Bartlett Commentaries
Market Commentary, 01 / 2010
2009 in ReviewEquity markets made additional progress in the latest quarter, continuing a steady resurgence from bear market lows reached last winter. Stocks were buoyed by several factors previously mentioned in our October commentary: encouraging corporate profit reports, significant merger and acquisition activity, and historically low interest rates. A year that began so badly, climaxing in panic during early March when stocks were in freefall worldwide, ended with returns exceeding 25% for most equity markets. It was also a great year for corporate and municipal bonds. Their prices rose as yield spreads returned to more normal levels, resulting in double-digit returns for many securities. U.S. Treasury bonds posted negative returns, an outcome we warned about last year noting extremely low yields that provided no margin of safety.
Economic and Market ConditionsThe stock market is widely recognized as a reliable leading economic indicator because it usually bottoms three to six months before recessions end. True to form, the market rebound started last March and economic recovery began in July. The US economy grew by approximately 2.5% in the third quarter and growth of 3% seems likely for the just completed fourth quarter. Recovery is underway in most European and Asian economies. The bond market is also a good economic barometer, and in this regard the steepening of the yield curve (long-term bond yields rising relative to short-term yields) has been encouraging.
Notwithstanding promising market signals, there is considerable skepticism about the nascent recovery. This mindset is actually healthy. It means companies have been vigilant about controlling costs and raising productivity, while consumers have been more careful about spending and saving. This also means that just a moderate improvement in corporate and household spending would buoy the economy. So it is noteworthy that business inventories increased in October after thirteen consecutive months of decline, indicating that companies are carefully preparing for continued improvement. Furthermore, research and development spending is expected to rebound in 2010 after a 3.8% cutback in 2009, the first decline since 2002. Consumer spending is more problematic but should improve this year because recent data show no significant worsening of the unemployment rate. Renewed business and consumer activity is critical to a sustained recovery. Government policy – monetary and fiscal – has done the heavy lifting so far but will eventually be reduced.
Outlook and StrategyThough the 2010 economy should be better than 2009, you should expect more subdued performance in financial markets. The best stock market years are near the end of recessions – 2009, 2003, 1991, 1982, and 1975 among recent examples. Signs of economic recovery invariably lead to anticipation of tighter monetary policy and higher interest rates, which are headwinds for stocks and bonds. Look for this pattern to repeat again in 2010. We think the domestic stock market is unlikely to return more than 8-10% this year, and bond returns in the low single digits are the best we can project given current interest rate levels.
We believe high quality companies are relatively cheap following a year when more speculative stocks were in the forefront. In general, high quality stocks have moderate price/earnings multiples of 10-15 based on realistic profit forecasts. Moreover, many have secure and growing dividends that are competitive with yields available in the bond market. The possibility of ongoing US dollar weakness, due to large and expanding federal budget deficits, makes us favor companies with significant overseas exposure, especially in emerging markets. Their earnings in foreign currencies could translate into more dollars. We also selectively favor foreign stocks and equity funds focused on overseas markets. Commodity-oriented companies, such as energy producers, are a continuing favorite. Finally, we remain on the lookout for special opportunities among middle and small capitalization stocks.
As for bonds, we think a very careful and selective approach is required because lower yields provide very little margin of safety. Corporate bonds still look much more attractive than Treasury securities, and municipal bonds are appropriate for investors in higher tax brackets. We favor bonds with less sensitivity to rising interest rates recognizing that inflationary pressures, though currently low, could gain traction in a few years if the Fed’s current very accommodative monetary policy is reversed. Furthermore, the aforementioned large federal budget deficits – though easily financed in 2009 – could ultimately lead to higher interest rates.
Be assured we are constantly aiming for a realistic balance between return and risk. This approach has been proven to deliver good risk-adjusted performance over the long term.
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