As 2010 comes to a close, it is a good time to reflect. More importantly, now is the time to position portfolios for the coming year. The past year has been a year of healing excesses. Perhaps the most obvious and painful is the excess leverage in the world. The consumer continues to pay down debt and save. Gone are the days of the credit card, whether the plastic type or the second mortgage, as frugality has found its way across the world. Corporations have shared in this frugality; strengthening their balance sheets by sitting on large amounts of cash, extending maturities on their debt, or both. Unfortunately, this healing process has the economy in a slow growth pattern with major industries like housing and banking still digging out. Even the government may have started to address excesses. The elections sent a strong message that people are concerned about jobs and about huge government deficits. While the recent tax breaks in exchange for an extension of social programs shows our legislators haven’t learned to move past politics, there has been a shift of power which should change the anti-business atmosphere of the past two years.

This leaves us questioning what will happen over the next year. Many believe the economy is stuck in a pattern of slow(or worse, NO) growth, high levels of unemployment, low inflation if not deflation, the Asian economies  cooling due to government forced rate increases,  and the European economies as a wildcard that could send us back into a double dip. On the other hand, some see almost 18 months of growth, the money supply now expanding at about 8% as QE2 is starting to kick in, GDP and other economic indicators perking up in the third quarter, and see the increase in commodity prices as a predictor of an accelerating economy. Perhaps this crosscurrent of thinking is why we saw treasury rates increasing a full percentage point over the last month, equities continuing to trade mostly up, and municipal bond yields approximating those of treasuries due to concern over local government debt.

As always, you have to keep one eye focused on where the economy is headed and another on valuations. The economy does appear headed for some improvement, albeit abnormally weak for this stage in a recovery. But, economic and corporate GROWTH aren’t based on whether or not the economy is good (it still isn’t), but on whether or not it is improving (it is). Bernanke and Company are still focused on doing everything possible to keep the economy growing, and, as they say: “don’t fight the Fed”. There are still many risks in 2011. Equity values are reasonable, but not cheap, with the median estimated P/E at 16.2 and yields at 1.9%. Even after the treasury yields have increased to 4.4% for the 30-year treasury, there still seems to be more risk than return.

So where does that lead us?

For equities we have seen values and expectations increase over the last year. Additionally, the concern about losing long term capital gain tax treatment most likely had people selling early in 2010. Congress just recently agreed to extend the tax rates, but the early seller effect had already been seen, likely causing selling pressure in the market to dry up over the last couple months. If true, this could mean sellers return in January. With this in mind, pay attention to valuations. Buying good companies at reasonable valuations not only gives you the opportunity for appreciation but will help protect you should any of our land mines (did we mention European sovereign issues) explode.

For fixed income you have to start with risk management as you implement your return strategy. We recommend trying to do this with 25% of your fixed income in short maturities (1-3 years), 50 % in 5 – 10 year maturities while leaning towards the mid to lower portion, and the remainder in longer maturities if you can get enough additional yield for the risk. We try to find values within each maturity spectrum. Municipal bonds with maturities of less than 10 years look attractive although we favor utilization of a select few mutual funds so as to avoid land mines. Rather than accept 4% for long maturity treasuries we favor a small allocation to a select group of preferred equities which are yielding 6.5 – 7 ¾%. On the short end of the maturity spectrum, we like a few closed end preferred funds with stated maturities, some short and floating rate preferreds, and a few short maturity mutual funds.

Before we leave, the one thing that is almost guaranteed is that as the year progresses investors will read and react to each piece of data that is released. One economic report will have people expecting a runaway economy and the next will have us worried about how weak the recovery is. Each of these reactions will lead to opportunities for those willing to look for value as people sell securities based on their perception of the daily news. Our job is to keep your portfolios positioned to take advantage of values while trying to manage risk should any of the major land mines rear their ugly heads.  Have a safe and happy holiday season with your family and friends, and we look forward to helping you and yours navigate the mine fields of investing in 2011.