Investment Outlook from Coronado’s Orion Capital Management

Dear Investors, During the fourth quarter of 2009, global equity markets continued their strong march upward, albeit at a slower pace than the preceding two quarters. To close out what has otherwise been a miserable decade for risk assets such as stocks and non-government bonds, virtually every risk asset screamed into the 2009 finish. Since the March lows, the U.S. stock market rose at a rate unseen since 1933. The Dow Jones Industrial Average, for example, rose 53.9% from its March trough. Not only was the trajectory of the rise nearly unprecedented, but it was accomplished with no significant setbacks along the way. Only the 7% sell-off in June and July stood in the way of the rally, but those losses were recovered quickly. Equities have certainly come a long way since March, but in the bigger picture the S&P 500 Index remains down nearly 29% from its October 2007 peak of 1565.15. The old Wall Street adage that the market “climbs a wall of worry” was never more appropriate than in 2009. The list of risks threatening the economy remains very long. The economy is now growing again-early reports peg fourth quarter GDP growth potentially north of 3 percent-and is no longer in recession, but unemployment remains in double-digits, consumer confidence is down, and both commercial and residential real estate prices, despite historically low interest rates, continue to sink. Unemployment is probably the most important and (thus far) intractable challenge facing the economy. The 85,000 jobs lost in December kept the unemployment rate at 10%, but the headline official employment numbers understate the awful state of the jobs market. This is because people who are discouraged and have stopped looking for work are not counted, and also because the headline number makes no distinction for those who are working part-time because they cannot find full-time employment. A broader measure of unemployment shows the real rate to be 17%. The economy is, however, shedding jobs at a much lower rate than earlier in the year, when losses of 500,000 per month were common. While the jobs figures certainly reflect the dire state of the workforce at present, it is not unusual for the unemployment rate to increase for up to a year after the beginning of an economic recovery. While the near term performance of the stock and bonds markets will be influenced greatly by how well (or poorly) the federal government is able to wean the economy from the massive monetary and fiscal stimulus it has provided since the financial crisis began in the fall of 2008, the major issue for U.S. dollar-based earners and investors over the next decade will likely be the challenging state of the federal government’s finances. As of January 1, 2010, the total U.S. federal debt was $12.2 trillion-or nearly $40,000 for each of our 307 million citizens. The White House Office of Management and Budget projects a federal budget deficit of $9 trillion over the next decade, which would bring our total debt to over $21 trillion. As our debt burden grows, so too does the percentage of government revenues (taxes) that are eaten up in interest costs. Last fiscal year, the interest on our national debt was $383 billion, while federal government tax revenues were just over $2 trillion. Thus, even today we are already spending 19 cents of every dollar of tax revenue on interest expense alone. As our debt soars, this calculus will look increasingly bleak as more and more of our tax dollars go merely to service our debt. And as interest costs continue to grow faster than tax revenues, fewer dollars will be available to fund our military, maintain our infrastructure, or aid our senior citizens. It is notable that our finances are in such a shambles today even before we begin to tackle the skyrocketing entitlement spending that is to occur over the coming decade as Baby Boomers retire. If our government stays on this path of spending more money than it brings in, Americans are headed inexorably for a lower standard of living. We will all suffer inflation, a weaker currency, higher interest rates and higher taxes. Fiscal difficulties notwithstanding, corporate America (outside of the financial sector) is in pretty good shape as we enter the new decade. The recession of the past two years has forced companies to optimize their cost structures and invest carefully. Now, as the recovery takes hold, companies are well positioned not only to increase their U.S. profits, but also to compete very well for the many growth opportunities overseas. And even within the financial sector, things are on the mend. The 0%-0.25% Fed funds rate virtually ensures that banks are making a very healthy net interest margin on their loans and are thus able to begin to rebuild their balance sheets even as they face continued losses on residential and commercial real estate loans. After their big run since March, however, stocks are no longer trading at historically cheap valuations. The S&P 500 is now trading at about 15 times the 2010 consensus estimate for operating earnings of $74.95, which is right in line with its long-term average. The credit markets have also recovered significantly since the financial crisis, leaving fewer bargains to be had. Within the milieu of this global economic recovery, however, are plenty of interesting companies doing innovative things. We will be working hard in 2010 to find and invest in these companies. I welcome your comments and feedback. Best Regards, Peter About Orion Capital Management LLC Founded in Coronado, California in 2002, Orion Capital Management LLC is an independent investment firm that manages assets for a broad spectrum of clients. The firm’s customized portfolio management services are grounded in independent investment research and objective judgment. Peter C. Thoms, CFA, Founder & Portfolio Manager 1330 Orange Avenue, Suite 302 | Coronado, CA 92118 Tel: (619) 435.1701 Fax: (619) 435.1706 Email: [email protected] Web: http://www.orioncapitalmgmt.com