On December 31st the U.S. stock market and most foreign markets notched their second consecutive year of gains since they bottomed in March 2009 in the wake of the global financial crisis. The S&P 500 Index advanced 12.8% while overseas the majority of markets were up with the only two significant sore spots being Japan and China. Japan’s Nikkei lost 3% while China’s Shanghai Composite lost 14%. Yields on the ten-year U.S. Treasury note fell from 3.83% on January 1, 2010 to close at 3.3% on December 31st. The Federal Reserve’s efforts to keep rates accommodative throughout the year were successful.

The U.S. economy appears to be gathering momentum as we enter 2011; many economists are calling for
GDP growth of 3% or higher this year. Unemployment, while still high at 9.4%, has begun to turn in the
right direction as both large businesses and small gain confidence in the sustainability of this recovery and
look to add workers. The recent drop in the calculated unemployment rate is no cause for celebration,
however. The U.S. economy needs to add at least a couple hundred thousand jobs per month just to keep up
with the 1% annual growth rate of our 307 million population. Only if GDP growth is higher than 3% will
we likely see a sharp drop in the unemployment rate.

In keeping with the medical metaphors of previous letters, the U.S. economy, as the patient, as left the
intensive care unit and is striding briskly under two crutches toward the hospital exit—probably to the
amazement of several of the doctors. Whether or not the patient is still able to walk after discarding the
crutches is something we will probably begin to find out in 2011 or 2012. These two loaner crutches are
provided courtesy of the Federal Reserve, but the Fed will eventually want them back . . .

Crutch #1 represents interest rates. The Fed has kept short-term interest rates at essentially zero since
December of 2008, thus keeping bank borrowing costs low while penalizing savers. With the Fed Funds
rate at this level banks have access to very cheap capital that they are using (purportedly) to make loans to
consumers. It also encourages investors to depart the short-term bond market for other places, such as the
stock and commodity markets, where the potential returns (and risks) are higher.

Crutch #2 represents quantitative easing. In November the Fed commenced the second round of
“quantitative easing,” which is known by the moniker “QE2.” Here’s how it works: basically the Fed
created $600 billion with a few keyboard strokes and is using that money to acquire—at the rate of about
$100 billion per month—U.S. Treasury securities in the open market. The purpose of this action is to drive
prices for these securities up and push down interest rates, thereby giving a booster shot to a still wobbly
economy by making it cheaper for consumers to borrow. In one way this program has been successful so
far: it has increased confidence and helped to support gains in the stock market. On the other hand, it has
failed in its goal to lower interest rates. In fact, rates were at their lowest when QE2 began and have been on
the rise ever since. Fed Chairman Bernanke thus achieved his goal of lowering rates by announcing his plan
to force rates lower, then promptly gave most of it back by actually beginning to implement the plan.

While the U.S. economy is picking up steam in the short term, there is no shortage of challenges looming in
the medium to long term. The deteriorating fiscal position of the U.S. tops the list of long-term issues. We
now have $14 trillion of federal debt, which equates to $45,000 for every man, woman and child in this
country. By the year 2020, should the debt hit $20 trillion (as numerous economists project), it may take
one-third of tax receipts just to pay interest on the debt, leaving a lot less to spend on Social Security,
Medicare or the military. Until now the U.S. has depended heavily on the kindness of foreign investors to
finance its spending, but there may be a day not too far away when the global bond market balks at
continuing to finance our profligacy at such low interest rates. It is critical that our elected leaders develop a
credible and workable plan to deal with our debt problems before global investors deal with our country by
selling down our currency, driving up our interest rates or both.

Another development that bears watching in 2011 is the impact of increasing commodity prices on our
recovery. The price for just about everything went up substantially in 2010. For example, copper was up by
a record 33%, oil was up 15%, gold was up 30%, corn was up 52%, wheat was up 47% and coffee was up
77%. It is likely that many of these increases were due to a torrent of speculative capital that may go into
reverse, but it is an inexorable trend that a growing, wealthier global population is competing for ever more
scarce natural resources. And as these input costs eventually work their way through the economy, they will
compress corporate profit margins and weigh on consumer spending.

The old Wall Street adage that the market “climbs a wall of worry” was certainly true in 2010. Having
something to worry about is not necessarily bad for stocks. But having nothing to worry about is definitely
bad for stocks. It is in times when the all-clear is sounding, the economy is booming, valuations are full and
investors are buoyant (e.g. 1999) that investors can be most confident in dismal future returns.

As usual, I welcome your comments and feedback.