Annual Review of 2009 and Outlook for 2010

Performance Summary

It is likely that very few, if any, investors will soon forget the capital markets of 2009 and the roller coaster ride that virtually everyone experienced. To be sure, it made no difference if investments were in the equity or fixed income markets, or if investments were exclusively domestic or diversified globally, the ride can only be described as a white-knuckle experience that will be talked about for many years to come.

Looking at the U.S. equity markets, the year began on a somber note following a very rocky end to 2008 with the equity markets in a free fall until eventually bottoming out on March 9, 2009. On that day, the Dow Jones Industrial Average (DJIA) reached 6,547 and the Standard & Poor’s 500 Index (S & P) hit 666, both measures being 12-year lows. Following that sentinel event, the markets staged a blistering rally that continued for the remainder of the year with only one brief and relatively shallow 7% pullback along the way. When all was said and done, the DJIA was up 18.8 % for the year while the S & P gained an impressive 23.5%. The most remarkable aspect about the advance from the March lows was the size of the rally. The DJIA advanced 59.3% from its March low and the S & P rose 67.5% from its low. In a similar vein, the Nasdaq Composite reached its 2009 low in March and then rallied an eye popping 79%, closing out the year with an impressive 43.9% advance for the entire period.

An analysis of the 2009 U.S. equity markets reveals some interesting facts about the components of the S & P 500 Index. According to Bespoke Investment Group, the 50 best performing stocks in the Index during 2008 gained only 9% last year while the 50 worst performers of 2008 doubled in price. Similarly, the 50 largest stocks in the Index advanced only 22% while the 50 smallest gained a whopping 113%. Interestingly, those stocks paying the highest dividends rose 36% and those stocks with no dividends climbed 72%. Finally, those companies with the most foreign revenue rallied 71% as the dollar weakened while those with the least foreign revenue rose only 28%.

Within the various style and capitalization categories, large-cap growth funds handily outperformed large-cap value funds, mid-cap growth funds narrowly bested mid-cap value funds, and small-cap growth funds outperformed their small-cap counterparts. The best performing equity group was the mid-cap growth funds with an average return of 40.4% for the year. Among the sector stock funds, science and technology turned in the best performance with a return of 53.8% with natural resources a distant second with a return of 40.5%. Also within the sector funds, utilities had the worst performance with a return of 16.4%.

A report on the markets would not be complete this year without some comments on the performance of the U.S. equity markets over the last decade, the first decade of the twenty-first century. Based upon records dating back almost two hundred years, the recently concluded calendar decade, which produced an average annual return of -0.4%, is the worst such period since 1820 when reliable records began. Of course, this dismal performance followed on the heels of the 1980s, when a bull market began, and the 1990s when the bull market gathered further steam. Interestingly, the 1990s was the best calendar decade in history with an average annual return of 17.6%. As the twenty-first century dawned, there were many strategists who sounded cautious and some who believed that more subdued returns were in the offing for the early part of the new century. Little did investors realize how poor the returns would be. “Regression-to-the-mean” can be a gut wrenching experience when the long-term annualized return from equity investing has been approximately 9.5%. With the beginning of a new decade, investors should probably lower their expectations for the next few years and expect average annual returns closer to 7% rather than the higher returns experienced only a short time ago.

During 2009, the international equity markets performed in a fashion similar to the U.S. market after reaching a nadir in the first calendar quarter. For the full year, some of the more impressive gains (in U.S. dollar terms) were Brazil +127.1%, Australia +70.9%, Hong Kong +67.4%, South Korea +56%, Mexico 48.2 %, Great Britain +39.5%, France +28.6% and Germany +24.1%.

Turning to fixed income, the credit markets were in disarray during the first quarter of 2009. However, with the U.S. Government implementing a broad-based stimulus package including many new programs initiated to restore liquidity and stability to the capital markets, investors gained confidence that the worst crisis since the Great Depression had been averted. The result was a record breaking flow of money into riskier assets and away from U.S. Treasuries. High-yield and low-rated corporate bonds returned 57.5% for the year according to a Merrill Lynch index. In addition, investment-grade bonds turned in an impressive performance of about 20% according to a Merrill Lynch index. With investors moving away from safe U.S. Treasuries and into riskier assts, the returns on U.S. Treasury notes and bonds showed losses of between 3% and 13% depending on their maturity. During the year, the U.S. government sold a record-breaking $2.1 trillion of new debt into the marketplace to fund its programs and budget deficit.

Economic Review of 2009

The U.S. economy began the year mired in a deep recession that officially began in December 2007 and was showing no signs of imminent recovery. Doom and gloom were pervasive as consumers hunkered down, businesses continued massive layoffs to slash operating costs and the Federal Reserve maintained an easy money policy to accommodate the credit markets. The newly installed Obama administration pushed through a massive fiscal stimulus package intended to jump start the economy and, hopefully, create millions of new jobs. The fiscal stimulus combined with creative and innovative new programs implemented by the Federal Reserve and the U.S. Treasury served to revive investor sentiment by early March and ignited a massive rally in the equity and fixed income markets that continued for the remainder of the year.

While investor confidence was restored to some degree, the economy was slow to respond and continued to show a further contraction in Gross Domestic Product (GDP) in the second calendar quarter. However, by the third quarter, the economy slowly gained some positive momentum helped in part by the “cash for clunkers” program, which gave a shot in the arm to the moribund automobile industry, and a one-time tax credit to first-time home buyers which was originally set to expire at the end of November. The fourth quarter gained further ground as exports surged, helped by the weak U.S. dollar which made goods produced within the U.S. more competitive in world markets. Additional help was provided when businesses were forced to increase production when inventories reached unacceptably low levels relative to final sales. Although there were signs that the manufacturing sector was improving on the back of rising order rates, businesses continued to layoff workers in an effort to squeeze as much profit as possible from every sales dollar. The year ended with various economic indicators showing a few more encouraging signs. Significantly, the all-important Christmas selling season was modestly better than had been expected as recently as late November. In spite of these positive signs, businesses continued to shed workers in December and the unemployment rate remained at an uncomfortable 10.0%.

Economic Outlook for 2010

While the economy begins the new year with a measure of positive momentum, there is no shortage of headwinds that will likely make this economic recovery and expansion more challenging than previous episodes. Among the issues on the horizon are such diverse items as the following:

A cautious and reluctant consumer (usually responsible for about 70% of GDP) will likely not provide the normal boost to economic activity following a recession as consumers continue to increase their savings rates and adjust their spending habits to the new economic realities.

High unemployment levels, currently at 10.0%, will likely be slow to decline due to a weaker than expected recovery and the huge numbers of workers who have become discouraged and withdrawn from the job market. When these out-of-work individuals return to the labor markets, their re-entry will keep upward pressure on the unemployment number well into 2010.

The sluggish automobile industry will likely struggle to regain its footing. While the industry benefited from the “cash for clunkers” program during the summer of 2009, it is thought that considerable demand was pulled into the summer months of last year and may adversely affect sales during the current model year.

The housing industry has struggled for the last two years but has shown some signs of stabilizing in recent months. However, much of the recent sales activity has been aided by a first-time buyer’s tax credit that was set to expire on November 30, 2009 but was extended until April 30, 2010. As part of the extension legislation, a smaller tax credit was made available to all home buyers. There is concern that once these special incentives expire this spring, the housing market may sink back to a lower level of transactions.

The threat of protectionism is ever-present and has become more of a threat recently as governments seek to protect their own industries from foreign competition. In a slow-growing economy, governments are particularly sensitive to pressure from their constituents to save jobs at home.

Increased taxes are in the offing as the U.S. Government grapples with an annual budget deficit in excess of $1 trillion. With projections showing trillion dollar deficits as far as the eye can see, it is a virtual certainty that a variety of taxes will be raised in the coming year which will exert fiscal drag on economic growth.

Inflation concerns are rising as the massive amounts of liquidity injected into the economy during the past 15 months work their way through the system. While inflation may not be a significant problem in 2010, due to the high unemployment rate and the amount of slack in the economy, there is concern that within the next couple of years inflation may become a worldwide problem.

Rising interest rates appear inevitable given the level of interest rates at the start of 2010. Although the Federal Reserve has kept short term rates at historic lows (0.00% to 0.25%), the Fed has indicated it will begin raising short term rates when it believes the economy has achieved a self-sustaining recovery. In fact, several Fed governors have stated that when the Fed begins raising rates, it may raise rates faster than in previous recoveries. Furthermore, with the U.S. Government issuing record amounts of debt to fund the budget deficit, it remains to be seen how long foreign buyers will be willing to purchase these securities without demanding higher interest rates than presently available. The benchmark 10-year U.S. Treasury began 2010 yielding approximately 3.80% with many strategists expecting the yield to rise to between 4.25% and 4.75% by the end of 2010.

U.S. debt is growing at an astonishing rate with the overall debt of the U.S. Government likely to double in the next five years. Fiscal discipline must be reinstated in the halls of Congress if the U.S. is to retain its status as a world leader.

The commercial real estate market is far from healthy with mortgage delinquency rates rising throughout 2009. Shopping centers are particularly hard hit and there are some knowledgeable professionals who believe this sector will be the next big problem for U.S. financial institutions.

National health insurance legislation will likely be enacted early in 2010 and promises to add additional financial burdens on consumers and small businesses. With these increased costs, small businesses will be less likely to add to their staffs which will further slow employment growth, a significant problem since small businesses have traditionally been the engines of employment growth within the U.S. economy.

Rising costs on small businesses due to increased government regulations will negatively impact small business and their hiring plans.

States and municipalities have festering budgetary problems that seem to grow worse with each passing month. If the economy experiences only modest growth in 2010, these government bodies will be faced with either further reducing the level of services to their citizens or imposing higher taxes or a combination of both.

In contrast, on the positive side there are signs that many countries around the world are experiencing renewed growth which is resulting in a significant pick-up in exports. This has provided a positive shot in the arm to many U.S. based businesses and bodes well for renewed growth, and with it, a need to hire additional workers. Overall, the U.S. economy appears to be poised for GDP growth of 2.5% to 3.00% for all of 2010. While subpar by most historical standards, growth of any size will be most welcome by consumers and investors having survived the worst economic and capital markets meltdown since the Great Depression.

Market Outlook

After the dramatic market action of 2009, the outlook for 2010 is decidedly more muted. If the economy experiences modest GDP growth, corporate profit growth will likely disappoint many investors who are anticipating a return to “the good old days”. During the last two years, corporate managers aggressively reduced payrolls to improve efficiency in an effort to squeeze as much profit as possible out of lackluster sales. While they did a remarkable job in a difficult environment, corporate profit margins are already at historically high levels and unlikely to improve further. Hence, managers are anxious for sales gains to drive profits but, given the level of economic uncertainty, will be reluctant to quickly add to payrolls Security analysts remain very optimistic about the growth of corporate profits in 2010 while investment strategists are more restrained in their forecasts. With expectations inordinately high, the likelihood of disappointments as corporate earnings are reported is higher than normal.

With respect to equities, the market appears to be priced for solid corporate profit growth and seems fully valued at current levels. Importantly, with price/earnings ratios already at long term averages, it is highly unlikely there will be a further expansion in P/E ratios particularly with the prospect of rising interest rates. Therefore, it seems prudent to expect equity returns in the 7% to 9% range with at least some risk to the downside. Furthermore, it is well to remember the markets have only experienced a brief 7% correction since the current rally began on March 9, 2009. A correction of 10% to 15% or even 20% should be expected at any time and would be considered a healthy development within a bull market. Nevertheless, markets have a history of climbing “walls of worry” so further market gains could occur in spite of all the concerns associated with the current economic recovery.

With respect to fixed income, U.S. Treasuries did not reward investors in 2009 and are likely to repeat that performance given the rising interest rate environment envisioned for 2010. High-yield and lower-rated corporate debt were the standout winners for 2009 but performance in 2010 should see returns not much different than the coupon on these debt instruments. Likewise, investment grade corporate bonds will likely produce return close to or slightly less than the coupon on these securities.

Stephen K. Kent, Jr., CFA, CIC
January 15, 2010