Mid Year Update 2009

As we pass the mid point of the year, many analysts and economists are predicting an economic recovery beginning sometime in the next six months. Whether or not this actually happens remains to be seen. These are the same people who have been predicting improvement in the second half of 2009 since the beginning of this year. Well, we are now in the second half of 2009 and each day that passes is one less day.

While we remain hopeful and optimistic about the chances for recovery, the economic data so far has been mixed; so we have to be realistic to the facts at hand. Stock price appreciation during the second quarter ending in June, which resulted in one of the best quarterly performances for the S&P 500 Index in the past decade, has basically discounted the expected improvement in the economy. In other words, everyone now believes the economy will improve sometime in the next six months and the stock market has moved higher in anticipation of that improvement. However, we believe there are several headwinds facing the markets as we move into the back half of 2009.

• The trajectory of economic growth could be weaker than most expect
• Savings rates (consumer and corporate) will probably remain high, curbing consumption
• Consumer expenditures could remain low for an extended period of time
• The likelihood of higher taxes in the future could impact any recovery
• Deleveraging of corporate and consumer balance sheets continues for some time.

Although the recession from a statistical standpoint is probably over, we should consider the possibility of a W-shaped economic recovery, wherein a brief period of positive growth over the few quarters (brought about by massive amounts of fiscal stimulus), would be followed by another economic setback sometime in 2010; given the headwinds above. This scenario seems more possible than a rapid V-shaped recovery. More importantly, we feel it is the unknown, not the known, that has the potential to move markets and in turn impact the economy. The biggest unknown is what will be the ultimate impact of deleveraging, new government policies/regulation, and massive fiscal stimulus all occurring simultaneously.

Just as an increasing of the money supply caused the stimulation in the economy and appreciation of asset prices earlier this decade, the destruction of money is causing a widespread global economic contraction. This contraction could last longer and impact an economic recovery more than most expect, perhaps into 2010. It should be understood that if money creation stimulates an economy then the destruction of massive amounts of money through deleveraging should have an opposite effect and diminish the hopes of a rapid and sustained recovery. Only time will tell.

According to some estimates, US households have lost over $13 trillion in wealth since the beginning of 2008; the worst decline on record. It is likely that this kind of destruction in wealth will have some lingering effects and undoubtedly influence consumer attitudes in the future. How does the government hope to replace over $13 trillion in lost wealth? The answer is simple - it can't. Time is the only instrument which will cure what ails us. Time is what will ultimately heal the economy.

As for the stock market, the economy is secondary to earnings. For the stock market it's all about earnings. Our current assessment is that the US market averages (based on S&P 500) are in the range of fair valuation based on current earnings estimates for 2009, along with the assumption earnings estimates increase this year. Our valuation assumes earnings estimates for the S&P 500 will increase to roughly $60 before year end; about where the consensus was at the beginning of the year. Current estimates for S&P 500 earnings for 2009 are roughly $56, a slight increase from one month ago. Earnings are just starting to be adjusted upward, which is a positive sign. If conditions continue to improve, we could expect upward adjustments to earnings estimates after second quarter earnings are released by companies this month. If earnings estimates increase, this will help support current valuations.

As we enter the back half of 2009, our hope is that the second half of this year is better than the second half of last year. We are sure you will agree!