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4th Quarter 2009
After the financial and
economic turmoil that began in 2008, 2009 saw the US
economy shrink by 2.5%. The stock market continued its
fall until the beginning of March but then staged a
sharp rally once signs of economic improvement appeared,
producing the best calendar year return since 2003,
while bringing to an end the worst decade on record
for US stock performance. The "Great Recession"
appears to be coming to an end and, although it involved
a lot of pain, proved less dire than many had feared.
GDP growth turned positive
in the second half of 2009, and we expect that trend
to continue, with GDP growth of 2.5 - 3% in 2010. The
continued recovery will be helped by increased demand
from emerging markets, the rebuilding of inventories
and an improvement in employment and personal incomes.
The index of Leading Economic Indicators has moved up
sharply while fiscal and monetary stimulus are working
their way through the system. We believe that the unemployment
rate has peaked and expect the economy to start adding
jobs within the next few months. GDP per employee has
now risen to the point where more hiring may be warranted.
An increase in hiring along with the rebound in household
net worth will produce a modest rise in personal incomes
and spending.
The main threat to GDP growth
lies in the private economy not recovering by the time
the effect of the unprecedented fiscal and monetary
stimulus wears off. Many states are in fiscal crisis
and have been supported by federal stimulus money which
is now going away. This may cause public sector employment
cuts - a problem if the private sector cannot pick up
the slack. Increases in taxation may also hamper the
business sector, particularly small business which provides
most of the nation's employment. While the domestic
real estate market has improved, there is still a shadow
over the housing market due to high inventories and
the commercial real estate market will continue to be
distressed for a while. A major unknown, however, also
lies in geo-political and global terror risks. Extremely
adverse events could affect US and world economies and
stock markets.
In the near term, inflation
and interest rates are likely to stay low. Inflation
will be subdued in the coming year due to low capacity
utilization and modest employment cost increases. The
Federal Reserve has stated its intention of keeping
interest rates low for the foreseeable future, but we
would expect them to start creeping up by year end.
There is a longer term inflation threat if the huge
amount of public debt becomes monetized, but so far
the velocity of money has stayed low (due to banks'
reluctance to lend combined with some slack loan demand)
and the Federal Reserve has laid out plans to remove
liquidity from the system when the economy is back on
track. It remains to be seen whether the political will
exists to do so once a widespread recovery is underway.
With the exception of the
financial sector, corporate America weathered the downturn
relatively well, managing to maintain margins through
astute cost control. A pick up in top line growth from
a reviving economy will allow profits to rise in the
double digits. Since the market is trading around its
long run average P/E of 15 (on forward earnings), we
believe that the increase in profits will allow the
US stock market to grow in the low double digits for
2010.
In the wake of a turbulent
2009 featuring volatile stock price moves on what we
believe to be unsustainable factors, we expect the market
environment in 2010 to be more favorable for our investment
process. Low quality stocks led the recovery rally last
year, and their returns relative to high quality stocks
reached peaks similar to those last seen in 2003 and
1999. History suggests high quality stocks retaking
leadership in 2010. Last year also saw a spike in stock
price correlations, which proved a difficult environment
for bottom-up stock selection processes like ours. Recently,
stock price correlations have begun to drop, a factor
which should make 2010 much more of a stock pickers
market. In 2009, companies generating losses enjoyed
the highest stock price returns, but as the business
cycle moves forward cash flow generation is likely to
be a much more important stock selection factor. We
expect more normal stock market behavior going forward
and stocks with better than average cash flow and profitability
to outperform in 2010.
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