January 2010

2009 Summary
This past year saw the best annual market performance since 2003—a year of recovery after the tech downturn. The S&P 500 finished 2009 with a gain of 26.5%.¹ Given such a high level of recovery for the broad market it is not surprising that we saw great variations in performance between sectors. High yield bonds did very well, with the U.S. OE High Yield Bond benchmark (Morningstar’s high yield fund benchmark) showing an increase of 45.5% for 2009!² Investment grade bonds also saw double digit returns, with the U.S. OE Intermediate-Term Bond and U.S. OE Long-Term Bond benchmarks (Morningstar’s benchmarks for corporate bond funds) posting returns of 13.4% and 15.9% respectively for the year—rates of return not seen since 1995.² While still down from its summer 2008 high, the broad market has recovered substantially from its spring 2009 low and is poised to continue to grow. The general consensus amongst economists is for continued economic recovery both within the U.S. and internationally in this coming year. I would not expect the market to repeat 2009’s performance in 2010 though. With the turmoil we have seen within the economy this past year there are several fronts to look to in trying to build realistic expectations for the coming year.

Corporate Earnings
Businesses in general have made a large number of cost-cutting moves over the past 18 months. This has left a number of companies in the position to see double-digit profit growth with only small increases in sales. As more companies emerge from this downturn more focused on their bottom lines, we will likely see stronger earnings push their stock prices higher. The consensus S&P 500 operating earnings estimate for 2010 is $77.56, a 30% increase over 2009.³ Blackrock has estimated 2009 4th quarter U.S. GDP to be up by about 4%⁴, a large rate for an established economy like ours. Growth is expected to be greater during the 1st half of the year, with either lower levels of growth or some slight correction into the 2nd half of the year. However, analysts are no longer discussing double dip recessions—only “loss of steam” or “slight corrections” as the economy transitions into a more normal growth mode from the current one of recovery.

World View
U.S. growth has been leading the global recovery. Expectations are for a rally of the U.S. Dollar against the Yen and Euro, with emerging market central banks tightening easy money policies relatively near to when the U.S. Federal Reserve Board does. Many emerging market based corporations and governments came through this downturn in better shape than developed markets due to better credit management and have become a sector to watch. I would expect this sector to do well in the next several years and would add money to this sector on market dips.

Interest Rates
Interest rates remain at historically low levels. The Federal Reserve has not indicated any near-term interest rate hikes, and is likely to communicate news well in advance before raising rates so as not to surprise the markets. The general consensus is that interest rates on U.S. Treasuries will see an increase in the coming year, but not by much as lower rates continue to help the economy recover.

Inflation
An area of concern we have heard much about this past year is inflation. Governments around the globe have been spending via various stimulus plans in order to fill the void left by consumers. The U.S. government has been aggressive in its fiscal policy- likely helping the economy from a worse showing had there been no intervention. Yet this spending comes at the same time the Baby Boom generation is beginning to retire, creating increased obligations for social welfare programs like Social Security, Medicare, and Medicaid. The Federal Reserve has acknowledged their awareness of this situation and will be monitoring the economy for signs of rising inflation as the economy regains ground lost. Continued excess capacity within both labor and production should keep inflation under control in the near term. The high inflation we saw in the late 1970’s and early 1980’s was partly fueled by significant wage increases, something we will probably not see in the next few years.

Signs of Employment Recovery
Economists are seeing signs of a cautious job recovery. Large temporary help firms—such as Manpower—release monthly data showing current demand for temporary help. These figures are an important data point. Due to the nature of their employment temporary workers are generally the first fired and the first rehired within a business. Data released by the Bureau of Labor Statistics shows a recent increase in the use of temporary help.³ Charting this data back through the 1960’s shows an inverse correlation between the general unemployment rate and the use of temporary workers. History has shown that a peak in unemployment tends to coincide with a bottoming of temporary labor demand. The data seems to be showing such a bottoming in the 4th quarter of last year. Given that we are already seeing a measurable increase in the use of temporary labor, it is likely that permanent hiring and, thus, lower general unemployment are to follow as these workers either become permanent employees or are replaced by permanent hires. This should result in an increase in personal consumption, accelerating the growth of the economy in the year ahead.

I would note that the Institute for Supply Management’s (ISM) Manufacturing Index rose again in December, continuing a 5-month trend.⁵ This report shows gains in new orders, production, employment, and prices, while showing a decline in customer inventory and order backlogs. With the exception of order backlogs, all of these measurements of manufacturing activity are furthering trends begun 3-9 months ago. This indicates a firm expansion of the manufacturing sector as manufacturers are trying to meet rising product demand. This is expected to lead to new hiring and bodes well for the overall economy.

Overview
We are recovering from a significant recession, not a depression. Businesses have shown concrete signs of recovery on several fronts and the probability of a double dip recession is now quite small. It must be noted that we are still in a recovery, not back to business as usual though. Unemployment levels are still high, continuing to place pressure on already battered housing and retail spending based sectors of the economy. However, preliminary signs of increased employment are becoming clearer and businesses are showing profits.

Housing is still a weak point in the economy. Historically low interest rates, the continued employment of the vast majority of the work force, and significantly lower home prices have worked in conjunction with the temporary first-time home buyer tax credit to help push outstanding inventory down. Still, national foreclosure rates remain at historically high levels—with some areas of the country affected dramatically by foreclosures. It will take time for housing to finish its correction, but as housing prices and interest rates remain relatively low this sector will recover in the long-term.

Unemployment is a lagging indicator and will remain so. In the tech downturn of 2001/2002 the stock market began going up in the spring of 2003. It was not until 2005 that unemployment returned to historic levels. Businesses do not make long-term investments in labor until they have strongly recovered from any negative impacts to their balance sheets. However, we are starting to see the unemployment situation in the country improve and are likely to see further gains as we move further into this recovery.

“Measured growth” seems to be the key economic phrase for 2010. While the statistics show the recession to have receded, the impact of it will be felt for some time. We are still facing changes to several sectors of our financial system via governmental regulatory reform as lessons are learned from this recession. We will still see areas of economic weakness, but now mixed with areas of growth. The economy has begun a recovery and will continue to do so this next year. While likely not as nail-bitingly dramatic as 2009, 2010 promises to be another interesting year on the economic front.

1) http://quote.morningstar.com/Index/Quote.aspx?ticker=SPX

2) Morningstar Office

3) Briefing.com—Economic View 12/4/2009

4) Blackrock Investment Commentary, 1/11/2010

5) http://www.ism.ws/ISMReport/MfgROB.cfm

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