In the last three weeks, publication of the balance of 2009 economic statistics, market action, and political developments have combined forcefully to create a volatile investing environment. They have also provided some indications of what we might expect in 2010. We felt that these developments warranted a postscript to the quarterly Perspectives newsletter which you recently received.

Fourth quarter 2009 GDP hit a six year high of +5.7%. The biggest contributor at +3.4% was a slower drawdown of inventories by businesses. Initially this may seem counterintuitive, but when businesses draw less from inventory, it means they will have to produce more unless consumption falls dramatically. And consumers did increase spending. Exports also surged. Consumer spending continues to be stronger in 2010 than anticipated, especially with current high levels of unemployment. Businesses have resumed making capital expenditures such as technology. Reported profits in S&P 500 companies increased an estimated 41% quarter over quarter in December 2009 after 7 negative quarters and are expected to log even higher percentage increases this year. Home prices appear to have bottomed and are turning up; home inventories are down.

Yet the market as measured by the S&P 500 has fallen over -9% from its 2010 high in January and is down almost -6% year to date as of this writing.

Why the turnaround from early January? And why did it rise throughout the last nine months of 2009 in the face of a barrage of bad news, while it falls in 2010 amid news which is better on balance, showing signs of stabilization and even economic growth?

The trouble began in the week ended January 22, when China announced measures to tighten monetary policy and raise bank lending reserves in the face of strong growth and rising inflation there. Tightening in China is a huge policy issue because of that country’s impact on global growth expectations and commodity prices, and steps taken to moderate growth there reverberate around the world. Domestically, the Democrats were thrown into disarray with Scott Brown’s election in Massachusetts and responded with populist rhetoric targeted primarily at financial institutions, pushing those stock prices down. The broader market followed.

With the abrupt turnaround in political focus away from health care reform to financial reform and more stimulus suggested, latent capitalist fears of increased government intervention in the economy and business took hold. At the World Economic Forum in Davos, Switzerland, US leadership was openly questioned. While markets generally like political gridlock because it prevents too much government intervention, they do not do well under weak presidents. There are also worries that the current gridlock may make it next to impossible to achieve deficit reduction which is of paramount importance.

In the administration’s proposed budget released February 1, increased taxes on higher income individuals and fees on large financial firms were inadequate to address the federal deficit, which is on track to hit a record for peacetime. Deficits abroad also made headlines. With Greece, Spain and Portugal in precarious straits, the concept of sovereign debt default (countries not paying principal and/or interest on their bonds) reared its ugly head, and the economic model of the European Union was challenged anew.

With all of this said, the simplest explanation of recent market action is that it just went up too far too fast in 2009, and we are encountering some profit-taking. The market leads GDP by many months and is a useful indicator of future economic trends, especially when the percentage moves are significant. At the moment, the percentage move is too small to be predicting a double dip recession or worse. Due to the strength (albeit uneven) of global growth, the underlying statistics argue more in favor of a buying opportunity developing.

Much will depend on policy decisions taken in the next weeks and months. Over the last nine days, the Obama administration has announced 8 new initiatives aimed at creating new jobs and lifting exports, but they are all instruments of the federal government. The market would prefer less intervention.

Please call us with any questions or feedback you might have. Our best wishes for a mutually prosperous year.

Ruth and John Mullen
February 5, 2010

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