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 January 2010 Taking Leave
That's a powerful run under any conditions, but 2009 was even more challenging. If nothing else, last year demonstrated why market timing tends to be loser's game. When the year started, there was little reason to believe equities could break even, much less post above-average gains. Nevertheless they did, despite a frozen credit market, tremendous deficit spending, and unemployment exceeding ten percent. Corporate earnings did improve in the latter part of the year, but that was mainly attributable to cost cutting, not real revenue growth.
The riskiest stocks led the market in both the early year declines as well as the subsequent rally. Small caps eclipsed large caps, and growth reassumed style leadership following a decade-long absence. Financial shares made a remarkable comeback, especially in light of the ongoing credit freeze. Bonds eked out small gains, but with interest rates near historic lows, they'll be hard pressed to achieve even those meager results in the coming year. That's to be expected as the economy makes the turn from recession to renewed growth.
Signs of Recovery In late December, President Obama told the Washington Post saving the economy was his biggest accomplishment in his first year in office. Although he didn't touch upon it, extricating the government from the economy will be an even bigger challenge in 2010. The Fed has signaled it's already contemplating the exit strategy. The statement released after the December Federal Open Market Committee Meeting offered a more upbeat reading on the economy and listed the support programs expiring in early 2010. Allowing them to do so is the first step in a return to more typical monetary conditions. Market watchers are looking for the first actual rate increase in mid-2010.
With short-term interest rates near zero, the Fed is in uncharted territory. So far they've done an admirable job with the credit crisis, but can they now reverse course without choking off the nascent recovery? On the other hand, waiting too long for signs of growth could give inflation an opportunity to take hold, an equally unappealing option. The Fed always seeks to keep the economy on an even keel, but when it reaches extremes as it did last year, a "soft landing" is even more elusive.
Rough Road for Bonds Higher long-term rates also negatively impact the housing market. Thirty-year mortgages are priced off the ten year Treasury Note. (This may seem odd, but the ten year note is actually a good approximation of the duration of thirty year mortgages given that so many are terminated early by sales or early repayment.) As the yield on the ten year Treasury Note rose over seven-tenths of a percent in the past two months of 2009, 30-year mortgage rates moved over five percent and closed in on six percent. Many economists believe the economy won't truly turn the corner until the housing market recovers or at least stabilizes. While rising yields may not thwart the recovery, they are likely to slow it as well as improvements in the housing market. On the other hand, others may benefit. Generally a widening yield spread indicates investors are becoming less risk averse. When they sell Treasury securities -- generally considered the "safest" and least risky investments -- they plow the proceeds into riskier alternatives such as stocks, commodities, or even high-yield bonds. Last year's paralyzing credit freeze followed from the opposite motive: Excessive risk aversion. Markets struggle under those conditions because they are prohibitive to trading and investment, inherently risky undertakings. But a steeply sloping yield curve is just the tonic for banks that borrow at the short end and lend at the long. The greater the difference between the two extremes, the greater their profit opportunity.
The last time yield spreads neared current levels was at the conclusion of recessions in 1992 and 2003. Both were followed by multi-year recoveries. Could this happen again in 2010? All else being equal, it would seem probable. But all else is not equal. While monetary policy is poised to return to more normal conditions, fiscal policy is another issue. Last year's $787 billion stimulus bill along with other emergency spending left record deficits. State governments -- that unlike the federal government don't have the luxury of printing dollars -- are already fiscally strapped and will be forced to raise taxes to make up the difference. Congress' national healthcare plan will imposes taxes years before benefits with some scheduled to kick in this year. In the past, the early stages of economic recovery has not been a fortuitous time to raise taxes and slow the process, but this time there aren't many alternatives. Can the recovery sustain the blow? We'll find out over the next twelve months.
Spotty Stock Picking It's hardly arguable that 2010 starts off in much better economic and financial condition than 2009, but beyond that, there's very little clarity for investors. As suggested above, fixed income investments have a tough road ahead as interest rates are sure to rise. Banks with decent balance sheets may be able to exploit the widening yield spread to boost profits and derivatively, share prices. But this won't be the case for all financial stocks, particularly insurers that will be subject to greater government regulation and price controls. Should inflation show signs of revival, Utilities, Energy, and Materials firms are best positioned. If the recovery continues apace, Techs and Industrials could lead the way. On the other hand, if there is a double-dip back towards recession, Consumer Staples and Utilities are the places to be. Until unemployment shows tangible improvement, consumer discretionary shares will remain under pressure All signs indicate the economy is pulling out of recession. How rapidly and to what extent is more in the hands of the government than the financial market. As unpredictable as the market has been over the past two years, it's still more predictable than the government. At the very least, 2010 should be interesting. Search this site! Just enter you key word or words:
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HE STOCK MARKET IS USUALLY only labeled "unpredictable" in the aftermath of a major decline, but that unpredictability produced a remarkably positive return in 2009. On the heels of 2008's one-in-fifty year loss, stocks
of the S&P 500 jumped 23.5 percent. Making that even more notable is the fact that the round trip from March lows left
them 65 percent above the bottom.
