Market Thoughts

I'm getting ready for an investment committee meeting on Monday, so it gave me a chance to try to synthesize our thoughts about the economy and markets.

Here's a copy of some of my notes:

Meeting Notes – 1/25/10

Overall:

Market is at an inflection point. Government catalysts for strong rally since March 2009 will be missing in 2010. Private sector needs to perk up.

Items to Watch:

1. Washington

· Odds against significant health changes. Negative for health care stocks, which had rallied since last November in anticipation of changes.

· “Glass Steagall Lite” removes financial sector tailwind;

· Confirmation of Bernanke for another term as Fed chairman in doubt;

· Taxes almost certainly have to rise for all.

· Defense spending will probably decline mid-2010

2. China
• Chinese economy growing rapidly again Stimulus package passed by the Chinese govt. had an immediate (positive) effect on economy;
• Still, some questions on sustainability of recovery, especially if trading partners remain sluggish;
• “War of words” on internet, climate policy, etc., doesn’t help. Also illustrates a more confident Chinese govt. that is less concerned about US opinion

3. Capital Markets

· Huge demand for lower quality credits – credit fears gone. Investors bidding lower quality assets aggressively – spreads nearly back to where they were in early 2008;

· Yield curve is at its steepest level in at least 25 years. The good news: Investors can’t stay in 0% cash forever. More good news: steep yield is usually a harbinger of strong economy.

· Higher yields and more future inflation pressures are widely anticipated. But is all of the “bad news” in the bond prices?

4. Earning expectations

· Consensus earnings expectations for S&P 500 +24% for 2010 and +21% for 2011. Groups with most expected earnings upside: energy/commodities (+47% in 2010) and technology (+26%). Lowest expectations in consumer staples (+7%) and telcom/utilities (+7%).

· While numbers may look aggressive initially, they are all coming off low bases in 2009. Overall S&P earnings not expected to get back to 2007 levels until 2011.

· On negative side, earning estimates are usually too high at the end of recessions. Also, analyst margin expectations are very high – near historic peak. Is this realistic?

5. Economy

· Unemployment a huge problem – actual figures in high teens if you include “discouraged” workers. Business reluctant to make new hires in uncertain economic environment. Final health care costs also not clear;

· Inflation simply not a problem – too much capacity. Unit growth volumes are rising, but pricing keeps falling

Investment Implications - Stocks

Overall Market

• Probably due for a correction but, if economy improves and short term interest rates remain low, market should finish year higher;
• Low quality, high beta stocks did best last year. Historically high quality outperforms over longer periods of time. Also, higher quality stocks are just statistically cheaper;
• Earning expectations are achievable, but are “upside surprises” possible?
• Large cap, dividend-paying stocks look cheap. Small cap stocks that offer M&A potential (i.e. large cash positions) might interesting as well.