Before writing our year-end newsletter, I always take a glance at the previous year's edition. In last year's version, "2009, thankfully" I identified two potential catalysts for a market rally in 2009. The first was a turn in the employment situation. Clearly, the employment numbers have improved over the course of the year, with the latest report showing that non-farm payroll employment was essentially flat in November. The second catalyst was corporate earnings. Here too, it seems clear that corporate earnings have bottomed with estimates for 2010 trending higher over the last several months, primarily led by greater than expected productivity. Not surprisingly, the market has rallied sharply from its March low, with the S&P 500 up approximately 25% for the year as this edition goes to print.
Skepticism abounds... OK, how many people think 2010 could be even better? My guess is not many. Typically, strong market years breed bullish prognostications, but that doesn't seem to be the case currently. Just why is that?
We can't blame it all on the Mayan Calendar... According to the Mayan Calendar the world is going to end on December 21, 2012. Admittedly, I have not studied this well known prophecy, nor frankly, do I plan to. Yet our sensitivity to doomsday scenarios has been heightened to such an extent that alarmist predictions are almost mainstream. Thankfully, alarmists are usually wrong. Remember Y2K? It turned out to be a non-event.
I am not saying there is nothing to worry about. The growing federal deficit and the fear of future inflation and higher interests certainly gives one pause. At the current pace it is difficult to envision our leaders in Washington having the political will to significantly reduce the deficit over any reasonable time frame. Meanwhile, individuals, families, and businesses are all working their way through the Great Deleveraging cycle. The federal government will eventually follow this trend. Keep in mind that it is the inflection point that will turn investor sentiment as it relates to the deficit, just like less job losses becomes a positive statistic. In other words, the market would likely rally sharply at even the hint that Washington is serious about tackling the deficit.
Back to the bearish case... Bearish forecasts are built on the foundation of accelerating inflation, rising interest rates, and a weak US $. For 2010, deflation is a greater risk, in my opinion, than accelerating inflation. The largest component of consumer inflation is unit labor costs, which continue to decline. As illustrated by the soaring productivity numbers, companies continue to find ways to produce more with less.
Can this continue forever? No, but as long as it does there will not be any pressure to increase wages and salaries. Moreover, the unemployment rate remains well above its long-term average, despite its recent drop in November. Again, it is difficult to see wage pressure while the unemployment rate remains so high.
My sense is the Fed will likely begin to gradually raise interest rates some time in 2010. This will not happen until the economy is fully and clearly on the road to recovery. But when it does, the slide in the US $ may abate. At least for 2010, the bearish case appears to stand on shaky ground.
The biggest surprises in 2010 will be... I think the biggest surprise in 2010 might be a stronger year than most expect. The catalysts for another impressive year are the same - employment and corporate earnings. What could derail these two drivers?
My primary concern for 2010 is the lack of support for small businesses, which historically have been the driving force behind growth in employment. It's hard to see health care reform as a positive development for small businesses. Meanwhile, credit remains tight for established small businesses, and is even less available for start-ups and emerging companies. Any progress to create a better environment for small businesses would be very positive for the overall market.
The current estimates for the S&P 500 calls for an increase in earnings of 27% in 2010. In response, the market P/E has rebounded from a low of 10x in December 2008 to 15x, more in-line with historical averages. What this means is that the market is not as undervalued as it was at the end of last year.
It seems logical, then, that strong corporate earnings growth, low inflation and interest rates, and an improving job market could support a rising trend in stock prices into 2010. As always, we will continually challenge our strategic thinking in response to changes in the economic landscape. Whatever develops, we will remain committed to finding industry-leading companies in attractive industries, and being disciplined regarding buy and sell points. This has been a tried and true formula for our continued out performance of the equity benchmarks.
We wish you all a blessed holiday season.
