2010 Outlook

Interest rates and stock prices are linked by perceived financial opportunities - risk versus reward. A prolonged period of artificially low interest rates will eventually lead to speculation and mal-investment as we witnessed over the past decade. The Federal Reserve has pegged short-term interest rates at near zero percent for the past twelve months, necessitating most investors to seek alternative methods of income through greater speculation in the market or accept a nominal return of less than 1% on cash. Early in 2010, the Fed sent notice to banks alerting them to guard against higher interest rates going forward – not exactly headline news given that nominal rates can’t go below 0%. No doubt the Fed was responding in part to growing concerns regarding the enormous supply of debt coming to market this year and the steepening of the yield curve by market forces in recent months. Throughout 2009, the Federal Reserve had more or less straightforwardly stated that its targeted Federal Funds rate would remain pegged at the 0-1/4 % level for the foreseeable future. While the truth plays out, the Fed realizes that there is greater risk in ending its free money and quantitative easing policies, that are attempting to reflate a deflationary economic environment, than in further debasing the U.S. dollar with the risk of hyperinflation later on. Maintaining the status quo, that is to say reviving confidence in an engorged fiat financial system, is the order of the day. Many astute economists have pointed out over the years that the hidden tax of inflation will result in the impoverishment of the middle class. As one of our clients recently suggested, we will need a return to tea party politics if we are to overcome the seemingly insurmountable issues confronting our country today.

Meanwhile, as investors we must operate within the financial circumstances of the time to best protect the purchasing power of our hard-earning capital and avoid many of the risks inherent in an increasingly speculative investment environment. At times, AICs’ advice may look overly cautious relative to the promises portrayed by those who profit from market instability. Regardless, our attention will continue to be focused on the long-term preservation of capital and purchasing power first and foremost.

The market gains from the lows set in March ‘09 represent an approximate 50% recovery from the losses sustained during the current downward cycle. It is interesting to note that approximately only 10% of the issues in the S&P 500 index are trading at new 52-week highs although the market is at a 15-month high. This recovery carries with it a higher degree of risk to invested capital than previous normal market recoveries, given the unprecedented level of government stimulus and the structural changes afoot in the economy. Housing and autos are not likely to lead us out of the current recession as they did in past modern recessions. Deleveraging in all sectors of the economy (with the exception of the public sector), unprecedented budget deficits, rising real unemployment levels exceeding 20%, the reserve currency status quandary, etc., prompt a different view of recovery this time around.

The outlook for 2010 from our perspective is one of upward pressure on interest rates, higher commodity prices, continued inflating of the currency, weakening housing prices, rising taxes, and further job losses. All is not lost however – corporate earnings could improve in coming months on a relative basis, given year-over-year comparisons. The question is; “has the market already priced in a better earnings picture?” In our opinion, the answer is “most likely”. Corporate capital spending remains subdued and rightly so given the prevailing economic uncertainties and the unanswered questions of higher taxes and health care cost going forward. If “money” can find its way into the economy (we remain somewhat skeptical of the governments efforts to date), then the market may continue to trend a little higher in the short run on the hopes of an eventual economic recovery and a return to job growth. However, if “money” remains on the balance sheets of the banks and credit (debt is “money”) continues to contract, then all asset prices are likely to recede further – potentially, much further –similar to what Japan has experienced over the past two decades.

An era of excessive debt and over-consumption cannot be resolved by still more borrowing and consumption. Something has got to give and that something is spending. Wealth is not created by producing “money” out of thin air … what is created are poor millionaires.

Overall, caution remains key as many economic and monetary storm clouds continue to hover on the horizon.

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