PDF version of the Market Outlook

The unbridled optimism we embraced one year ago was based on what we thought were absurdly low asset prices and the depression-era sentiment that accompanied them. That optimism has tempered in consideration of the percentage gains we have seen since that time. Our outlook is still a positive one, but we think it is now prudent to be more selective with respect to asset class weightings and more particular in regards to entry points for new investment. It is also sensible to maintain the liquidity that would be required to capitalize on corrections in market prices as we move forward. The Dow Jones Industrials (+5.1%), Standard & Poor’s 500 (+5.4%) and Nasdaq Composite (+7.1%) all finished the month with substantial gains. Industrials led sector performance for a second month in a row with a gain of 12.4%, while the telecom sector was the worst performer, posting a loss of 5.6% (source: Bloomberg.com).

We believe the Labor Department’s announcement that employers added 162,000 jobs last month will be the catalyst that finally draws individual investors back into domestic equities, providing the incremental demand necessary to achieve our fair value estimate of 1350 for the S&P 500 in 2010. The irony is that today’s payroll number is the caboose of economic indicators and not the engine. It has limited value as a forecasting tool with respect to the stock market. The jobs created last month simply affirm that our bullish outlook a year ago was an accurate one, and they validate to a large extent the increase in stock prices to date. In contrast, the media and most investors will likely view this news as a sign the coast is finally clear to take on risk in equities, and it will raise their hopes that the recovery is sustainable.

Just as the majority of investors buy into the recovery theme, we believe it is coming to an end, giving birth to a new economic expansion. The momentum in economic activity continues to gain strength. Corporate profits are on pace to exceed record highs in the second quarter. The four-week moving average for unemployment claims is now down to a new cycle low, and we expect job creation will average 100-200,000 per month through the remainder of this year. Railcar loadings and trucking activity are both on the rise, reflecting the increase in industrial production necessary to rebuild depleted inventories. The rise in consumer net worth, due to increases in home prices and asset values, has revived consumer spending. We believe nominal GDP will exceed its 2008 high in the current quarter, marking the point at which we transition from recovery to expansion. Why then are we tempering our enthusiasm?

The largest percentage gains in a bull market accompany the recovery. This period is best defined by a steady uptrend in leading economic indicators. We believe this period is nearing an end, and we expect the uptrend in leading indicators to stall in coming months. The expansions that followed previous recoveries have lasted an average of five years, and while we have no expectations yet for the one we believe is underway, we suspect the rate of asset appreciation is likely to slow and become more discriminatory. In May 2009 we established a target of 1200 for the S&P 500, which implied a forward return of 30% and marked the level at which the index was valued just prior to the onset of the credit crisis. We increased our fair value target to 1350 in January, which implies approximately 15% upside from current levels. We arrive at this target by applying a 16 multiple to our revised estimate of $85 in earnings for the S&P 500 in 2010. While our forecasts for economic growth, employment gains and corporate earnings remain well above consensus, we believe the next phase of this bull market will be far more challenging for investors than the 75% surge we have seen over the past year.

Our caution stems from several events we expect to unfold between now and year-end, the increase in volatility that is likely to accompany each and the uncertainty with respect to how investors will respond. We discussed the risks we see in international equity markets last month. China’s economy will undoubtedly slow from what was likely the peak rate of growth (we estimate 12%) in the quarter just ended, as the rate of inflation accelerates this summer well above the 3% target established by the central government. We expect interest rates and regulatory reserve requirements will increase as lending slows throughout the year. Sovereign debt issuance by EU member nations with heavy debt loads will plague the Eurozone in coming months, and we don’t doubt the possibility that intervention by the IMF will be necessary.

We expect the Federal Reserve to begin increasing short-term interest rates at its August meeting in response to stronger than expected gains in consumer spending and monthly payrolls, and we estimate the Fed funds rate will end the year in the 1.5 – 2% range. While such a move should be viewed as a return to normal market conditions, and imply that the economy is improving, rate-hike cycles have historically led to modest price declines in stocks. But we are far more concerned with what we believe will be a significant rise in long-term interest rates leading up to, and following, this inevitable event, and the consequences for the bond market.

Investors have been willing to take almost any risk to obtain an attractive fixed-income return in lieu of investing in the stock market. The weekly data provided by the Investment Company Institute (ICI) shows that investors continue to purchase taxable bond funds at more than ten times the amount being invested in stock funds, and the stock fund purchases that are occurring are predominately foreign funds. China has been a net seller of Treasuries for three months in a row. The avalanche of new Treasury supply required to fund our deficits will put upward pressure on yields. The negative returns for utility stocks this year, which serve as an interest rate proxy for equities, are indicating that rates are headed higher. Perhaps most disconcerting is that the Social Security trust fund is projected to pay out $29 billion more in benefits than it collects in taxes this year. As a result, the Treasury will need to begin paying back the approximately $2.5 trillion that Congress has borrowed from the trust fund over the past twenty years by issuing even more public debt. We expect 10-year Treasury yields to approach 5% by year-end, and the yields on other categories of taxable debt to rise in concert, resulting in negative returns for bond fund investors in the year ahead.

Our investment strategy could not run more contrarian to the fund flows we have seen in recent weeks. We have reduced our exposure to international equity markets and largely eliminated or hedged our exposure to fixed-income vehicles that are susceptible to principal loss in a rising interest rate environment. We have addressed the market risks we believe lie ahead and the potential for an increase in volatility by raising our cash levels. We do not believe these concerns will undermine the bull market. They simply necessitate a more tactical approach. In fact, the rise in interest rates may ultimately lead to a reallocation from fixed-income to common stocks.

We have been consistently bullish on financials dating back to the supposed insolvency of our banking sector. It comes as no surprise to us that this group has led S&P 500 sector performance over the past year, and we continue to believe financials offer investors the best risk-reward moving forward. We recently highlighted the data point that the 30-day delinquency rate for home mortgages declined in the fourth quarter of 2009. Now we find that the number of borrowers who have caught up on delinquent loans (cure rate) in the month of February exceeded the number of borrowers newly delinquent for the first time in four years. We expect these numbers to improve as payrolls grow, and we anticipate financials will continue to outperform, if not lead, the broad market in 2010.

Fuller Asset Management, LLC (FAM) is an SEC registered investment advisor. FAM and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisors by those states in which FAM maintains clients. FAM may only transact business in those states in which it is noticed filed, or qualifies for an exemption or exclusion from registration requirements.

This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. All information presented in this newsletter is believed to be reliable, but no representation or warranty (express or implied) is made or given by any person as to the accuracy or completeness of the information contained herein and no responsibility or liability is accepted for any such information or opinions. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security. Any subsequent, direct communication by FAM with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides.

For additional information about FAM, including fees and services, send for our disclosure statement as set forth on Form ADV from FAM using contact information herein. Please read the disclosure statement carefully before you invest or send money.

PDF version of the Market Outlook

The stock market ascent that began in March 2009 stalled on January 19th, at which point the S&P 500 had risen approximately 72% from the bear market lows. We view the correction that followed through early February as a healthy consolidation of these substantial gains. Despite this correction, the Dow Jones Industrials (+2.6%), Standard & Poor’s 500 (+2.8%) and Nasdaq Composite (+4.2%) all finished the month on a positive note. Industrials led sector performance with a gain of 4.5%, while the utility sector was the worst performer, posting a loss of 1.8%. We believe it is now critical to differentiate between the varying stages and underlying strength of the economic recoveries underway in the United States, Europe and the developing world, led by China.

We continue to see a strong and steady economic recovery in the United States, yet the public has dismissed the idea, and the stock market for that matter, because they don’t see it! Main Street’s pain has been in many ways Wall Street’s gain, but not in terms of bonuses and bailouts. Increases in employment and compensation have been muted since the recovery began, which in turn has been good news for inflation, productivity and corporate profits. The ratio of corporate savings relative to investment is at a record high, while capital expenditure as a percentage of GDP is at its lowest level in 38 years. This is a business-led recovery, not consumer-led as it was in the previous recovery, driven by increases in capital spending and inventory rebuilding. The gains in productivity and profits we have seen to date are what will eventually lead to an increase in employment and then consumer spending. Were it not for severe winter storms that swept the country last month, we believe we would be realizing these increases by now. We anticipate the first significant rise in employment (100-200,000) when March figures are reported in early April. This may be the positive sign that shifts public and investor sentiment, setting the stage for the stock market to eclipse the highs we saw in January.

Beyond 2010 the country faces major headwinds. It was Albert Einstein who said, “We can’t solve problems by using the same kind of thinking we used when we created them.” The vast amount of funds set aside in the Recovery Act ($275 billion) to invest in projects that create jobs has yet to be paid out. We have no explanation as to why, other than the obvious politicization of the funds in front of an election. The eventual spending will surely help sustain the recovery through year-end and into early 2011. Yet the majority of stimulus funds paid out so far have been used to postpone the harsh reality facing state and local governments in the years ahead – spending cuts and tax increases. The band-aids (stimulus funds) used to balance state budgets will fall off at the end of the year, and an additional $53 billion will be needed to balance budgets in fiscal 2011. This doesn’t begin to address the $1 trillion gap between the assets state governments hold and their future healthcare and pension liabilities. We remain cognizant of these longer-term issues, but do not think they present significant risks to the bull market this year. The impact long-term fiscal issues will have on financial markets in 2011 will be a function of the strength and sustainability of the expansion underway.

Our immediate concern now lies with international markets, and it has led to a change in our investment strategy. We stated at the beginning of the year that inflation abroad “will force central banks in developing countries to tighten monetary policy sooner than most expect, leading to what could be a significant correction in emerging markets.” Shortly thereafter, China increased short-term borrowing rates and regulator reserve requirements for its banking system in an effort to slow lending and avert price inflation. India has tightened monetary policy in hopes of containing a double-digit rise in food price inflation. We have also seen central bank rate increases in Australia, Malaysia and Israel. The benchmark for international stock market performance (MSCI EAFE Index) declined nearly 14% from its January 19th high before recovering some in recent weeks. What is troubling us is the recent divergence in performance between the international equity markets, led by China, and the United States. Despite what we expect to be robust growth in the developing world, we think the likely continuation of tighter monetary policy will limit the upside for emerging markets until later this year. But it is the European continent that concerns us most.

Europe’s economic stimulus plan, and the recovery that followed, have been faint when compared to the U.S. and China, and we expect virtually no economic growth in 2010 as a result. More importantly, the manner in which the European Union deals with the fiscal crisis in Greece has broad implications for the rest of Europe. We believe the EU will bail out Greece, but any ad hoc intervention that does not also address the fiscal crisis facing the member nations of Spain, Portugal, Italy and Ireland will be reminiscent of the Federal Reserve sweeping Bear Stearns under the rug of JP Morgan in March 2008. Could Greece be to Europe what Bear Stearns was to our financial markets in March 2008 – a warning sign? We don’t know. What we do know is that the same vulture investors that manipulated the debt and equity prices of our financial institutions in 2008 have taken aim at sovereign debt in Europe. Their weapon of choice is the credit default swap. If the EU chooses to address the fiscal crises of member nations on a case-by-case basis, rather than contain the systemic risk through a program similar to that of the Troubled Asset Relief Program (TARP) in the United States, then we fear more volatility in the months ahead. The indicators we rely on tell us to focus on wealth preservation with respect to international markets, and we believe it prudent to reduce that exposure at this time.

These concerns do not mute our optimism for domestic stocks. Despite efforts to contain inflation and slow its economy, we believe China will continue to lead the global expansion. The lending quotas established by the central government for 2010, while significantly reduced from 2009 levels, are still 40% above the trend that existed prior to the financial crisis in 2008. China’s imports are now growing at a faster rate than its exports. Our exports to developing markets, which have surged at an annualized rate of more than 40% over the past six months, now exceed those to developed ones. There is a major shift in the balance of trade underway that we believe will offset the likely decline in domestic consumption resulting from higher taxes and reduced levels of public spending.

We are also finding reasons for optimism within our own borders. Home prices, as measured by the Case-Shiller home price index, have now increased seven months in a row, which strengthens bank balance sheets and increases consumer net worth. Even more encouraging was a decline in the 30-day mortgage delinquency rate during the fourth quarter of last year. Some might discount this improvement as temporary due to government assistance, but the programs available do not prevent delinquencies. They assist already delinquent homeowners in order to prevent foreclosures. We believe the decline in delinquencies is coincidental to the decline in unemployment claims, soon to be employment gains, which should only serve to solidify the gains in home prices we have seen so far.

As we reduce our exposure abroad, we intend to look for opportunities in these markets, both developed and developing, later this year. We will be measuring the success of central banks in developing countries as they attempt to navigate soft landings, and we will be monitoring the European Union’s efforts to stabilize the fiscal crises plaguing several member nations. We continue to believe the U.S. will be the best performing stock market in 2010. We established a target of 1200 for the S&P 500 in May 2009. We then increased that target to 1350 at the beginning of this year on the basis that the economy would grow in excess of 4% and corporate profits would soar 25% in 2010. We now believe our profit estimates for the S&P 500 ($80) to be conservative, but we are not changing our target. Our sector emphasis remains focused on financials, industrials, energy, materials and technology.

Fuller Asset Management, LLC (FAM) is an SEC registered investment advisor. FAM and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisors by those states in which FAM maintains clients. FAM may only transact business in those states in which it is noticed filed, or qualifies for an exemption or exclusion from registration requirements.

This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. All information presented in this newsletter is believed to be reliable, but no representation or warranty (express or implied) is made or given by any person as to the accuracy or completeness of the information contained herein and no responsibility or liability is accepted for any such information or opinions. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security. Any subsequent, direct communication by FAM with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides.

For additional information about FAM, including fees and services, send for our disclosure statement as set forth on Form ADV from FAM using contact information herein. Please read the disclosure statement carefully before you invest or send money.

Performance History

*Composite inception 10/17/2005

Trailing Total Returns

PDF version of the Market Outlook

We decided to depart from our typical format this month to address the President directly in an effort to shed light on what we believe to be the greatest risk facing our country and our financial markets through the remainder of his first term in office. The Dow Jones Industrials (-3.5%), Standard & Poor’s 500 (-3.7%) and Nasdaq Composite (-5.4%) all finished lower for the month. Healthcare led sector performance with a gain of less than 1%, while the telecom sector was the worst performer, posting a loss of more than 9%.

Dear Mr. President,

It was with sound reason and centrist views as a candidate that independent voters accepted you as a viable alternative to the status quo. Yet in recent months your policy agenda has taken a sharp left hand turn off the road we believe leads to a sustainable economic recovery—a road that divides the two opposing and dysfunctional ideologies that plague Congress. Voters in Massachusetts made this abundantly clear following a special election last month in what could be interpreted as a demand that you reprioritize your agenda. Your response has been to push a more populist message that Democrats hope to be politically advantageous come November, but we view this as imprudent. The Dow Jones Industrials (-3.5%), Standard & Poor’s 500 (-3.7%) and Nasdaq Composite (-5.4%) all finished lower for the month. Healthcare led sector performance with a gain of less than 1%, while the telecom sector was the worst performer, posting a loss of more than 9%.

We endorsed your $787 billion stimulus plan last February under the auspice that it would be focused on the investments necessary to transform our economy and lead to economic growth that created jobs. What we have seen up to this point is predominately transfer payments, entitlement spending and tax benefits intended to induce consumption based growth. According to your website (recovery.gov), only $58 billion of the $275 billion in stimulus funds set aside for the grants, loans and contracts that create jobs have been paid out. Could this be one reason that the public is frustrated?

Your healthcare reform efforts, while well intentioned, did not succeed because you chose to focus on coverage before addressing cost containment. Forcing insurance companies to provide coverage for all and reducing government reimbursement rates would lead healthcare providers to negotiate higher rates with managed care companies. The higher rates would then be passed on to the insured in the form of higher premiums. The uncertainty surrounding such significant changes is more than Americans are willing to accept during difficult economic times. Our greater concern should be how we can continue to pay costs that are rising at more than double the rate of inflation. We believe that some states, facing bankruptcy, may have no choice but to no longer participate in the Medicaid program.

Your Administration’s response to the growing frustration over the economy has been to enflame the public’s outrage over the bailout on Wall Street. Meaningful financial reform that will prevent a future crisis has little to do with dictating salaries and bonuses or imposing a tax on bank liabilities to recoup losses from the bailout. Perhaps it is simply good politics, but it wreaks a hypocrisy that further undermines the public’s trust of government and thwarts the potential for progress. It is more than disingenuous to question compensation practices after approving $6 million pay packages for the CEOs of Fannie Mae and Freddie Mac this year and last, especially when the Congressional Budget Office estimates the total cost to taxpayers for the government takeover of both companies will be $389 billion. Proposing the largest banks pay a fee to cover the projected $68 billion loss likely to result from bailing out AIG and the auto industry is equally as glib when they have all repaid the loans they were forced to take with interest.

It would behoove you to recognize that we require as robust a recovery on Wall Street now as we hope to see on Main Street in the near future in order to maintain the high levels of economic growth needed to avert the looming fiscal crisis that lies ahead. Our $14+ trillion economy is saddled with more than $12 trillion in national debt. Your 2010 budget proposal totaling $3.8 trillion, which is expected to approximate 25% of GDP, has been exalted by your handlers as similar to President Reagan’s 1983 budget, which followed a recession and his first year in office. That budge totaled nearly 24% of GDP. The critical difference is that the national debt stood at less than 40% of GDP, and not the 85% we grant that you inherited today. We spent more on interest payments last year ($200 billion) than it cost to finance the wars in Iraq and Afghanistan in what was a historically low interest rate environment.

Based on Congressional Budget Office projections for the deficit over the next three years, even if we assume a 5% nominal rate of economic growth (GDP) and no increase in interest payments, the debt-to-GDP ratio will approach 100%. Economic growth has historically slowed dramatically in developed economies when this ratio exceeds 90%. Slower rates of growth result in a decline in tax revenue that further increases the deficit. Rising debt levels inevitably result in higher borrowing costs as creditors demand to be compensated for the additional risk. You can be sure that Republicans in Congress will continue to push for tax cuts, while Democrats insist on more spending initiatives, but since both are delusional, neither will materially reduce the deficit until a new crisis unfolds. Ultimately, you must use your powers of persuasion to raise taxes, reduce spending and embrace pro-growth policies that expand GDP in order to avert another financial crisis that would undermine your Presidency.

At the present time, we perceive there to be more risk to the bond market than in the stock market given the potential for a substantial increase in interest rates. We have noted our concern regarding individual investors piling into bond funds at what we believe is the bottom of the interest rate cycle, but the latest investment strategy to surface in the world of pension funds is a far better contrarian indicator. The State of Wisconsin Investment Board, which manages $78 billion, recently approved the adoption of a strategy to leverage their safest investments (government and investment grade bonds) in an effort to boost returns in lieu of investing in risky stocks following a decade of negative returns.

We believe the correction in stock prices last month (6% from recent highs) was in reaction to the more severe declines we have seen in developing markets. Australia has already raised interest rates three times in the past three months. China and India have both raised short-term rates and reserve requirement for their banking systems. They are tightening monetary policy to reign in the rise in inflation that naturally follows unprecedented economic stimulus. As the engines of global growth, it is not surprising to see investors pull risk off the table, but it is too early to tell whether these countries, led by China, will be able to contain inflation without stymieing economic growth. For the moment, the uptrend in equities markets has not been interrupted and we view this pullback as a consolidation of recent gains until we breach the previous lows on the S&P 500.

Performance History

*Composite inception 10/17/2005

Trailing Total Returns

PDF version of the Market Outlook

In 2009 our financial markets staged a historic rally from the bear market low established in March. That low coincided with what was the deepest point of contraction in economic activity during the worst economic downturn since the Great Depression. The Dow Jones Industrials finished the year with a gain of 18.8%, while the Standard & Poor’s 500 rose 23.5% and the Nasdaq Composite soared 43.9%. Technology led sector performance for the year up an astonishing 59.9%, while the telecommunications sector was the worst performer, finishing the year up just 2.6% (source:Bloomberg.com).

We began last year with an outlook that stock and bond prices, with the exception of Treasuries, would rise dramatically, on the basis that the forced deleveraging and panic-selling that devastated asset prices had run their course, and that the recession most feared was a depression would end by summer. We challenged claims by Wall Street’s most celebrated analysts that our banks were insolvent, under-capitalized and near nationalization just two weeks prior to the March lows. We established an upside target of 1200 for the S&P 500 at the end of April, believing that those sectors more leveraged to an improvement in the economic outlook, such as technology, industrials, financials and consumer discretionary, would lead in performance, while more defensively oriented sectors like healthcare, consumer staples and utilities would lag. We maintained our bullish stance throughout the year, focusing on the steady improvement in leading economic indicators that began in April as our guide.

As we reflect on the accuracy of our predictions over the past year, it comes as a small consolation to our shortcomings in the fall of 2008, when we fell victim to the same confirmation bias that we believe afflicts the majority of individual investors today. Investors are rightfully disillusioned after a decade marked by two recessions, worn out from two wars and a deficit that have no end in sight and absent any growth in industrial production, employment or real wages. The S&P 500 has lost an average of nearly 1% per annum for the past ten years – truly a lost decade. Furthermore, the investor class holds great disdain for the populist policies of the Obama administration, the bailouts on Wall Street, and the general ineffectiveness of elected officials that refuse to accept responsibility, instead directing blame towards anyone but themselves. In this environment, it is human nature to conclude that the future will be bleak, and then search for evidence that supports this conclusion.

The media serves to further entrench the prevailing attitudes of investors by awarding experts with extreme ideological views on either side of each issue more exposure and attention than they deserve. Common sense and practicality usually fall somewhere in between, as both sides distort reality in an effort to support their arguments. The most popular and mainstream views about our current state of affairs are often best depicted on the covers of magazines. One of Time’s recent issues was titled, “The Decade From Hell,” and a recent cover of The Economist shows a map of the United States falling into a chasm with the likeness of the Grand Canyon.

These sentiments are a far better representation of what has been, rather than an indication of what is likely to be in the future. Unwavering pessimism was a prerequisite to a legitimate market outlook at the beginning of 2009 for the consensus of investors, similar to the way cautious skepticism is today, yet stock and bond prices soared over the past nine months in what was the greatest percentage increase on record. As dismal as the prospects were at the beginning of 2009, the outlook could not have been any brighter at the beginning of the decade just ended, with government surpluses, near full employment and unprecedented prosperity. Few anticipated that we had come to the end of an 18-year secular bull market that began in 1982.

The flow of funds in 2009 best exemplifies the bearish sentiment that prevails today. The cash hoard earning negligible returns still stands well north of $3 trillion. Inflows of money into bond funds, gold, emerging markets and hedge vehicles stood in sharp contrast to the steady outflow of dollars from domestic stock funds throughout the year. We acknowledge that the state of the economy looks as grim today as it did following the severe recession of 1981-82. That was a time when deficits were soaring, unemployment exceeded 10%, and regressive tax cuts led to the elimination of interest deductions on every form of loan except home mortgages. The S&P 500 had produced a negligible real rate of return for nearly 16 years. Few foresaw the beginning of what would be an 18-year secular bull market in August 1982, during which the S&P 500 averaged double-digit rates of return.

It has been said that necessity is the mother of all invention. It was the necessity to build up our national defense during the Cold War in the early 1980’s, and the deficit spending that allowed us to do so, that gave birth in part to a technology revolution which transformed our economy and propelled economic growth in the years that followed. Today’s greatest necessity is energy. We expect solutions to the skyrocketing demand for new sources of energy to be at the forefront of the next secular bull market. We believe this bull market began last March, as we find ourselves at a similar crossroad to that of August 1982.

The improvement over the past nine months in leading economic indicators and the rate of decline in unemployment claims mirrors that which took place in 1982. We believe the unemployment rate peaked at 10.2%, and that January data will show the economy is creating jobs again. Regardless of the ideology behind fiscal and monetary stimulus, there is no denying a synchronized global upturn in economic activity is underway. Powering the recovery in the year ahead will be a staggering rise in industrial production to rebuild the record plunge in inventories, increases in capital spending by corporations and continued improvement in our trade deficit. We anticipate the spending of remaining stimulus funds on infrastructure projects will accelerate as we near the mid-term elections in November, serving to strengthen the robust data we would normally expect to see at this stage in the business cycle. We expect the economy will grow in excess of 4% and corporate profits will rise 25% in 2010. Based on these expectations, we are raising our target for the S&P 500 to 1350.

This outlook considers historical precedent, human nature and the current economic and investment landscape. Investors need to recalibrate their US-centric way of thinking to grasp the power of the recovery, for it is unlike any other in recent times. Waiting for a resurgence in home prices or consumer spending as an indication of economic health will leave investors empty-handed. This recovery is being led by developing countries, historically debt-laden and dependent on the U.S. for growth following previous economic downturns. Today, these countries, led by China, India and Brazil, have trade and budget surpluses and an emerging middle class to lead global growth.

We are fully aware of the headwinds the market is likely to encounter as the year unfolds. Our housing market is in the early stages of stabilization, growth in consumer spending will be lackluster as the savings rate rises and many of the federal government’s initiatives will detract from real growth. The fiscal and monetary stimulus programs will eventually wind down, and the economy will be forced to rely on the private sector for growth. The recovery will ultimately lead to higher rates of inflation and interest rates, as real growth strengthens and becomes more consistent.

Where we see risk in the financial markets is where most individual investors have sought a safe haven over the past year. Long-term interest rates are likely to rise from current levels, diminishing returns for bond fund investors. The dollar is likely to strengthen modestly, limiting the upside potential for gold investors. While we expect the core rate of inflation in the U.S. to remain tame in the year ahead, the nominal rate, which includes food and energy, should rise as the global economy recovers. We believe this will force central banks in developing countries to tighten monetary policy sooner than most expect, leading to what could be a significant correction in emerging markets. We expect the Federal Reserve to raise short-term interest rates this summer. Although this event is highly anticipated, previous Fed tightening cycles have led to modest corrections in the stock market. This will likely dictate a rotation out of market sectors more leveraged toward economic expansion, and into more defensive ones. It may also present headwinds for commodities.

We continue to believe the stock market’s advance will be led by the energy, materials, industrials and technology sectors as the recovery gains speed in the first half of the year. The financial sector presents one of the greatest risk-reward scenarios to us through year-end on the basis of a return to normalized earnings. While our outlook is extremely bullish, we do not intend to turn a blind eye to the message that the markets may be sending through relative price movements in various asset classes. The lessons we learned in 2008 are forever burned into our psyche, and we refuse to entrench ourselves in an outlook based upon what we think should transpire. When the facts change, so will our outlook.

PDF version of the Market Outlook

The stock market resumed its ascent in November with the Dow Jones Industrials (+6.5%), Standard & Poor’s 500 (+5.7%) and Nasdaq Composite (+4.9%) all registering gains for the month and new highs for the year. Materials led sector performance with a gain of 11.3%, while the energy sector was the worst performer, posting a gain of just 2.8% (source: Bloomberg.com). Bulls and bears are engaged in an intellectual tug of war over the mixed messages financial markets are sending as the value of the U.S. dollar plunges to multi-decade lows and the price of gold soars to all-time highs, while Treasury yields decline to levels not seen since the financial crisis. What do these developments tell us about the probable direction of interest rates and asset prices in 2010?

The U.S. dollar has been gradually eroding in value relative to the currencies of other developed countries ever since our budget surpluses turned to deficits nearly eight years ago. Our economic growth has been slow, debt-induced and accompanied by relatively low interest rates. The dollar’s long-term decline can be attributed to foreign capital withdrawing from our market and flowing to other markets that exhibit higher rates of growth and return. The major risks a weakening dollar present are that foreigners may no longer choose to fund our deficits by purchasing Treasury debt, and that the prices paid for the goods and services we import could increase. Both have the potential to cause a rise in interest rates and the rate of inflation that would further hamper economic growth. For these reasons, the federal government always purports to have a “strong dollar” policy, regardless of its economic agenda. Yet as the dollar has depreciated, inflation remains subdued, interest rates are near historic lows and foreign demand for Treasury debt remains strong.

Currency traders have more influence on the dollar’s value in the short rather than long term. We believe the dollar’s rapid decline this year can best be explained by the Federal Reserve’s interest rate policy. A currency’s yield is determined by short-term interest rates, and once the Fed lowered this rate to zero at the end of last year, there was little incentive for traders to hold the U.S. dollar. Dollars have been sold in exchange for foreign currencies that carry a higher yield in order to earn the interest rate differential on what is called the “carry trade.” Today, one could sell a U.S. dollar yielding practically zero and purchase an Australian dollar yielding more than 3%. The Fed has informed investors that it intends to keep interest rates low for an “extended period of time,” which has only served to reinforce the carry trade and place more downward pressure on the dollar. The Fed did emphasize that the extended period could be cut short by a rise in inflation expectations or a decline in the unemployment rate.

The bears have argued that the carry trade is brewing a new asset bubble in financial markets on the premise that speculators are leveraging their currency exchange bets by borrowing dollars at low interest rates to invest in stocks, bonds and commodities. This did occur in years past, with the Japanese yen serving as the funding currency, enabled by Japan’s central bank rates hovering near levels similar those in the U.S. today. Fueling the bear’s fear is the striking inverse correlation between the dollar and other financial asset classes. When the dollar falls, we see stocks, bonds and commodities rise in value, and when the dollar rises, they fall in value. The hole in this argument is that the loans which would be outstanding to fund this leverage don’t exist. We believe this to be more of a behavioral response by traders over fear that the influence a leveraged carry trade might present, rather than its actual existence. We believe that it is this fear that has led to a surge in the price of gold. The public’s insatiable appetite for the yellow metal reminds us of the euphoria that accompanied oil’s rise to $146/barrel in the summer of 2008. A strengthening of the dollar that should coincide with the continuation of the economic expansion could spell trouble for the gold trade.

While the negative aspects of a weak dollar have been center stage recently, there are significant benefits that we believe the Federal Reserve is welcoming, if not encouraging, with its current monetary policy, in light of our need to source economic growth beyond consumption. American companies are far more competitive in the global economy as the dollar weakens, because the goods and services we export become less expensive in foreign markets. The U.S. now exports more to developing economies than it does to developed ones, which is a trend that should continue, given that developing economies are leading the recovery. This has resulted in a surge in corporate profits. These profits ultimately lead to increases in employment and capital expenditures. This improvement in competitiveness is also encouraging an increase in foreign investment in the U.S. manufacturing sector, which in turn creates jobs and further improves our trade deficit. For these reasons we should be welcoming a weak dollar as the economy recovers, but ultimately anticipating its recovery at the same time. We believe a reversal in the dollar’s slide will ensue next year as the U.S. economy begins to create jobs and the Fed slowly begins to tighten monetary policy.

The decline in bond yields, Treasury yields in particular, has led to spectacular returns for bond funds this year. Individual investors have shunned stock funds, despite the historic rally, in lieu of income alternatives to the puny yields offered by money markets. We attribute the decline in Treasury yields to the unprecedented securities purchases made by both the Federal Reserve and the money-center banks. The Fed initiated a program in March to purchase $300 billion of Treasury debt and $1.25 trillion of mortgage-backed securities in an effort to keep interest rates artificially low and flood the banking system with liquidity. The objective was to encourage banks to lend, but up to this point they have been investing this cash in government bonds. Why? The government has imposed draconian capital requirements on the banks, which they must maintain if not increase, in order to repay the loans they received earlier in the year. Every new loan they make requires additional capital. Why make loans when a significant profit can be realized on a government bond that requires no additional capital so long as short-term interest rates are near zero. The percentage of bank balance sheets held in Treasuries has reached historically high levels.
The Fed recently completed its Treasury purchase program and will have fulfilled its target for mortgage-backed securities by next March. As loan demand recovers next year and lending standards begin to ease, the banks that are purchasing Treasuries today will likely be net sellers tomorrow. The absence of this demand and ultimate rise in short-term interest rates from levels that can’t go any lower will lead to an increase in bond yields, limiting the upside returns to bond funds that the public appears to be chasing today. We suppose interest rates could continue to decline from here, the dollar could spiral significantly lower and gold could soar another few hundred dollars, but we think a contrarian move on all three fronts is more likely.

The stock market has made a series of higher highs and higher lows since the bull market began in March. Until we see the market break below a previous low, we see little need for concern, and view each pullback as an opportunity to invest. Our upside target for the S&P 500 remains 1200. From a sector positioning standpoint, we believe it is prudent to underweight consumer discretionary stocks moving forward, and continue to underweight the healthcare, utility and staples sectors. We believe financials will reestablish their leadership position as we enter the new year and continue to view the energy, industrial, materials and technology sectors favorably on the basis that the global economic expansion will continue well into 2010.

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The string of seven consecutive monthly gains in stock prices ended in October over concerns that the economic recovery is losing momentum, despite a report that the economy grew 3.5% last quarter, signifying that the recession is likely over. The Standard & Poor’s 500 (-1.9%) and Nasdaq Composite (-3.6%) both edged lower, while the Dow Jones Industrials finished the month unchanged. Energy led sector performance with a gain of 3.2%, while the financial sector was the worst performer, posting a loss of 6% (source:Bloomberg.com).

Concerns that the recovery had stalled emerged following reports that weekly unemployment claims increased, consumer spending in September declined for the first time in five months, and consumer confidence slid in October. These reports cast doubt on the sustainability of the recovery, which many believe to be mostly driven by government stimulus. Fueling the negative sentiment were fears that the end of the home-buyer tax credit in November will bring a halt to the improvements in home prices and sales. Cynics argue that when the government’s stimulus efforts run their course, the economy will slip back into recession. Yet at the same time the index of U. S. leading economic indicators rose in September for a sixth straight month.

The market correction underway, similar to the ones we saw in July and September, is a correction in confidence and not economic fundamentals. While a weekly figure for first-time unemployment claims did rise, the four-week moving average declined for an eighth consecutive week to the lowest level in nine months. The decline in consumer spending for September was due to the end of the cash-for-clunkers program. Consumer spending actually rose on a monthly basis when auto sales are excluded from this artificially inflated figure. In fact, the current level of chain-store sales are on pace to far exceed the National Retail Federation’s projection for a year-over-year decline in November and December. We expect Congress to approve an extension and expansion of the home-buyer tax credit this month that will further support home values and sales through April of next year.

We can’t deny investors’ concerns and the public’s dismay, given the short-sighted policies coming out of Washington and the politicization of the economic stimulus funds to date. The vast majority of the billions of dollars approved for investment sit idle. What’s the excuse? The original plan was to spend the funds over a two-year period. Why two years? It is no coincidence that the mid-term elections will be held approximately two years after the economic stimulus plan was enacted. Meanwhile, programs designed to induce consumption, like cash-for-clunkers and the home-buyer tax, credit simply steal future demand so as to create the illusion that the status quo is better than reality dictates. These misplaced priorities are clearly demonstrated by the Obama administration’s announcement to send $250 checks to social security recipients for a total of $13 billion, compared to the $3.4 billion made available for projects aimed at modernizing the nation’s power grid. The $250 checks may buy lots of $10 toys at Walmart come year-end, and even fewer votes for incumbents in next year’s mid-term elections, but they do little to support job growth or the long-term investments we need to stay competitive in the global economy. Give a social security recipient a check for $250 and you feed him for a week. Create a job and you feed a middle-class family for a lifetime.

The sustainability of this recovery and continuation of the bull market underway depends predominately on one thing – employment. We still find more reasons to be optimistic than pessimistic, because our focus is on what the jobs data will look like six months from now rather than on what it was last month. Ironically, the rise in consumer spending (ex-autos) that contributed to a 3.5% advance in GDP last quarter is not the driver of growth or employment upon which our bullish outlook is dependent. That driver has yet to materialize. This is a profits-led recovery. The surge in corporate profits over the past nine months is unprecedented for a recessionary period. Therefore we should be focusing on the inevitable revival of corporate spending that will lead to job growth. Companies reduced labor costs and consumers cut spending earlier this year well in excess of what the severity of the recession in economic activity would normally dictate. This is because practically everyone assumed the recession was really a depression.

As home prices have stabilized and financial markets have recovered, consumer net worth has increased nearly $5 trillion over the past year. It has now returned to a level relative to disposable income consistent with the historical average that predates the stock market and housing bubbles of the past decade. We know that a rise in consumer net worth leads consumer spending by approximately six months, which bodes well for sustaining current spending levels as we move forward. Furthermore, we believe that earlier this year the 90% of consumers who are still employed cut back on spending more than necessary for fear their net worth would continue to decline. The dissipation of their fear explains the incremental rise in spending (ex-autos) from depressed levels over recent months and runs counter to the argument that the increase was stimulus induced.

Under the same misconception, corporations reduced expenses and cut employment well in excess of the peak-to-trough decline in economic growth (3.7%) in preparation for what they thought might be a depression. As a result, productivity and profits have soared and capital spending is down to its lowest level as a percentage of GDP in decades. Corporate revenues inevitably rise when the economy begins to expand, forcing companies to increase spending on capital equipment and to hire more workers.

Temporary employment continues to improve and the rate of decline in unemployment claims now exceeds the pace set in the previous two recoveries (1991 and 2001). Manufacturing employment surveys and the Institute for Supply Management’s payroll indicators are all moving higher. The current trajectory of the data leads us to believe we will see job growth by year-end, but the unemployment rate will still exceed 10% in the near term. An unemployment rate of 10% isn’t much different than the current 9.8%, but there will be a psychological impact on the public and undoubtedly visions of pink slips for politicians come next November. Herein lies the silver lining.

The unemployment rate exceeded 10% just two months prior to the mid-term elections in 1982, and the Republicans suffered significant losses in the House and Senate. We believe a 10% unemployment rate today will force the Obama administration to surrender political gamesmanship and accelerate an initiative Democrats intended to use prior to next year’s mid-term elections – a new jobs tax credit for businesses. We believe this would garner overwhelming support from both sides of the aisle and serve to speed up the improvement in employment that is already underway.

Another significant driver of economic and employment growth in coming quarters has yet to unfold. Businesses have continued to reduce inventories despite the improvement in sales activity. While industrial production is increasing, it is not increasing at the rate of end demand, so inventory-to-sales ratios are still declining. Businesses will be forced to bring inventories in line with sales over the next several months, which should boost economic growth more than most expect, further improving employment.

The trend in leading indicators that measure economic health six months from now collectively point to an improvement in the coincident and lagging indicators (unemployment rate) that the media emphasizes and the general public relies on to make emotionally based investment decisions. We believe these leading indicators will peak during the second quarter of 2010, at which point we are likely to temper our bullish outlook. In other words, when the unemployment rate is finally beginning to fall from its peak, and weekly unemployment claims (leading indicator) have bottomed, the majority of investors will finally feel comfortable taking on risk. From that point moving forward, stock market gains are likely to be muted relative to the gains we will have seen over the previous year. Investors scoffed at the idea of investing in stocks last April as leading indicators began to rise month-over-month, but they are likely to be euphoric several months from now just as these indicators peak. We believe we are beginning the seventh-inning stretch of the historic rise in stocks prices that began in March, and though we expect the breadth of participation to narrow in coming months, our upside target for the S&P 500 remains 1200. When the facts change, so will our outlook.

Our bottom line is that the economy is on the mend. The equation that supports our bullish outlook is unprecedented levels of liquidity plus historically low interest rates combined with elevated skepticism equals higher asset prices. Investors still hold more than $3.5 trillion in money market funds, which is nearly twice the historical average relative to the value of the stock market. The Federal Reserve is highly unlikely to raise short-term interest rates until the unemployment rate begins to decline, which we believe won’t occur until next spring. We can’t think of a bull market more loathed by the investor public than the one that began in March. Investor sentiment remains extremely subdued as evidenced by the flow of funds into stock and bond mutual funds. While investors directed more than $200 billion into bond funds during the first eight months of the year, there has been a net flow of just $15 billion into stock funds. This is all the evidence we need to know that most investors have not subscribed to the recovery thesis. The market should find its footing once again in November, following what may be a 10% correction from the October highs, but we would view this as yet another buying opportunity as the market averages achieve new highs before year-end.