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

Fuller Asset Management, LLC (“Fuller Asset Management”) is an SEC registered investment adviser. The Fuller Large Cap Growth Composite Portfolio (the “Composite Portfolio”) represents actual client accounts invested according to Fuller Asset Management’s proprietary investment strategy. The Composite Portfolio invests in individual equity securities with a view toward capital appreciation.

The results of the Composite Portfolio are net the actual Fuller Asset Management investment advisory fees charged to the client accounts within the composite, brokerage commissions and other expenses. Fuller Asset Management’s investment advisory fees are described in the disclosure statement of Part II of the Form ADV which is available upon request.

Accounts within the Composite Portfolio are held with different custodians so they are subject to different commissions and other charges. In addition, withdrawals and deposits, and account size among other factors creates variations in performance among accounts within the Composite Portfolio and also in comparison to the Composite Portfolio.

The results of the Composite Portfolio include dividends and other earnings. Comparison of the Composite Portfolio to the Russell 1000 Growth Total Return and the S&P 500 Total Return is for illustrative purposes in relation to the potential performance of large capitalization stock only and the volatility of the Russell 1000 Growth Total Return and S&P 500 Total Return may be materially different from the volatility of the Composite Portfolio due to varying degrees of diversification and/or other factors.

Past performance of the Composite Portfolio may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above, in part because client accounts may be allocated among several portfolios. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

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.

PDF version of the Market Outlook

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.

Performance History

*Composite inception 10/17/2005

Trailing Total Returns

Fuller Asset Management, LLC (“Fuller Asset Management”) is an SEC registered investment adviser. The Fuller Large Cap Growth Composite Portfolio (the “Composite Portfolio”) represents actual client accounts invested according to Fuller Asset Management’s proprietary investment strategy. The Composite Portfolio invests in individual equity securities with a view toward capital appreciation.

The results of the Composite Portfolio are net the actual Fuller Asset Management investment advisory fees charged to the client accounts within the composite, brokerage commissions and other expenses. Fuller Asset Management’s investment advisory fees are described in the disclosure statement of Part II of the Form ADV which is available upon request.

Accounts within the Composite Portfolio are held with different custodians so they are subject to different commissions and other charges. In addition, withdrawals and deposits, and account size among other factors creates variations in performance among accounts within the Composite Portfolio and also in comparison to the Composite Portfolio.

The results of the Composite Portfolio include dividends and other earnings. Comparison of the Composite Portfolio to the Russell 1000 Growth Total Return and the S&P 500 Total Return is for illustrative purposes in relation to the potential performance of large capitalization stock only and the volatility of the Russell 1000 Growth Total Return and S&P 500 Total Return may be materially different from the volatility of the Composite Portfolio due to varying degrees of diversification and/or other factors.

Past performance of the Composite Portfolio may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above, in part because client accounts may be allocated among several portfolios. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

PDF version of the Market Outlook

The bulls have long been overdue for a rest given the torrid pace of the rally that began last March. September, which has historically been the worst performing month of the year for the stock market, provided a golden opportunity for a correction, yet the markets refused to cooperate. The Dow Jones Industrials (+2.3%), Standard & Poor’s 500 (+3.6%) and Nasdaq Composite (+5.6%) all finished the month of September with substantial gains. Industrials led sector performance with a gain of 6.6%, while healthcare was the worst performing sector, posting a gain of less than 1% (source:Bloomberg.com).

We could not summon a more supportive environment for financial markets. The negative numbers that the bears cling to are all lagging indicators, while the positive ones are all either leading or coincident. As the dollar continues to weaken, Treasury yields are falling, inflation is non-existent and credit spreads have collapsed. Stock, bond and commodity prices are rising in concert, and home values have registered their third consecutive month-over-month increase. Liquidity is still abundant and investor sentiment is cautious at best.

Critical to sustaining the market’s current uptrend through year-end will be a continuation of the improvement in housing and employment data. There are reasons to be optimistic on both fronts. With home prices still depressed and mortgage rates below 5%, home affordability is at record highs. The S&P/Case-Shiller home-price index recently reported its largest monthly gain in nearly four years (for July) as the trend in sales of existing and new homes continues to improve. Some have argued that the numbers are skewed because the majority of sales have been foreclosures. When the $8,000 tax credit for first-time home buyers ends in November, sales will slide and home prices will decline again. Yet further analysis of the monthly data reveals that the percentage of sales attributable to first-time home buyers has steadily declined from March through July. We believe that the incremental rise in home prices will continue, which will support a further improvement in sales.

We are anticipating further declines in weekly unemployment claims and in the number of jobs lost each month, with the expectation that there will be job gains by year-end. Corporate profits have risen dramatically over the past six months, despite the lack of economic growth, primarily due to the reduction of labor costs. As profits have risen, business confidence has gradually improved, which is a precursor to hiring new employees. Now that the economy is expanding again, revenues will start to rise and companies will be forced to hire new workers to meet demand for goods and services.

There is no better evidence of the improvement in business confidence than the flurry of acquisitions and strategic investments announced around the world last month. This is an indication that financial markets remain undervalued, despite their meteoric rise since March. Regardless, individual investor sentiment remains guarded, as shown by the net redemptions from equity mutual funds in recent weeks. The consensus of leading economists is equally as reserved in their expectations for corporate earnings and economic growth in the year ahead. This caution is significant because it is the dichotomy between perception and reality that determines the potential for market returns moving forward. We believe the vital signs for the economy indicate that the consensus of investors and economists are still too pessimistic.

As the gap between perception and reality closes in the months ahead, we will need to more closely monitor some major headwinds that have the potential to steer this bull market off course. One major concern is that once the inventory cycle has run its course and the benefits from the economic stimulus plan end, the artificial prosperity we enjoyed from debt-induced consumer spending over the past decade will not be there to support economic growth. At this stage, we are not concerned.

Household wealth rose in the second quarter for the first time in two years as the amount of consumer debt continued to decline, and retail sales are on track to increase in the third quarter, even when we subtract the boost in auto sales from government subsidies. Consumer spending will undoubtedly level off next year as the savings rate rises, but even if its contribution to economic growth is negligible, we see an offsetting factor that few are acknowledging. In previous recoveries our imports of goods rose dramatically as our exports to trading partners declined, leading to an increase in the trade deficit that detracted from growth. This was in large part due to the indebtedness of developing countries and their lack of domestic consumption. Today developing countries are leading the recovery because they avoided the leverage that encumbers growth and have realized the emergence of their own middle classes. As a result, our exports are rising faster than our imports, which is narrowing the trade deficit and contributing to growth. We believe this new development, should it sustain itself long-term, has the potential to offset the decline in domestic consumer spending as the savings rate rises.

Another concern is inflation. The government’s prudent response to the bursting of the credit bubble has been to inflate our way out of it by increasing the money supply, lowering short-term interest rates to zero, and borrowing and spending even more. Opponents of this policy point to the weakening of the dollar that has resulted and the inflationary pressures they believe will follow. The nominal rate of inflation, which includes energy, is set to soar over the next few months, but not for the reasons just mentioned. Energy prices plunged in the fourth quarter of last year, which means the year-over-year comparison used to determine the headline inflation rate will show a substantial increase as we enter the fourth quarter of 2009. We expect this to raise concerns, but they are misguided. The Federal Reserve focuses on the core rate of Personal Consumption Expenditures (PCE) when determining inflation risks and monetary policy. This inflation gauge measures the average increase in prices for all domestic personal consumption and accounts for changes in spending habits caused by price changes. This figure is forecasted to decline over the next year by leading economists, which will substantially ease the need for the Federal Reserve to withdraw liquidity and tighten monetary policy to the extent that it thwarts the rise in asset prices.

Fearful memories are persistent in people’s minds. Many of us know someone who lived through the Great Depression and was permanently changed as a result. This apprehension is pervasive today in light of the dramatic downturn in the economy and financial markets last year. Fed Chairman Bernanke offered his expert opinion just days ago that the recession is “likely over.” The market is up nearly 58% from the lows in March leading up to his conclusion. Our message has always been that the markets look forward 6-12 months. The financial media will continue to get lost in the day-to-day minutia, with its central focus on reporting what will attract the most viewers, as opposed to truly informing investors. We will continue to focus on incoming data that is forward looking (leading indicators) and allow this information to dictate our investment strategy. In our May Outlook we established a year-end target of 1200 for the S&P 500. Over the past five months our confidence in this forecast has only increased as the arguments for sustainable growth continue to outweigh the potential headwinds.

PDF version of the Market Outlook

A powerful and synchronized upturn in the global economy is underway. While the bears have been convinced for months that a significant decline lurks just around the corner, the bulls remain in complete control of this market. The Dow Jones Industrials (+3.5%), Standard & Poor’s 500 (+3.6%) and Nasdaq Composite (+1.5%) all finished the month of August with impressive gains. Financials led sector performance with a gain of 12.8%, while telecommunications was the worst performing sector, posting a loss of 2.4% (source: Bloomberg.com).

At the beginning of the year we built our case for an economic recovery unfolding during the summer months, led by a dramatic rise in stock and bonds prices (with the exception of Treasuries), on the expectation that financial markets would look beyond the recession and toward recovery. This outlook was considered highly improbable at the time by most on Wall Street. At the end of March we staked claim to the idea that a new bull market in stocks was underway–a notion considered equally implausible by most investors. Our assertion in May that the financial sector would lead the rally through the remainder of the year was easily the most unbelievable of our predictions based on the media reports about bank nationalization then prevalent. These views were not brave attempts to throw a Hail Mary pass deep into the end zone, but conclusions we believed were logical, based on the facts presented to us. Our main objective has always been to interpret the economic data and filter the news flow without bias in an effort to explain to our readers how things really are, as opposed to how we would like them to be. Using this same methodology today, we believe the economy will continue to improve and we are finding more reasons to be optimistic about the financial markets.

The bullish camp is no longer the ghost town that it was earlier in the year. Most investors will acknowledge that the recession many feared was a depression now appears to be ending, and the stock market has rallied more than 50% from the March lows, led by the financial sector. As corporate earnings reports and data measuring the health of the economy have beat expectations, leading economists and influential market strategists have been forced to raise their estimates. This is not to say that investor sentiment, a contrarian indicator, is overly optimistic by any measure. The state of panic most felt at the beginning of the year has abated, but the cash held in money market funds earning next to nothing still approximates 40% of the value of Standard & Poor’s 500.

The bears argue that the 50% surge in the stock market is “irrational exuberance.” They claim that the improvement in the economy is temporary and stimulus-induced. When the stimulus fades the economy will slip back into recession. They believe that the surge in corporate profits is a result of nothing more than cost cutting and that we are unlikely to see revenue growth in the year ahead. They see tepid consumer spending and a rise in the savings rate as significant drags on economic growth with no offset. Home prices will continue to decline, loan losses will continue to mount and the unemployment rate will continue to rise. The problem with this line of thinking is that there is nothing to support it given the economic data we have seen in recent months. Instead, we believe the negative sentiment on Wall Street is an expression of the overwhelming disdain the investor class has for the populist policies of the Obama administration. Yet it is a huge mistake to base an investment strategy on the hope that it will validate a particular political view. We must simply play the hand we are dealt.

The 50% rise in stock prices is truly historic, but so was last year’s decline. We view the market as being down more than 20% over the past 12 months and just returning to levels first reached more than a decade ago. We believe the economic recovery to date is more attributable to an improvement in business confidence and the inventory rebuilding that results from a normalization of the business cycle than to the economic stimulus. The bulk of the $274 billion in infrastructure spending included in the stimulus plan has yet to be distributed. It is perfectly normal to see the initial rise in corporate profits result from cost cutting as we embark on a recovery. What is not normal is to see a rise in profits during the first half of this year that set a record for a recessionary period. This bodes very well for employment gains in the months ahead. We acknowledge that the consumer will be a drag on growth, but this negative is balanced by the benefits we are realizing from the steady improvement in our trade deficit.

We do believe this new bull market is at an inflection point, but not one that will bring comfort to the bears. Stocks began to recover in March at the same time that economic indicators which historically lead a recovery in economic growth began to turn up. These indicators are collectively known as the Leading Economic Index (LEI). Some of the components of this index that we have discussed in recent months include weekly unemployment claims, the money supply, consumer confidence and new orders from purchasing managers (PMI). The sequential improvement in this index since March has led to its first year-over-year increase, which historically coincides with the end of recessions. This now sets the stage for an improvement in coincident indicators of economic growth–an improvement that we believe will lead to a significant turn in investor sentiment and a new leg up in this bull market.

Industrial production is likely to soar over the coming months in an effort to rebuild the unprecedented decline in inventories that followed the credit crisis. We believe the economy will grow north of 4% through the end of this year and well into 2010. As a result, the improvement in employment numbers is also likely to be more robust than the consensus expects. The trends in layoff announcements and unemployment claims continue to improve. The stabilization in home prices and increase in new home starts should lead to an increase in construction employment. The recovery in stocks and bonds should lead to an increase in employment in the financial sector. As for the $274 billion in infrastructure spending included in the stimulus plan, less than a third of the proposed projects are funded and only a fraction are underway. Regardless, a significant number of jobs will be created as a result.

We are not deaf to the long-term headwinds that face our economy and we are not attempting to spin the data available to achieve a desired outcome. We are simply focusing on what matters most to the financial markets. We believe that when investors see a resumption of economic growth that exceeds consensus estimates, accompanied by the continued improvement in employment data, sentiment will shift from skeptical to optimistic, and the trillions in cash now earning negligible returns in money market funds will move into the stock market. Our initial target in this next leg up in the bull market is 1200 for the S&P 500. A correction of 5-10% from current levels will not sway our outlook, since we believe it will be met with aggressive buying by those that missed this initial rally off the March lows.