Market Commentary - January 2010

In 2009 the unprecedented global effort to shore up faltering worldwide markets and prevent a collapse of the financial system finally gained traction. It required a combination of fiscal and monetary stimulus from nearly every major country. U.S. markets reacted quickly; investors saw the economy pull away from the brink of disaster, and financial investments came roaring back. They came back from a very low place; 2008 was the third worst year in more than a century, and markets had continued their plunge through February 2009. Yet against a backdrop of tentative economic recovery and much uncertainty, the stock market, contrary to most expectations, recovered a significant part of its losses by the end of the year.

Stock Markets

The Dow gained 18.8% in 2009, finishing at 10,428.05, while the S&P 500 ended the year at 1,115.10, up 23.5%. Smaller US stocks, measured by the S&P Small Cap 600 index, added 24.4%. The Cohen & Steers Realty Majors index, which measures publicly traded real estate investment returns, rose 18.9%.  International markets came back even more strongly, with returns for US investors magnified by a falling dollar.  Emerging and developing markets led the recovery; the MSCI Emerging Market index added a staggering 66.2% for the year, while the MSCI Developed Market index rose 23.2%.

Fixed Income Markets

The fixed income component of our clients' portfolios had a mixed year. Investor concern remained over future inflation risks; despite low short term rates the 10 year treasury bond had dismal returns, dropping 9.3% in value for 2009. However, the real fixed income story in 2009 was the return on corporate and higher yielding bonds, which recovered from a seemingly hopeless credit scenario at the end of 2008. High yield bonds, measured by the ML High Yield master index, gained over 57%. Despite below average returns in the treasury market, investors have moved heavily into bond funds, partly the result of risk avoidance, partly in response to CD and bank yields hovering below 1%. According to the Wall Street Journal, bonds funds had nearly $239 billion of net inflows between March and November 2009, at the expense of stock funds and money markets.

Corporate Earnings

Considering the severity of the recession, corporate results have been unexpectedly strong, and positive comparisons are expected to continue into 2010. Upward earnings revisions have been coming in at a remarkable pace as well; positive earnings revisions typically correlate with gains in employment. The consensus estimates for year over year earnings growth are near 35% for the next two quarters (although there are sure to be interim disappointments along the way.) Business investment is increasingly robust, fueled in part by the dramatic rise in the savings rate. This redirection of funds from consumption to savings has a short term negative impact on the economy, but is an excellent indication of higher future investment in research and development, production capacity and innovation, all of which bode well for financial markets.

Fed Watch...Unwinding the stimulus

Much of this has been made possible by massive borrowing for direct spending stimulus, as well as the Fed's monetary policy, which has made funds readily available to financial markets and institutions. At some point, as concern over inflation overshadows the fear that the economy will sag again, the orientation of monetary policy will shift, and stock markets are likely to react strongly. On the other hand, if the Fed is too slow to react, long term interest rates could rise, along with the specter of out of control inflation.

The question is, once we remove the crutches, can we stand and move forward on our own? The government has loaned and spent over $8 trillion to rescue the economy.   Real estate values have started to stabilize in most of the country and sales have increased, helped along by low mortgage rates and by the Fed’s program of buying FNMA and FHLMC debt. Withdrawal of the Fed from the mortgage backed security market could add another 100-150 basis points to mortgage rates, possibly cutting short the nascent housing recovery. 

The case for financial investments still remains strong

Focused asset allocation, a written investment plan to provide continuity of investor behavior and periodic rebalancing continue to be the foundations of our clients' investment strategy going forward. There is still short term risk in the equity markets; valuations are much less attractive than in early 2009 for both stocks and bonds.  A 10-15% correction seems probable at some point in the next two quarters, but given where we believe we are in the recovery process, it would be good for the market, (if a little scary to already rattled investors,) and provide a foundation for greater gains going forward. Much money still remains on the sidelines, and investors have not totally regained their appetite for risk. Since the markets hit their lows in February and began to recover, nearly $13 billion has flowed out of stock funds, and bond funds have seen unprecedented additions.  With savings and CD yields at extremely low levels, investor liquidity remains a potent factor in moving stock prices higher.

We have come a long way; we still have a long way to go. This past decade will be remembered as a lost decade for stock investors, beginning as it did at the height of the technology bubble, and ending in the midst of a recession. Even though we face significant challenges going forward, there is good reason to believe that the next ten years will be more rewarding for financial investors. The US economy retains global leadership in many areas, and despite the shocks in 2008-2009, remains the strongest and safest (and most promising) environment for investors in the world.

Steven Weber
Registered Investment Advisor
The Bedminster Group

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