instruments and encouraging people to move out of negligible return cash deposits and into riskier assets such as stocks and corporate debt.

The $787 billion fiscal stimulus passed into law last February has only expended approximately 30% of its resources through the end of the year. This leaves a tremendous amount of demand available to underpin the economy in 2010. Additionally, it is likely that with unemployment remaining elevated well into 2010 and toward the mid-term Congressional elections, even more federal stimulus could be brought to bear, by using returned TARP funds or further appropriations, if politically feasible.

The unprecedented strength of these two policies contributed to economic growth in the second half of 2009 that consistently exceeded the low expectations of Wall Street analysts. With these policies remaining solidly in force throughout 2010, we believe economic growth will continue to surprise Wall Street on the upside. This will be supportive of stocks and commodities and lead to higher yields on bonds, as was the case in 2009.

Longer-term, we remain concerned about the severe structural imbalances of the global economy. These imbalances, (American indebtedness, over reliance on consumption, and a heavily service oriented economy, versus foreign reliance on saving, investment, and manufacturing,) primarily contributed to the financial panic of 2008 and concomitant recession. Specifically, the global financial system lent trillions of dollars against unsustainably appreciating American real estate. American investment banking institutions, in turn, borrowed trillions more to facilitate the production of mortgage backed securities. Many Wall Street institutions were taking on leverage of 35 to 40 times their equity, a previously unheard of amount. This was essentially an immense pyramid scheme, and when new money stopped flowing into the system, it collapsed under its own weight.

These imbalances are not meaningfully being addressed by global policymakers, and as such, have the potential to lead to even more severe economic dislocations in the years to come. What we have essentially seen in response to the current crisis is the governments of the world doubling down on the existing economic order. America focused its response on supporting its dominant finance, real estate, and consumer sectors, while foreign governments were more oriented toward investment and manufacturing in their stimulus programs. The net result is a global economic system that is little more stable than before the crisis. The only real difference is that many of the risks that previously existed in the private sector are now born by governments, ether explicitly or implicitly.

It is in this light that we remain bullish on commodities and strongly bearish on long-term debt. Faced with exploding deficits and debt levels, we feel it likely that the US government will ultimately be forced to accelerate the debasement of the dollar in order to finance both its operations and debt repayment and servcing obligations. We believe this process is already underway. Over the long-term, dollar debasement will drive the rebalancing of the global economy that is necessary if sustainable growth and full employment are to be achieved. America will become more manufacturing and investment oriented, with more of its investment financed internally through domestic savings. Dollar debasement will drive up the cost of borrowing in dollars, pushing bond prices down, and make hard assets that cannot be produced as easily as paper money, such as gold and oil, more valuable.

Stocks can do moderately well in such an environment, particularly if they have exposure to overseas markets, benefiting from relatively stronger foreign currencies and economies. The risk to this scenario is that the decline in the dollar becomes disorderly, leading to a panic in the United States Treasury market that underpins the global financial system. Such an event would be highly destabilizing and would likely throw the American, if not the wider global economy into a deeper recession than we have experienced in the mortgage crisis. We are by no means forecasting this as a certainty, but are recognizing it as a very real threat that could materialize in the next five to ten years. Although we do not own any long-term debt, government or otherwise, we monitor these markets closely to stay on top of developments in the overall economic and financial environment.

For 2010, we see the S&P500 trading in a range from 925 to 1275. Its current level is 1115. For the reasons stated above, we believe the market will end the year toward the upper end of this range. As discussed earlier, however, we feel the biggest risk to this forecast would be a precipitous increase in long-term bond yields. Such an outcome would make the bond market more competitive in terms of relative returns to stocks and also undercut economic growth and government support for the economy by further restricting private sector credit and increasing the cost of government stimulus and deficit spending.